Simon J. Evenett, Professor, University of St. Gallen

03.11.2011   Public sector austerity plans have received much media coverage over the past years. But in economies such as the US, UK and Spain, where consumers ran up huge private debts during the boom years, private austerity will constrain national economic performance.


The past 18 months have seen government after government cut spending and increase taxes. Some have been more successful than others. Greece, for example, wasn’t and by the summer of 2011 it had to be rescued from another debt crisis. Concerns that insufficient progress tackling fiscal deficits in Italy, Spain and even France have rattled financial markets in the Eurozone. Meanwhile, US politicians played Russian roulette with the markets when they failed to raise the federal debt ceiling in an orderly manner.


A Shifting Focus

The focus back then was clearly on public austerity. But this overlooks the growing private austerity in many of the economies where individuals ran up huge debts during the boom years. Repaying those debts will alter medium to long-term national economic performance in at least three ways, each described in the sections that follow. Bearing in mind that private consumption expenditures are between six to ten times as large as government spending on goods and services in most industrialized economies, then the impact of private austerity on the concerned economies could be much more severe than the announced public sector retrenchment.
 
That private sector debts grew fast in many countries is not in doubt. Figure 1 shows the rising percentage of US personal disposable income that went on debt repayments since 1980. That this percentage rose despite the generally low and falling interest rates since 1980 strongly suggests that US households were taking on substantial amounts of additional debt. Similar evidence can be found in other Anglo-Saxon industrialized countries – and interestingly a rising number of the largest, fast growing emerging markets. In a nutshell, by liberalizing consumer credit governments were able to finance much of recent growth on the private sector's balance sheet.


Counting on Private Spending

One reason public austerity has been overlooked is that certain leading politicians have assured us that the private sector will pick up the slack as the public sector contracts. Economists have long highlighted the connection between cutting fiscal deficits and private sector expansion – as lower sales of new government debt offers less competition for a nation’s saving pool, public sector austerity is said to reduce the crowding out of private investment. Many other factors do, however, determine both the private sector’s decision to invest and individuals’ decision to save. Doubts about future sales growth, driven in part by individuals attempts to pay down their debts, could account for private austerity depressing corporate investment more than any benefits resulting from reduced crowding out. This raises the question as to where the additional aggregate spending will come from in an era of public and private austerity. For now it suffices to note that in a world integrated through international trade, the combination of private and public austerity can hold back a nation’s recovery along with that of its trading partners. But this is just the tip of the iceberg.


Pressures on Policy Makers Shift

Sustained private austerity induced by debt repayment requires increased private sector saving. The resulting fall in consumption expenditures, lower investment outlays, on top of cuts in government demand for goods and services and higher taxes, imply that economic recoveries and growth over the medium term depend more on improvements in net exports (national exports minus national exports). However, it is mathematically impossible for every nation to increase its net exports at the same time, as one nation's greater trade surplus must be matched somewhere else by a lower trade surplus or by a trade deficit.

If they have not figured it out yet, politicians will soon realize that boosting net exports is one way to try to lift their economy out of austerity-driven low growth. Pressure for competitive currency devaluations will grow for economies with floating exchange rates. Meanwhile, the temptation to use protectionism to restrict imports will become harder to resist. Politicians may seek to overcome the lack of a feel good factor with appeals to patriotism, as they justify measures to boost net exports. The large amounts of outstanding private sector debt will also have another effect, this time on central bankers who set monetary policy. Interest rates in most countries now are at, or near, their historic lows. Should they for any reason rise, then the increased interest payments on the private sector debt will further cut into consumption spending, and/or loan repayment will slow down. Either way, private austerity will cut deeper or last longer, further delaying full economic recovery.


Allowing Moderate Inflation?

For this reason, as inflation rates rise – as is the case right now due to higher oil and commodity prices – central banks will postpone interest rates increases or raise them more slowly than otherwise. These developments would over time undermine the central banks’ reputations for being tough on inflation, ultimately resulting in the financial markets asking for higher inflation-related risk premiums on all forms of financial debt. In a strange way, this amounts to a longer-term corrective mechanism: Sustained private austerity today may result in longer-term increases in interest rates that discourage the borrowing splurges of yesteryear. The temptation to let inflation rise – and persist – at moderate levels may be particularly appealing for policymakers and central bankers in countries facing large public and private deficits. Even moderate inflation rates over a few years can put a sizeable dent in the real value of outstanding debts, both public and private. Of course, this applies to countries facing public as well as private austerity. Still, this argument highlights the longer-term consequences of excessive debt build ups for macroeconomic policymaking.


Greater Rigidities in the Labor Market

For many the single worst decision in recent years was perhaps that to buy a house with a sizeable mortgage. With substantial falls in property market values, driven partly by a collapse in bank lending, as well as by the demand collapse which often fell harder on some regions than others, many people found themselves facing job loss as well as holding on to negative equity (a mortgage exceeding the present market value of the property in question). This has had important implications for the flexibility of labor markets and on the migration of labor precisely in the Anglo-Saxon economies that were thought to have an advantage over their more paternalistic rivals on Continental Europe, in Japan, Korea and elsewhere. The much higher rates of intra-national migration seen in the United States has long been said to be one of the reasons why unemployment there was lower. Falls in property values have undermined that mobility, at the moment when it was the most needed! Full economic recovery becomes harder to accomplish – and certainly takes longer – if labor mobility is impaired.

Of course, there is one way that homeowners can liberate themselves from the shackles of negative equity and that is to default. But such defaults would only pass the problem on to the financial institution that now owns the loans in question (with securitization that do need not be the bank that originated the loan.) Private austerity then ultimately either leads to the creation of a less flexible labor market or another round of financial sector bailouts – both quite ugly alternatives.


Debt Gets a Worse Name

The widely-accepted idea that the future growth of the industrialized economies is going to depend on well-trained knowledge workers may have to be revisited in an era of private austerity. Public opinion has a tendency to overreact to severe adverse circumstances, such as those that the world economy is recovering from right now. In several countries going into debt is now seen as a far less prudent thing to do, especially for those such as the young with few physical or financial assets. This shift in attitudes, away from taking on debt, could not have come at a worse time. Mindful of concerns about equality of access to higher education, many governments have directly or indirectly supported the creation of debt schemes for university students so that they can pay higher tuition fees as well as living costs. With private austerity adding to the nervousness about post-graduation labor market prospects, in addition to greater aversion to taking on debt after the global economic crisis, some students from lower-income households will decide not to pursue advanced training or go to college. Should this happen on a sufficiently large scale, it would have longer-term implications for the composition of national labor forces, levels of inequality, as well as for the university sector, which would almost certainly face a shake-out.


Rentier Society Living on Past Successes

Only now do we begin to see the harm done by the 30-year build up of personal sector debt. Recovering from the high levels of personal debt will, for some countries, require substantial private austerity – and possibly some defaults. The drivers of economic growth, the flexibility of labor markets, and the incentives to stay on at college will each take a hit as a result of growing private austerity. As the concerned countries save more, they will become more like rentier societies able to offer less and be less attractive business environments to workers, investors and entrepreneurs. The backlash against public austerity programmes may be tiny compared to the protests against the medium- to long-term consequences of private austerity. The fallout from the go-go years of the 1980s, 1990s and 2000s is far from over. Worse, the rapid build up of private debt in many of the leading emerging markets suggests that private austerity may eventually spread its poison to the remaining growth poles of the world economy.

source: Credit Suisse