The GIIPS countries on the periphery of Europe are undertaking fiscal retrenchment that is largely self-defeating, because they have little choice given the structure of the eurozone’s governance, and Germany’s policy position. The United States, in contrast, is undertaking reducing government spending not because it has to, but because of an ideology that sees austerity as a convenient means of bludgeoning the opponents of a reasoned fiscal policy.
Last week, I had the opportunity to participate in a panel on “Assessing the Austerity Experiment”, at the Center for American Progress. (The video of the proceedings is here). The panel included Carlos Mulas-Grenados, Jared Bernstein, and Zach Schiller, and was moderated by Michael Ettlinger, and took place at an opportune time; that morning France had been downgraded by Moody’s, and Italian yields had risen above Spanish yields (which were both above 7%).
Figure 1: Ten year harmonized government bond yields, and yields for June 12. Source: ECB, and FT for June.It’s clear from this graph that the approach of muddling through, dealing on an ad hoc basis with each crisis with aid conditioned on fiscal consolidation, is not working. It’s not working partly because in the demand determined models we teach in intermediate macro work cutting government spending and raising taxes tends to depress output, as highlighted in this post. But when the countries affected are closely linked by trade, then the total effect of the contractionary policies conducted in individual countries results in even greater contraction. 
Had these economies been on floating exchange rates, the contractionary effects might have been mitigated by depreciated currencies. But membership in the eurozone meant that shock absorber was gone. That is why the prospect of an expansionary fiscal contraction was never very plausible in the case of the GIIPS. But as long as the rest of the eurozone countries were unwilling to provide substantially more financing or transfers to the GIIPS, these governments had little alternative to fiscal consolidation. That is the fate of many, many countries that have faced IMF stabilization packages in earlier decades.
In contrast, in the United States, the sovereign has easy access to financing. Benchmark yields are 1.5%, real interest rates at the ten year horizon are zero, according to TIPS. The dollar remains the pre-eminent reserve and international currency, and certainly promises to remain so in the near term, given the sovereign debt crises in the rest of the world. And yet, the next figure shows that government consumption spending is exerting a drag on GDP, at both the state and Federal levels.
Figure 2: Contributions to GDP growth, form state and local government (green) and from Federal government (red), and all else (blue), in percentage points. Source: BEA, 2012Q1 second release.Now turn to the individual states; they have to run pretty much balanced budgets. But they could have run balanced budgets at relatively high levels of spending, or relatively low levels of spending.
In contrast to Europe, the choice to slash spending and taxes was unforced. In the absence of tax cuts, spending could have been maintained at higher levels. Furthermore, the Federal government had the resources to further support the state and local governments. According to the CEA, by June 2011, the ARRA had provided for $130.8 billion in transfers to the states. It’s clear from Figure 3 that this support helped maintain spending levels.
Figure 3: State and local receipts (blue), state and local receipts ex ARRA transfers (red), and state and local spending (green), all as a share of potential GDP. Source: BEA, 2012Q1 second release, CEA, and author’s calculations. Assumes 2011Q3-2012Q4 transfers at $4 billion per quarter.Truly, much of the distress at the state and local level is essentially a self-inflicted wound, that allows a push for smaller government to proceed under the guise of austerity. Figure 4 presents comparative behavior of indicators of aggregate economic activity in the Midwest region.
Figure 4: Log coincident economic indices, normalized to 2011M01=0. Source: Philadelphia Fed, and author’s calculations.Update 6:15pm: Note that Wisconsin, which has aggressively cut spending, has lagged far behind the nation, and Fed district neighbors, since 2011M01.
This post originally appeared at Econbrowser and is posted with permission.