Stop the Cuts

The Truth About Austerity

Recently I have been frustrated by the controversy over whether Britain’s policy of austerity has led to a double dip recession in the UK. Progressive economists like Paul Krugman assert that a policy of austerity has been an utter failure, proving that government spending is needed to lift an economy out of malaise and put it back on the track of prosperity and growth. Laissez faire economists argue that Britain’s debt has in reality increased while they have touted a course of austerity. Therefore economic stagnation in the country cannot be attributed to a policy of austerity because such a policy has not actually been carried out.

I find both sides to be misleading in this whole conversation. I hope to clear up what austerity is and the real implications it has for an economy, both in the short run and the long run. “Austerity” essentially entails a government policy aimed at cutting budget deficits through either increased tax revenue and/or reducing government debt. In even simpler terms, it is a policy in which the government aims to not spend what it does not have. If you need further help in understanding the concept, I would recommend viewing this Saturday Night Live skit that explains the simple truth that families cannot buy stuff they are unable to afford without getting into trouble financially. The same concept can be applied to the government.

The reality is that in the very recent past and present time, governments around the world have been more irresponsible in spending money that they do not have than at any point in modern history. I recommend watching the documentary I.O.U.S.A. to gain perspective on just how irresponsible our own government has been relative to its entire history.

Two Implications of Austerity

Pain in the Short Run: This is where I believe laissez faire economists have been misleading their readers. There is every reason to believe that a policy of government austerity will cause economic pain in the immediate future. Either a) government raises taxes on its citizens to acquire more money, leaving households with less wealth to spend and invest themselves and/or b) government cuts spending and decreases the benefits received by households. Therefore with a policy of government austerity, we should expect tough times economically in the immediate future or what economists call the “short run.” A good economist should not be surprised if the economy seems to stagnate in the wake of austerity. Consider the fact that the Wall Street Journal reports that half of US households currently receive government benefits. If our government would pursue a course of austerity, these benefits would decrease and those households benefitting from handouts would have less wealth.

Prosperity in the Long Run: This is where Keynesian economists such as Krugman have it wrong. They push for increasing the level of government spending, accelerating the magnitude of budget deficits and the accumulation of debt in hopes to lift the economy out of recession. However, this is a completely unsustainable way to achieve economic progress. While such a policy of active government can reap prosperity in the short run, such prosperity is artificial and cannot last for long. A policy of austerity, on the other hand, will lead to prosperity in the long run. The point at which people start dealing with economic reality is the point at which real economic growth can occur. Governments around the globe have been trying to distort economic reality through accumulating debt and manipulating the money supply. Our global economic woes are a direct result of governments attempting to circumvent the economic laws of nature. While Keynesians may argue that austerity is no solution, it is in fact a necessary and healthy step towards accepting reality and getting back on a path where individuals are given the opportunity to increase their standards of living. Any alternative will only result in economic stagnation and a decrease in living standards in the long run.

Call to the Economist

The good economist should predict there will be some economic pain as a result of austerity in the immediate future. In this regard, there is some truth in what Krugman argues. On the other hand, the economist should remain adamant that a policy of austerity is absolutely necessary for prosperity in the long run and that any benefits of government activism in the short run are illusory and only lead to more problems. Just like a household cannot continue to spend what it does not have without incurring increasing amounts of financial trouble, neither can a government. Claims to the contrary are not only facilitating the erosion of the economic well-being of many countries, but more importantly are chipping away at the virtue of responsibility among the citizenry of those countries.

, , ,

6 Responses to The Truth About Austerity

  1. Peter May 30, 2012 at 9:59 am #

    You can’t dumb down economics and public finance by comparing the government to a household.

    “However, this is a completely unsustainable way to achieve economic progress. While such a policy of active government can reap prosperity in the short run, such prosperity is artificial and cannot last for long.”

    What you’re talking about is permanent government spending increase. What economies in recession need is temporary gov spending increase in order to raise aggregate demand and lower the negative short term impact of the recession, specially if the recession is as drastic as this one (see Spain’s unemployment for example). After the recession ends, so do the temporary spending increases and the country is capable of generating enough growth and tax revenue much faster than they would in case of austerity so the portion of debt / gdp starts shrinking sooner. So there’s no talk of permanent, exponential increase in government spending that would be unsustainable as you seem to understand it. The great recession in 30s was drastically shortened by temporary increases in gov spending that jumpstarted the economy and ended as soon as recession did. That’s the solution to the combination of recession and debt, not austerity which prolongs the recession and hurts the tax revenue and becomes self defeating way of tackling debt because for every 100b you cut, you lose about 40-60b in tax revenue.

  2. jdellape May 30, 2012 at 12:17 pm #

    Peter,

    I appreciate you taking the time to read the article and giving your feedback. There’s a fundamental difference in our viewpoint of how recessions start in the first place that leads us to two completely different conclusions on how an economy can escape recession. I believe that a sound understanding of economics shows that governments are not capable of efficiently allocating resources and free markets are. I also believe that recessions are triggered when governments distort the allocation of resources via credit expansion, monetary inflation and indebtedness.
    As far as your understanding of the Great Depression, I would recommend checking out Murray Rothbard’s book America’s Great Depression or this article (http://mises.org/daily/3515) by Hans Sennholz to get a different viewpoint on America’s worst recession.

    Furthermore, I don’t think you can reduce our problems to aggregate measures. I don’t buy the argument that temporary government spending will put the economy back on track by giving the needed, temporary boost to aggregate demand and gdp. I don’t think that the government is capable of allocating resources efficiently in the midst of or outside of a recession. Thus we only get more malinvestment with government spending regardless of the present state of the economy. For more on government’s inability to allocate resources efficiently, I recommend reading Mises’ Bureaucracy.

    Hopefully this at least gives you a better understanding of where I’m coming from.

  3. Peter May 31, 2012 at 4:12 pm #

    Jdellape,

    Thanks for the reply. There is nothing that makes government inherently unable to allocate resources; the success of a venture depends on efficiency of the management, not on the ownership type.

    Recession occurs when the expansion bubble bursts, which is a natural part of a cycle in economy and it regularly happened long before monetary policy and high gov spending existed.

    There is a point during expansion in which the growth momentum builds on itself rather than its merit and the expectations create artificial growth because the spending and prices increase due to expectations. If you expect X stock to go up, you’ll buy that stock, increasing the demand and raising the price. When this happens on a large scale, a bubble is formed. When the bubble bursts and prices plummet, the recession occurs and people lose jobs, demand falls because the general population can’t afford to buy as much stuff as before. If gov doesn’t intervene, the process of coming back up is slow: there’s little incentive to invest because the demand is low. If government spends on stuff like social transfers, public works (usually construction / infrastructure jobs) people get money to spend and demand rises. Rising demand gives incentive to produce more, which leads to job creation. That’s the rationale behind stimulus packages.

    As far as free markets being better at allocation: it is true in most areas of the economy. However, there are certain markets and industries where market imperfections prevent free market from functioning as it should. Cases like natural monopolies with high fixed costs where there’s no point for there to be more than one supplier (plumbing, electricity), highly needed products with low demand elasticity that have high operating costs and no substitutes (health care), pure public goods (military, police). In these cases, the free market allocation of resources leads to inequality and redistribution of wealth from consumer to suppliers because suppliers posses disproportional negotiating power (if you don’t buy health insurance and you get sick – you’re in trouble) allowing the supplier to hike up the price simply because he can. Now you could say “but won’t just another supplier come in and lower the price?”. If he does and they start competing, the price will surely go down but than neither of them will make any money because these industries rely on economies of scale to be profitable. That’s why despite high costs of health care and insurance you don’t see investors building hospitals one next to another – because they’d cannibalize each other’s profits.

    What happens when government steps in? It nationalizes the health care system (see universal health care in Europe) and offers lower price while hedging the entire risk to the whole population. The results? The more free-marketing leaning health care system in US costs US population and government nearly 17% of GDP while European economies spend between 9-11% of GDP and rank higher in efficiency in virtually every study (see World Health Organization research from 2000., they analyzed and compared all health care systems in the world; the research isn’t being done anymore because of extremely high costs, but things didn’t change drastically since 2000.)

    “I don’t think that the government is capable of allocating resources efficiently in the midst of or outside of a recession.”

    Can you elaborate on this? What exactly makes the government unable to do that? You could argue that there’s a more efficient use for resources government would spend on a stimulus package. However, the positive effect of said package greatly exceeds anything the free market would do because such high investment from the private sector wouldn’t yield expected returns. The reason this is worth it for the government is because they reap the benefit of increased tax revenue when the economy comes back up.

    Let’s say gov borrows money to spend on the stimulus package and thus increases the public debt. The faster exit from recession means faster return to high tax revenue – which in combination with GDP growth makes the stimulus package effect on public debt negligible for two reasons: 1) higher GDP means lower debt:GDP ratio and 2) higher tax revenue covers the interest rate on created debt and more, making it a profitable investment.

    That is not to say that all public debt is cost efficient, most of it wasn’t. In US’ case big portion of the debt comes from excessive military spending (military industrial complex lobbying), oil & agriculture subsidies, medicare and medicaid which are ineffective compared to universal health care system cause they pay supplies for their profits, rather than government doing the work itself instead of paying someone a premium to do it for them, lack of taxation (bush-era tax cuts were a huge mistake because government entered deficit in the time of expansion rather than using that time to create a suffcit and pay off portion of the debt instead of injecting more money into the economy, creating a bubble).

    All these things don’t mean that there’s something inherently wrong with government spending. There are plenty of countries where leadership didn’t mismanage the economy or take advantage of their position to pander to big business (oil and agriculture subsidies, military industrial complex, health care industry, etc). Bad management of US economy isn’t a proof that government in somehow flawed and unable to fix imperfections in these sectors of the economy. Like I said at the start, the success of a venture depends on efficiency of the management, not on the ownership type.

    Sorry for the long post, got carried away. :)

    • jdellape May 31, 2012 at 8:29 pm #

      Peter,

      I appreciate your comment back and am slightly frightened by the length of it at the same time. I’ll say from the outset that I probably won’t be able to match the length of your post, but will try to address the main issues as well as I can.

      In response to your remark “the success of a venture depends on efficiency of the management, not on the ownership type”:

      I think I see where you’re coming from here. Claiming “government” cannot allocate resources efficiently may come off as if I am saying every government official allocates resources the same way. I admit that all government actors do not act uniformly to a given situation. Different individuals make different choices, including government officials. To clarify my point, I’ll focus on the INCENTIVES that government officials have as opposed to the incentives that those in the private sector have in allocating resources. Individuals working in businesses in the private sector are constrained by profits. The business manager has to produce a product that individuals desire more than the inputs required to make the product. The customer has to be willing to pay more for the businesses product than the cost of the businesses inputs or else the business will not be able to survive. This is how the private sector allocates resources efficiently. They take inputs and allocate them towards producing output that is more valuable to consumers.

      Government actors, on the other hand, are not constrained by profits. I think that’s something everyone would agree with. I believe this difference in constraints does mean that there is a difference in the inherent efficiency of the ownership type. Politicians are constrained by votes. So in the decisions they make with the resources they are given, they have incentive to act in a way that will gain them as many votes as possible. Hence pandering to special interests. Those working in the government bureaucracy are constrained by the regulations and procedures they are given. They have incentive to simply follow the rules with the resources they are given, but it is impossible to prove that they are providing any net benefit to society with the resources they’re given. Because they’re not constrained by making profits, society sees a lot of resources wasted in government bureaucracy.

      Specific information is another issue when we discuss allocation by the private sector v. allocation by the government. Just intuitively speaking, it makes sense that individuals engaged in market exchange have a better idea of how resources should be allocated in production processes than government officials do. This is my problem when you say that government just needs to spend money to get the economy back on track. How does it know where to spend it? How does it know how much to spend? I think producers and consumers who are involved in those processes should have the say of where resources go, not the government. They have a superior quality and quantity of information to make the decisions.

      In response to “Recession occurs when the expansion bubble bursts, which is a natural part of a cycle in economy…expectations create artificial growth because the spending and prices increase due to expectations”

      I don’t agree with your view of the business cycle. I don’t think that artificial booms are a natural part of economic activity. Austrian Business Cycle Theory demonstrates that fractional reserve banking is the sources of booms or “bubbles”. By lending out more money than their customers actually have on deposit, banks discoordinate economic activity and set the bubble into motion. I won’t go into the theory fully, but will refer you to “mises.org” to read up on this theory more. I do agree with you however that the growth which occurs during the boom is “artificial”. I don’t find the expectations/irrational exuberance explanation as the root cause of the bubble satisfactory.

      My last response to: “If government spends on stuff like social transfers, public works (usually construction / infrastructure jobs) people get money to spend and demand rises. Rising demand gives incentive to produce more, which leads to job creation.”

      This seems to contradict what you said earlier in claiming that expectations create “artificial growth”. If the growth was artificial in the first place (which we agree on), why should government attempt to sustain it? It sounds like you’re saying expectations created a level of spending and prices which is out of whack with the reality of what economic actors actually want. So why ask the government to maintain that level of spending and prices? And obviously if artificial growth occurred, allowing that artificial growth to contract will cause a decrease in production in some industries and an increase in unemployment. But do we have good reason to believe that once this contraction occurs, those people will be permanently unemployed or that production will fall off permanently? I believe that once the “artificial” (as you called it) growth is liquidated, resources will then be freed up to be allocated to where they are most profitable and most wanted by society.

      In hindsight, I wrote more than I anticipated. I realize that I didn’t address everything, but really do appreciate your post and am very interested in what you said about healthcare costs in American v. Europe. I plan on looking into that further. Thanks again!

  4. Peter June 1, 2012 at 6:49 am #

    Jdellape,

    You’re right when it comes to reasoning as to what motivates private sector and what motivates the government and I’m not disputing that. However, can we agree that certain products on the market like military, health care, education, police and other things governments usually provide are necessary for the society even if they don’t produce profit? They cost a lot so in order for them to produce profit, specially on a customer to customer basis, the prices would be high, thus hurting a very big portion of the population (low and mid income families). Taking care of people with certain diseases can cost millions of dollars and many families can’t afford that. Would it be humane and acceptable to let market decide who lives? What about equality of chances?

    Another thing to point out when it comes to these sectors is externalities, which are impossible to precisely calculate. Healthier population means less time missed from work, higher employment, better utilization of human resources. Education produces externalities as well: bringing higher paying jobs to the country, increasing future tax revenue, bringing more innovation in technology, business, medicine, etc. The problem with market allocating resources in these cases is that market doesn’t take into account externalities because they don’t affect supplier and consumer directly and they have little to no incentive to accept lower / higher price. However, the government can take that into account and set the prices that will balance between the total gains and total costs (both monetarily and in terms of externalities).

    “This is my problem when you say that government just needs to spend money to get the economy back on track. How does it know where to spend it?”

    Government employs economists, many successful people from the private sector and such, it’s not as if politicians who went to law school are making the decisions by themselves. Most of their decisions are based on feedback and advice from economists, that’s why they have institutes that do research or hire universities to do it, rely on statistics from IMF, central banks or organizations like oecd. It’s not as if the only factor they take into account is votes.

    I also think you diminish the importance of democracy. People want government to take care of things the markets aren’t efficient for reasons I already went through, and they’re willing to pay taxes for it. As a society we decided that equality of chances is important, that people shouldn’t go bankrupt or die if they get ill because it’s too expensive to treat them, that intelligent and hard working people from poor families should also have a chance at higher education and so on. It doesn’t matter if as a result these industries aren’t profitable in terms of accounting bottom line – the society is willing to pay taxes to make up for it because their contribution is worth it.

    As far recession and expansion:

    I study economics and nearly every university in the world teaches keynesian economics. I know it’s silly to make calls to authority but I believe there is a reason for that. I don’t know enough about Austrian school teachings to attempt to discredit them, but I will try to address the parts you mentioned.

    “Austrian Business Cycle Theory demonstrates that fractional reserve banking is the sources of booms or “bubbles”. By lending out more money than their customers actually have on deposit, banks discoordinate economic activity and set the bubble into motion.”

    There’s no doubt monetary expansion helps create the bubble, however it’s just one of the factors in the equation. First, let me point out that great depression in 30s was a result of a huge stock bubble which government spending or monetary policy took no part in and the cycles existed long before that so it’s not as if the keynesian approach is what’s creating the cycles – they were already there. Recessions lasted much longer back then as well, because the governments wouldn’t interfere and attempt to speed up the process. I believe that even though the there are negative aspects of growing money supply during the expansion, without that growth it would be impossible to achieve the long term growth. If the money supply was fixed, than as the economy grows the interest rate would go up significantly and it would reduce the number of businesses / projects that are profitable and would constrain the growth beyond what’s reasonable, which would limit the long term growth because if we had to dismiss the least profitable project every time a more profitable one comes along, the overall growth would be much lower.

    “This seems to contradict what you said earlier in claiming that expectations create “artificial growth”. If the growth was artificial in the first place (which we agree on), why should government attempt to sustain it?”

    Not all of it was artificial. Most of the expansion is the growth of tangible variables – actual goods and services. However in time, the GDP grows beyond potential GDP (see keynesian graphs; potential GDP is the one that is sustainable in longer term without creating inflation).

    When bubble bursts and recession occurs, the GDP falls below the potential – which is also below long term trend [if you look at the 30-40 year graphs of GDP of any developed country, you’ll see that long term GDP grows following a somewhat linear trend – but it’s rarely AT the trend value, it’s usually above it (expansions) and then shortly falls below it (recession)]. What I’m advocating isn’t government spending that creates growth above the trend, but merely helping economy reach “normal” height after the recession hits, because recession puts it below the trend. Once it’s there, the stimulus ends, and the market can allocate resources according to demand and supply (in sectors where free market is efficient). This way the length of the recession is significantly shortened, reducing the time during which the negative aspects are present like excess unemployment and its social / psychological impact on individuals, reduced tax revenue and lower economic activity overall which hurts private sector as well.

    Another thing we have to take into account is the stabilizing factor of fiscal policy: taxes (specially progressive ones) reduce the growth of bubbles to a degree and government spending reduces the negative impact of the recession because even though the GDP drops, part of the GDP is government spending, which remains at fixed amount (or very close to fixed amount), preventing recession from having a more drastic impacts. That’s why 2007-2012 crisis affected US more than high spending European economies (specially SWE/NORW) because high government spending remained. If you look at the graphs on oecd.org for general government total outlays you’ll see that the influence of the crisis was more drastic in the US because the private sector is a bigger chunk of the economy. Compare that to the fall in GDP itself from country to country and you’ll see there’s a stabilizing effect of the fiscal policy. So it’s not as if the government’s influence is all negative.

    I will check out the Austrian school thories at some point, I’m kind of stuffed with exams right now though. Thanks for the reply!

    • Lynn January 3, 2013 at 10:39 am #

      It is amazing how their can be two opposing views on Austerity with seemingly no way to ever prove either one.

      I believe in your simple assessment of the situation and those who think governments are somehow magically different than business or individual finances are plainly lost in a belief system not based on math.

      I am a simple Dairy farmer that is living in the house my Great grandfather built in 1870. All my family history and belief system is based on austerity and fiscal conservatism. We have never had any financial disaster or upheaval in150 years of business. Not even in the depression years even though my ancestors were not in the government farm program and took no subsidies.

      I will not claim things were not tight but we made it through without needing help.

      Experts can claim what ever they want but I base my financial and economic beliefs on 150 years of success of what has worked in practice. I wonder how many can match that?

Leave a Reply

UA-32859158-1