Fiscal austerity and the youth employment crisis
A commentary in the VoxEU Debate: Development and the crisis
Fiscal austerity and the youth employment crisis
Iyanatul Islam and Anis Chowdhury
Lack of job opportunities for young people has become painfully evident in the advanced economies, and most notably in the Euro zone and the UK. This has emerged against the grim background of a lingering recession. Growth in the Euro zone has been virtually zero in the most recent quarter while the UK is in the throes of a ‘double dip’ recession. Spain and Greece have the dubious distinction of having 50% of their young people without a job. Real hourly wage rates for high school graduates fell by 11.6% between 2007 and 20011 in the United States, while the unemployment rate rose to 32% from 17% between 2007 and 2011. The IMF projections for the advanced economies as a whole is that the unemployment rate is likely to be a little over 8% by 2013 – 2.4 percentage points higher than what prevailed in the pre-crisis period. A rule-of-thumb is that this implies a projected youth unemployment rate of about 16% by the end of 2013.
Failure to find a job following a downturn can impose long-run ‘scarring’ effects on young people. These effects are manifested in reduced employment and earnings opportunities that can last decades. Young people with limited skills and from disadvantaged backgrounds are particularly vulnerable to ‘scarring’ effects. There are also well known social costs associated with high and persistent youth unemployment: higher incidence of unhappiness, higher crime rates, higher inequality, higher fiscal costs in terms of foregone output and lower tax revenues, and higher political and social tensions.
To what extent can the youth employment crisis of today be traced to the fiscal austerity programmes that have taken hold in more than 90% of the advanced economies since 2009? This fiscal retrenchment is particularly pronounced in the Euro zone and the UK. It was triggered by the belief that the rich world faced an unsustainable increase in public debt following the implementation of the stimulus packages to cope with the negative aggregate demand shock unleashed by the global economic and financial crisis of 2007-2009. At the time, those who advocated the fiscal austerity programmes argued in favour of bold and decisive action in terms of spending cuts and tax adjustments on the ground that the historical evidence shows a positive association between fiscal austerity and output expansion. Hence, the belief was that kick-starting growth in the EU and other parts of the rich world require boosting ‘market confidence’ that would spur investment and create jobs. This was best achieved, went the argument, through ‘front-loaded’ fiscal austerity programmes.
More than two years have elapsed since the start of this experiment and the outcomes have unfortunately not been friendly to the cause of fiscal austerity advocates or ‘austerians’ as they have sometimes been called. There is a high correlation (0.69) between percentage point changes in general government structural fiscal balance (% of potential GDP) and percentage point changes in youth unemployment rates in Europe during period 2009-2011. The increase in youth unemployment rates between 2009 and 2011 tends to be higher for economies which have undergone strong fiscal tightening. Simple regression estimates (R2 = 0.47) suggest that a one percentage point increase in the structural (cyclically adjusted) fiscal balance is estimated to raise the youth unemployment rate by 1.5 percentage points. These estimates also suggest that 47% of the variations in youth unemployment rates across the OECD can be attributed to variations in fiscal policy.
More elaborate macroeconometric models suggest that the fiscal entrenchments will be associated with negative employment growth of the order of 0.2% over the medium term. This is line with the standard Keynesian dictum that fiscal consolidations are contractionary when actual output is below potential output. This appears to be the case for the Euro zone and the UK given that the tepid recovery which emerged after the global economic and financial crisis of 2007-2009 did not have sufficient time to take hold as there was a decisive switch from fiscal stimulus to consolidation between 2009 and 2010.
Of course, these contractionary consequences can be offset by expansionary monetary policy and exchange rate devaluations. Yet, members of the Euro zone do not have an independent exchange rate policy, nor do they have independent monetary policy. The challenges of dealing with the lack of growth and jobs have to be tackled at the EU level. Calls are now being made by prominent economists and media commentators – along with long-standing critics of fiscal policy in the EU and advanced economies in general – that governments, most notably the Euro zone and UK, should change course, especially in light of growing concerns about the political and social sustainability of fiscal austerity programmes in the rich world.
Policy-makers should go for a gradual approach to fiscal consolidation and find fiscally neutral ways in which targeted interventions towards job creation for young people can be supported. An example of a fiscally neutral intervention to assist young people find jobs is to make it mandatory for public sector organizations to hire long-term unemployed young workers for, say, two years, and spend an equivalent of the unemployment and job search benefits that would be spent on them. This will transform the role of government as a provider of unemployment and job search benefits to an employer of last resort.
Measures are also needed to boost consumer confidence and demand. This is not helped by wide-spread lay-offs or lowering of wages – the other plank of the current policy approach to the EU jobs crisis – as part of structural adjustment to boost productivity and competitiveness. While a reduction in wages by some firms may increase their profitability relative to competitors, when all firms within a country seek to cut wages, they can engender the ‘paradox of thrift’ and thus depress aggregate demand beyond the contractionary consequences of current fiscal tightening. Additionally, when all nations seek to achieve competitiveness by wage cuts, it amounts to competitive devaluations with no impact on exports, but adverse impacts on living conditions.
Critics of various alternative policy proposals that are now being offered might argue that they are irrelevant in dealing with the youth employment crisis. This is because poor youth employment outcomes are primarily seen to be the product of structural factors – such as a skills mismatch –onerous labour regulations and a poor business climate that constrain employment opportunities for young people. Indeed, one recent commentary that adopts a global perspective on the youth employment crisis and meticulously documents its social costs hardly touches on the fiscal austerity programme in the EU and does not ponder on its implications for young job-seekers. Instead, the menu of policy recommendations concentrates on supply-side measures, such as reducing the skills mismatch, reforming labour market institutions and improving the business environment. This narrative is not fully compatible with the stylised facts.
Structural factors are useful in understanding levels of youth unemployment, but they do not necessarily explain recent trends in youth unemployment. It is difficult to argue that the skills mismatch has worsened significantly between now and 2007. Furthermore, the dominant trend is a reduction, rather than an increase, in employment protection legislation across a large group of countries and especially in the advanced economies. Similarly, it is difficult to argue that the business environment in terms of red tape and bureaucratic impediments have worsened significantly in the aftermath of the 2008-2009 global financial and economic crises. What has changed is a decisive shift from fiscal stimulus to fiscal consolidation between 2009 and now. The costs of this shift are unfortunately being borne disproportionately by young men and women.
 Iyanatul Islam, ILO, Geneva and Griffith University, Australia; Anis Chowdhury, UN-DESA, New York and University of Western Sydney, Australia. The views expressed here are strictly personal and do not necessarily reflect the views of the United Nations or any of its agencies/funds/programs
 Shierholz, Heidi et al (2012), ‘The Class of 2012: Labor Markets for Young Graduates Remain Grim’, Economic Policy Institute, Briefing Paper No. 340
 IMF (2012) World Economic Outlook
 See Bell, David and David Blanchflower (2009). ‘What should be done about rising unemployment in the UK?’, Stirling Economics Discussion Papers 2009-06; Morsy, Hanan (2012). ‘Scarred Generation’. Finance & Development, 49(1), 15-17
 For a review of the issues and evidence pertaining to fiscal austerity and growth, see Islam, Iyanatul and Anis Chowdhury (2012). Revisiting the evidence on expansionary fiscal austerity: Alesina’s hour?; http://www.voxeu.org/index.php?q=node/7679 [2 May 2012]. Islam, Iyanatul and Anis Chowdhury (2010). Fiscal consolidation, growth and employment: what do we know? G-24 Policy Brief No.57; http://www.g24.org/PolicyBriefs/pbno57.pdf [2 May 2012].
 The detailed findings are reported in Maki Matsumoto and Martina Hengge and Iyanatul Islam (2012). ‘Tackling the youth employment crisis: a macroeconomic perspective’. ILO Working Paper No. 124
 ILO and International Institute for Labour Studies (IILS) (2012). The World of Work Report: Better Jobs for a Better Economy (Geneva).
Krugman (2012), Romer (2012a, 2012b), Summers (2012), Weisbrot and Montecino (2012), and Wolf (2012) have consistently criticized the stance of fiscal policy in the advanced economies in general and the EU in particular. Romer (op.cit) notes that successful cases of ‘back-loaded’ fiscal consolidation can be found in the experiences of USA, Sweden and Australia during the 1990s. Krugman, Paul (2012). ‘Austerity and Growth’. New York Times, April 24. Romer, Christina (2012a). Fiscal Policy in the Crisis: Lessons and Policy Implications. University of California, Berkeley. Romer, Christina (2012b). ‘Hey, Not So Fast on European Austerity’. New York Times, April 29. Summers, Larry. (2012). ‘Growth Not Austerity is the Best Remedy for Europe’. Financial Times, April 30. Weisbrot, Mark and Montecino, Juan Antonio (2012). ‘More Pain, No Gain for Greece: Is the Euro Worth the Costs of Pro-Cyclical Fiscal Policy and Internal Devaluation?’ Center for Economic and Policy Research, Washington DC. Wolf, Martin (2012). ‘The impact of fiscal austerity in the eurozone’. Financial Times, April 27.
 Morsy, op. cit
 ILO/IILS (2012, chapter 3)