Why Austerity Is a Dangerous Idea

When everyone tries it at once, austerity makes the debt bigger, not smaller

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The current debt and deficit panic is nothing new. It’s been a staple of American politics since the Republic’s inception. But this season it has taken a new turn. Congress, the fiscal arm of the government, is engaged in asymmetric siege warfare. On one side the Republicans want only cuts, on the other the Democrats want both cuts and tax increases. Both agree however that cuts are absolutely necessary; the only question is the timing and magnitude involved. Unfortunately, budget cuts are exactly the wrong thing to do at this moment. And before anyone throws up their hands and says “Keynesian claptrap,” there is nothing necessarily Keynesian in what I am about to say. Simple logic and arithmetic will suffice.

(MORE: America’s Forgotten Economic Challenge)

Austerity, the policy of cutting state spending to solve debt and growth problems, sells itself to us through a strange combination of morality and seduction. Its moral claim lies in the love of parsimony over prodigality that characterizes economic thought from Adam Smith onward. In this morality play, saving leads to investment, and investment leads to growth. Spending, in contrast, leads to consumption, and consumption leads to debt, especially when the government is involved. What we see in Greece therefore is simply the most egregious example of a secular trend toward overspending. We must cut to restore ourselves and not become Greece. So the story goes.

Austerity suggests that you can have your cake and eat it too, but only when you cut the cake first. Cuts are seen to be growth enhancing, not growth retarding. They restore that all-important “business confidence” necessary for the economy to function.

There is however a rather big problem with this line of thinking. The first is that for people to save, they need to have income from which to save. So if you are, for example, a state in the euro zone today, and every similar state saves at the same time by cutting spending, the result is the shrinkage of everyone’s economy since they are one another’s trading partners and sources of income. Perversely, their debt goes up, not down, relative to their (shrinking) GDP, which is what has happened to every European country that has undergone an austerity program since 2010. They now have more debt, not less.

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Austerity, when everyone tries it at once, makes the debt bigger, not smaller. The E.U. is one of the two largest growth centers of the global economy. If the U.S., the other big one, decides to join in this “austerity binge” the result will be more, not less, U.S. debt and an even bigger growth crisis for the global economy.

So why then did so many countries in Europe do this? It’s about money all right, but not in the way you think. As we found out in the mortgage crisis in the U.S., you can’t have overborrowing without overlending, and core European banks (which are twice the size and three times as levered up as their “too big to fail” American counterparts) overlent to southern Europe on an epic scale, spending northern European savings in southern European bond markets and stuffing their balance sheets with those bonds in the process. Now that these bonds have gone bad, deprived of national currencies with which the governments responsible for these banks could bail them out (a side effect of the euro) European states are reduced to cutting, adding liquidity and praying while the situation goes from bad to worse. Cutting in such a world turbocharges the already bad shrinkage problem.

What about the theory that cuts will lead to greater confidence if only we lose our fear of the cuts and really go for it? The technical, and very non-Keynesian idea here is called the expansionary fiscal-consolidation hypothesis. It goes like this: when the government cuts spending in the middle of a recession, despite the economy falling about our ears with jobs and income evaporating around us, we will know that years ahead the state will be smaller and so we will pay less taxes relative to our lifetime income. Buoyed by this knowledge we will spend more today, despite the recession, thereby curing it. This is the mechanism that is supposed to make us all more confident and spend more. If you know anyone in the world who actually behaves like this, don’t lend them any money.

(MORE: Why the Argument for Austerity Took a Big Hit Recently)

Given then that cuts lead to more debt and less confidence, does it follow that we can have whatever level of debt and deficit we like with no consequences? Absolutely not. And this is where a Keynesian idea is appropriate: that the time for austerity is the boom, not the slump. Countries that have successfully reduced debt have done so when others are expanding and their own economy is booming, which makes perfect sense.

This is why austerity is a dangerous idea: it doesn’t work in the world that we actually inhabit. In the imaginary world of austerity, cuts always happen to someone else. Sadly, as Europe is proving all too well, in the world that we actually inhabit there is no “someone else” to pass the costs on to as we all try to shrink to grow.

19 comments
lizatpatea
lizatpatea

My Trust has recently become a mortgagee to the tune of 22 million. The loans that I am getting from the land owners are at 0% for  50 years. I have sucuritized the debt onto the the public balance sheet via the PPSR. From your analysis  Mark, the land owners have loaned the State $22 million at 0% whereas what happens when a bank becomes a mortgagee (is given a mortgage) they on loan it to the State and clip the ticket plus interest. Surely states cannot be so dim as to not know this is what is going on? Or are the complicit? 

RonPagliassotti
RonPagliassotti

Spending leads to consumption and consumption does not have to lead to debt or at least out of control debt. I'm not sure when the business model changed so much, maybe in the early 80's, "grow or die" you know the debt model. You can now see how that worked out. In the US just about every municipality over the next decade is facing major crisis due to the promises made to municipal workers and teachers in their retirement and health care in retirement that they won't be able to pay for. State and Federal are facing the same problem with no practical solution. Defined benefit is one of the problems, there are others. Creating social programs to help everybody rather than looking for ways to solve the no marketable skills problem of the inner city youth for the last 4 or 5 decades. Finding ways to bring mfg back to fill all those lost jobs. Remember, elected officials will and do promise anything to get votes, no matter how much it cost the current and future tax payer. Those who take other peoples money and don't pay the taxes don't think much about it or couldn't care less(they get most of their basics free and don't have to earn it, but they scream like h**l when they join the workforce and see whats taken out of their paycheck.

danioton5
danioton5

Austerity as usually meant by Keynesians won't work.  That I agree with, and unfortunately M Blyth as far as I can tell doesn't understand any other kind.  If by austerity you mean raise taxes on the private sector with cuts to humanitarian spending the it will not work.  

But if we do something along the lines of Hayek or Hutt and cut government spending (i.e. number of government workers including cuts in compensation for those remaining, size of bureaucracy, anti business regulations, and cuts along those lines) then there will be a J curve effect in the short term but renewed growth soon after as private sector applies additional freed up resources to productive attempts to create value.  Not all attempts to create value work in the private sector, but for sure almost all government spending beyond basics has little value - i.e. there is no multiplier.

It simply will not work to retain government (or increase it) spending to 'stimulate' growth.  The basic reason is that government spending on pretty whatever cannot substitute for private spending.  Keynesians are misled by focusing on the flow of currency, which is also why they believe that central banks can somehow jump start the economy by increasing the amount of currency and lowering interest rates.  The basic Keynesian model appears to work and can do so for many years - even decades - as long as debt levels are manageably low but once debt levels begin to approach problematical levels - as they have done in Europe - then more currency and lower interest rates won't help.  It's not an issue of morality or confidence levels.  Low confidence is an effect not a cause.

In Europe the debt levels were allowed to rise higher than 'normal' because of the Basal accords which from the early 90's have incentivized banks to load up on sovereign debt (vs private lending) thus removing a natural ceiling level that would have brought fiscally irresponsible behavior under control much earlier.  The ceiling was removed.  Debt levels have risen to levels that threaten the banking systems and in effect have paralyzed them and perversely in certain cases forced them to continue suicidal purchasing of additional sovereign debt (political pressure).  

Anyway, real austerity  - smoothed with humanitarian assistance to get through the initial painful J curve effect - is the only way back.  Iceland and Latvia and to some extend Ireland seem to me very good real world examples that real austerity - cutting government - vs the Keynesian version of attacking the private sector in the vain hope that a new credit expansion can be ignited is the only viable solution.

If we continue to adopt the Keynesian version of austerity or increase government spending we will get a very long depression. If we throw into the mix attempts by central banks (QE) to stimulate the economy we will get a situation even worse in which we experience simultaneously 'deflation' and 'inflation' which will also simultaneously inhibit real economic growth.  Imagine a blow torch applied to your right hand even as someone applies liquid nitrogen to your left and they tell you how good it is because the average temperature is just right.

LaughinChance
LaughinChance

  Why reading about Austerity in the MSMedia is dangerous...

Because they don't disclose the truth, sins of omission are everywhere.

If one reads "The Truth About Taxes and Spending in Europe" at realclearpolitics you'll DISCOVER some European Countries are doing all right economically & that what you are fed from the MSM is lacking in two critical items (both of which Obama has us doing here):

"Yet other countries in Asia and Latin America have flourished. What are the weakest economies doing wrong? What are the strongest doing right?

All PIIGGS have two things in common. First of all, government spending grew dramatically — from an average of 43.2% of GDP in 2007 to 52.6% by 2010.

Spending was modestly trimmed by 2012 in a few cases, yet the ratio of spending to GDP still remained 3 to 6 percentage points higher than it had been in 2007.

second thing the PIIGGS have in common. The highest income tax rate was recently increased in every one of the troubled PIIGGS except Italy (where it was already too high at 43%)."
http://www.realclearpolitics.com/articles/2013/04/05/the_truth_about_taxes_and_spending_in_europe.html#ixzz2RDkppJrl 

walstir
walstir

“budget cuts are exactly the wrong thing to do at this moment”

Austerity doesn’t mean running smaller deficits - austerity means reducing one’s expenditures to the point that they are equal to or less than one’s income.   And somehow, it almost never seems be be the right moment for that, because:

early recovery stage excuse:

- it’s too soon since the economy hasn’t fully recovered

full recovery stage excuse:

- after the deprivation and suffering of the crisis we’re entitled to a party

boom stage excuses:

- accumulated deficits aren’t a problem because they are a shrinking percentage of GDP

- now we can afford to borrow to tackle long standing social need problems

late boom stage excuse:

- austerity now will trigger another crisis

next crisis stage excuse:

- this new crisis requires borrowing - not austerity

Then go to the top of the excuse list and repeat forever.



BobShafer
BobShafer

Yes, Keep ringing up those Trillion dollar Deficits, what could possibly go wrong.

tsvskibum
tsvskibum

why do we want to close National Parks because of austerity? Oh yeah people like the current crop of Republicans have been trying to kill National Parks because the interfere with making money which creates jobs and lines the pockets of... Republicans

shaysite
shaysite

Where are all of the austerity idiots, when you need them to read something important?!!

dancooper4
dancooper4

@TIME @TIMEIdeas and taxing through the nose, 17 trillion and climbing and spending 150 for buck you take in is a good idea?

d90272
d90272

@TIME @TIMEIdeas spending is the only way to prosperity. Seems to be working great for France

arvay
arvay

This simple truth -- "And this is where a Keynesian idea is appropriate: that the time for austerity is the boom, not the slump"

 . .  will continue to be ignored by the people who actually run the country -- the One Percenters whose lobbyists write "our" laws and who have evolved from a "noblesse oblige" class into parasitic narcissists who will trigger an eruption and their own demise. Obama buys into their nonsesne as well as the Tea Party. 

As clear evidence from Eurpe indicates, austerity kills growh and stunts any chance of recovery. As any clear-thinking businessperson knows -- you can't reverse the fortunes of a failing company with constant cubacks. That's not a strategy for recovery, it's a strategy to sell the ompany at a bargain proce.

Who will our owners sell us to?

lachlanwells1990
lachlanwells1990

@arvay This is the sad truth indeed. Many people accuse the government and politicians of looking out for the economy above all else, but in reality they don't even listen to any economist worth their salt either: they are looking out for their INTERESTS. George W Bush running deficits during a boom time is not advocated by economists. Austerity during a recession/downturn is not advocated by economists.