Economics

The myth of austerity

Many politicians and commentators such as Paul Krugman claim that Europe’s problem is austerity, i.e., there is insufficient government spending. The common argument goes like this: Due to a reduction of government spending, there is insufficient demand in the economy leading to unemployment. The unemployment makes things even worse as aggregate demand falls even more, causing a fall in government revenues and an increase in government deficits. European governments pressured by Germany (which did not learn from the supposedly fateful policies of Chancellor Heinrich Brüning) then reduce government spending even further, lowering demand by laying off public employees and cutting back on government transfers. This reduces demand even more in a never ending downward spiral of misery. What can be done to break out of the spiral? The answer given by commentators is simply to end austerity, boost government spending and aggregate demand. Paul Krugman even argues in favor for a preparation against an alien invasion, which would induce government to spend more. So the story goes. But is it true?

First of all, is there really austerity in the eurozone? One would think that a person is austere when she saves, i.e., if she spends less than she earns. Well, there exists not one country in the eurozone that is austere. They all spend more than they receive in revenues.

In fact, government deficits are extremely high, at unsustainable levels, as can been seen in the following chart that portrays government deficits in percentage of GDP. Note that the figures for 2012 are what governments wish for.

The absolute figures of government deficits in billion euros are even more impressive.

A good picture of “austerity” is also to compare government expenditures and revenues (relation of public expenditures and revenues in percentage).

Imagine that a person you know spends 12 percent more in 2008 than her income, spends 31 percent more than her income the next year, spends 25 percent more than her income in 2010, and 26 percent more than her income in 2011. Would you regard this person as austere? And would you regard this behavior as sustainable? This is what the Spanish government has done. It shows itself incapable of changing this course. Perversely, this “austerity” is then made responsible for a shrinking Spanish economy and high unemployment.

Unfortunately, austerity is the necessary condition for recovery in Spain, the eurozone, and elsewhere. The reduction of government spending makes real resources available for the private sector that formerly had been absorbed by the state. Reducing government spending makes profitable new private investment projects and saves old ones from bankruptcy.

Take the following example. Tom wants to open a restaurant. He makes the following calculations. He estimates the restaurant’s revenues at $10,000 per month. The expected costs are the following: $4,000 for rent; $1,000 for utilities; $2,000 for food; and $4,000 for wages. With expected revenues of $10,000 and costs of $11,000 Tom will not start his business.

Let’s now assume that the government is more austere, i.e., it reduces government spending. Let’s assume that the government closes a consumer-protection agency and sells the agency’s building on the market. As a consequence, there is a tendency for housing prices and rents to fall. The same is true for wages. The laid-off bureaucrats search for new jobs, exerting downward pressure on wage rates. Further, the agency does not consume utilities anymore, leading toward a tendency of cheaper utilities. Tom may now rent space for his restaurant in the former agency for $3,000 as rents are coming down. His expected utility bill falls to $500, and hiring some of the former bureaucrats as dish washers and waiters reduces his wage expenditures to $3,000. Now with expected revenue at $10,000 and costs at $8,500 the expected profits amounts to $1,500 and Tom can start his business.

As the government has reduced spending it can even reduce tax rates, which may increase Tom’s after-tax profits. Thanks to austerity the government could also reduce its deficit. The money formerly used to finance the government deficit can now be lent to Tom for an initial investment to make the former agency’s rooms suitable for a restaurant. Indeed, one of the main problems in countries such as Spain these days is that the real savings of the people are soaked up and channeled to the government via the banking system. Loans are practically unavailable for private companies, because banks use their funds to buy government bonds in order to finance the public deficit.

In the end, the question amounts to the following: Who shall determine what is produced and how? The government that uses resources for its own purposes (such as a “consumer-protection” agency, welfare programs, or wars), or entrepreneurs in a competitive process and as agents of consumers, trying to satisfy consumer wants with ever better and cheaper products (like Tom, who uses part of the resources formerly used in the government agency for his restaurant).

If you think the second option is better, austerity is the way to go. More austerity and less government spending mean fewer resources for the public sector (fewer “agencies”) and more resources for the private sector, which uses them to satisfy consumer wants (more restaurants). Austerity is the solution to the problems in Europe and in the United States, as it fosters sustainable growth and reduces government deficits.

Lower GDP?

But does austerity not at least temporarily reduce GDP and lead to a downward spiral of economic activity?

Unfortunately, GDP is a quite misleading figure. GDP is defined as the market value of all final goods and services produced in a country in a given period.

There are two minor reasons why a lower GDP may not always be a bad sign.

The first reason relates to the treatment of government expenditures. Let us imagine a government bureaucrat who licenses businesses. When he denies a license for an investment project that never comes into being, how much wealth is destroyed? Is it the expected revenues of the project or its expected profits? What if the bureaucrat has unknowingly prevented an innovation that could save the economy billions of dollars per year? It is hard to say how much wealth destruction is caused by the bureaucrat. We could just arbitrarily take his salary of $50,000 per year and subtract it from private production. GDP would be lower.

Now hold your breath. In practice, the opposite is done. Government expenditures count positively in GDP. The wealth destroying activity of the bureaucrat raises GDP by $50,000. This implies that if the government licensing agency is closed and the bureaucrat is laid off, then the immediate effect of this austerity is a fall in GDP by $50,000. Yet, this fall in GDP is a good sign for private production and the satisfaction of consumer wants.

Second, if the structure of production is distorted after an artificial boom, the restructuring also entails a temporary fall in GDP. Indeed, one could only maintain GDP if production remained unchanged. If Spain or the United States had continued to use their boom structure of production, they would have continued to build the amount of housing they did in 2007. The restructuring requires a shrinking of the housing sector, i.e., a reduced use of factors of production in this sector. Factors of production must be transferred to those sectors where they are most urgently demanded by consumers. The restructuring is not instantaneous but organized by entrepreneurs in a competitive process that is burdensome and takes time. In this transition period, when jobs are destroyed in the overblown sectors, GDP tends to fall. This fall in GDP is just a sign that the necessary restructuring is underway. The alternative would be to produce the amount of housing of 2007. If GDP did not fall sharply, it would mean that the wealth-destroying boom was continuing as it did in the years 2005–2007.

Conclusion

Public austerity is a necessary condition for private flourishing and a rapid recovery. The problem of Europe (and the United States) is not too much but too little austerity — or its complete absence. A fall of GDP can be an indicator that the necessary and healthy restructuring of the economy is underway.

This article was previously published at Mises.org.

11 comments to The myth of austerity

  • OK, what’s the response to MMT types that maintain that in contemporary fiat money regimes sovereign countries can create as much money as needed to stimulate aggregate demand, since a check from the government cannot bounce?

    • Here is a response from an MMT supporter.
      First, I didn’t see any mention in Philip Bagus’s article of what is generally accepted as being the main reason for austerity in Europe. That’s the fact that the periphery is uncompetitive compared to the core, thus the periphery needs to cut its wages and prices (i.e.effectively devalue its currency). Currency devaluation can be done easily and quickly where a country issues its own currency. Unfortunately it’s an extremely slow and costly process for a country in a common currency area.
      I.e. the reasons for austerity in Europe are COMPLETELY DIFFERENT to the reasons elsewhere. A difference that seems to elude Bagus.
      Next, he assumes that because a country has a high national debt, therefor its government has been profligate. Complete nonsense. It would be possible for a country to devote a SMALL proportion of GDP to public spending while paying for that with too much borrowing compared to tax. Such a government would end up with too much national debt.
      Conversely, it would be possible for a country to devote a LARGE proportion of GDP to public spending while paying for it all with tax. Such a country would end up with a small or non-existent debt.
      Next, Bagus trotts out the standard Austrian idea that if booms distort the market it takes TIME to unwind those distortions. (Incidentally, congratulations to Bagus for inserting the word “if” there. I agree that booms CAN BRING distortions, but they don’t necessarily do so. That’s better than the standard Austrian story which assumes that booms are ALWAYS distortionary.)
      Anyway, as Bagus rightly points out, it COULD BE that the property lead boom and build up of construction related employees etc might take some time to unwind. Well dozens or hundreds of us non-Austrians were aware of this possibility immediately after the crisis hit, so we looked at the evidence. And the evidence seems to be that construction employees find no more difficulty finding alternative work than those who lose jobs in other industries.

      • First, I didn’t see any mention in Philip Bagus’s article of what is generally accepted as being the main reason for austerity in Europe. That’s the fact that the periphery is uncompetitive compared to the core, thus the periphery needs to cut its wages and prices (i.e.effectively devalue its currency).

        Generally accepted is suspicious right off the bat. If the periphery is uncompetitive with the core, maybe the issue is there are not only too few producers and too many parasites, but the parasites are literally standing in the way of the producers. The remedy isn’t cutting wages and prices, it’s increasing productivity, which isn’t accomplished by bureaucratic regulation.

        Next, Bagus trotts out the standard Austrian idea that if booms distort the market it takes TIME to unwind those distortions.

        No process is instantaneous, everything takes time, how could Bagus be wrong about that? Just as the market distortion didn’t occur in a moment, it won’t be dispelled in one either.

        And the evidence seems to be that construction employees find no more difficulty finding alternative work than those who lose jobs in other industries.

        What evidence would that be? Could it be the huge number of currently unemployed construction workers? Who, incidentally, are, or have been, generally receiving unemployment benefits, which could be characterized as both an insurance policy for mortgage, car and rent payments and as a subsidy for construction companies that have no desire to find new workers when needed to replace those that have moved on to other pursuits.

      • Robert Sadler Robert Sadler

        Ralph,

        You seem to have misunderstood the point of Phillip’s article. It is not a discussion of the reasons for austerity but an argument that there is no austerity taking place!

  • Paul Marks Paul Marks

    Government spending is out of control in these countries – that (not waffle about core and edge) is a reason for the talk of “austerity”.

    And, as far as government spending is concered, it is talk.

    Government spending in all these countries is actually higher (yes HIGHER) now than it was in 2007 (before the crises officially started).

    However, their are difference between E.U. countries that are NOT related to government spending.

    Here it may even be possible to find some common ground with our friends from the economics “mainstream”.

    The Labour Codes (the webs of regulations) in countries such as Greece, Italy, France and Spain might as well be deliberatly designed to create unemployment.

    Whatever one’s view of monetary and fiscal matters – can we at least all agree that these Labour Codes (these regulations that cripple the labour market and create mass unemployment) need to be abolished.

    As do the various pro union laws.

  • It’s important to recognize the fact that official figures of the PIIGS don’t reflect that a significant portion of the economy has moved “underground” to avoid both regulation and taxes that have simply become too much to bear. Quas-businesses and individuals can supply goods and services through the black market far more cheaply than regulated and taxed firms. Customers, always interested in saving money, turn to these alternatives which take business away from efficient but highly regulated companies and denies the state tax revenues, producing unemployment in the normal commercial sector cutting government revenues.

  • Paul Marks Paul Marks

    Mr Musgrave is at least partly correct.

    China does not have taxes and it does not have the LABOUR CODE of countries like Greece, Italy, France, Spain…….

    Sorry but an expansionary monetary policy will not really help such countries.

    They need dramatically lower tax rates (but NOT a bigger deficit – and that means REAL cuts in government spending) and they need (need desperatly) to SCRAP their “Labour Codes”.

    Not modify them in such and such a way…. it is too late for that.

    They need to GET RID OF the Labour Codes.

  • Paul Marks Paul Marks

    There is some “austerity” Robert – although (at the risk of sounding like Bill Clinton) “it depends what you mean by” the word “austerity”.

    If the word means “government spending has gone down” then it is indeed a myth.

    But if it means “taxes have gone up” – then there has been lots and lots of austerity.

    The thing is the two are conflated.

    For example, the media (even Fox News) described various people who killed themselves in Italy died were “protesting over the cuts”.

    Actually they had been audited by the tax police – (very tough since the coup – the E.U. backed “velvet coup”).

    But taxes are good, nice, fluffy – especially on evil “capitalists”.

    So when people talk about the horrors of “Austerity” they assume it must mean a cut in government spending.

    • Robert Sadler Robert Sadler

      I guess I mean in the manner it has been presented by the government. I’m not sure that taxes have gone up significantly or how you define “lots”, but in my view, the “austerity” that the government promised us has not materialised.

  • Paul Marks Paul Marks

    I was thinking of many European countries – where taxes have indeed greatly increased.