Why Austerity Spending Cuts Don’t Work

The Greek secession from the euro is drawing closer. According to two non-English speaking European news sites there have been informal phone conversations between prime ministers in the EU to prepare the member states for the repercussions when – not if – Greece leaves. So far these conversations are mere rumors, and normally I would not comment on them. However, there are enough of other indicators pointing to a Greek departure that we have good reasons to assume that these rumors may indeed be accurate.

It is understandable, but extremely unfortunate, that Greece chooses the easy way out of its problems. The problem is that they are doing it to save themselves from having to implement more austerity policies dictated by the EU and the European Central Bank (ECB). This is a short-term and entirely erroneous strategy to solve the country’s notorious government budget problems. But nothing good will come out of a shift in Greek fiscal policy from destructive austerity to the alternative that the country’s anti-EU parties are suggesting, namely a return to the old path of government spending. To make matters worse, there seems to be a rising support in Greece for higher taxes on “the rich” and even nationalization of some private businesses.

Sadly, it looks like Greece is beyond rescue at this point. The best we can do is try to learn from the Greek experience and save other European countries from a similar fate – and, most important of all, try to save America from making the same stupid mistake that hurled Greece into a fiscal black hole.

There are two lessons to be learned here. The first is not very controversial: the Greek crisis originates in out-of-control government spending and has nothing to do with some “financial crisis”. To the extent that private banks have failed, it is because they have been lending money to the Greek government and been strong-armed into writing down what the government owes them.

The second lesson  is that we essentially only get one chance at saving a country in Greece’s position. If you put the wrong policies to work, you aggravate an already serious situation and make it essentially impossible to put the right kind of policies to work. The problem with Greece is that it has been trying to put the exactly wrong policies to work over the past three years: spending cuts combined with tax hikes.

That combination, also known as “austerity”, is bad at any time and lethal to an economy if put to work at the wrong moment. To see why, let us do an experiment based on the latest so called Stabilisierungsprogramm that the EU and the ECB imposed on Greece last year. This program contained a number of measures that were aimed at reducing or reining in government spending. Two of the most direct measures in terms of spending cuts were:  

Analyzing the spending cuts in the IKA is complicated. The foundation is a mix of entitlement programs bundled together under one umbrella for no apparent reason. It covers cash benefits such as pensions or income replacement due to unemployment or sickness; it also covers in-kind services such as health care, dental care and even “spa therapies” and “therapeutic tourism”. In other words, it provides most of what you will find on a welfare statist’s wish list.

The heterogeneity of IKA programs means that it is difficult to immediately assess the effects of government cutting spending on the foundation. The only tangible cut that has come out of it yet is a 22-percent reduction in unemployment benefits (though these are technically administrated by another government entity – the eligibility requirements fall under the IKA’s jurisdiction). This cut has direct effects for our analysis here.

Before we get there, though, let us get back to the 15,000 workers that the ECB austerity program forces the Greek government to lay off in one year. This is part of a plan to cut away ten times as many government employees by 2015, admittedly a much more drastic number as it means doing away with more than a third of government employees (not counting the approximately 650,000 who work for government-owned enterprises). 

Long-term, such big cuts in government spending are necessary. But more importantly, the programs they work for and administrate must also go. That would take structural reforms of a kind that neither the Greek government nor the EU/ECB have considered. Since they are interested only in panic-driven cuts here and now, we are going to conduct our little experiment based on that premise.

The very purpose with laying off 15,000 government workers in one year is, of course, to remove them from government payroll. This allows a spending cut and, in theory, a dollar-for-dollar corresponding reduction in the budget deficit. In order to determine with good precision just how much spending is reduced from these layoffs we need to know where the layoffs actually took place. That level of data is not yet available (other than in anecdotal form). However, we can make a general estimate based on compensation data from the International Labor Organization (ILO). Suppose, therefore, that a Greek government worker makes, on average, 24,000 euros per year. This is a tad on the low end, somewhat biased toward employees in the health care sector and other typical government service jobs rather than administration. However, in order to fire such large amounts of employees, the Greek government will inevitably have to cut in to the large cadres of lower-paid employees that are currently on taxpayers’ payroll. Besides, as the next assumption shows, the actual numbers matter less than the mechanics of the analysis.

It is extremely unlikely that these 15,000 government employees will find private sector jobs: according to Eurostat, unemployment in Greece has shot up from 7.7 percent in 2008 to 17.7 percent in 2011. (Youth unemployment is a devastating 44 percent.) It is therefore reasonable to assume that they will all be on tax-paid unemployment benefits for at least a year. Currently, the unemployment benefits system in Greece does not compensate by percentage of earnings, as in most other welfare states. Instead, the compensation is a fixed monthly amount. Before the austerity package was imposed, the benefit was 454 euros per month; since March of 2012 it has been reduced to 360 euros per month.

Suppose, now, that we put all our 15,000 newly unemployed government workers on unemployment benefits. They each receive an annual amount of 4,320 euros – dangerously close to the established poverty threshold in Greece – which adds up to 64.8 million euros per year in new unemployment benefit costs to government. This is a far cry from the 360 million euros that taxpayers paid these workers every year while they were on government payroll. The austerity program mandates the 360 million spending cut, and it looks like it accomplished a net cut of 295.2 million.

However, there is more to this sordid story. There is no established, universal welfare program in Greece. Unlike the United States, the Greek welfare state is heavily biased toward providing benefits for those who work, as well as a single-payer health care system. For this reason, we can assume that our 15,000 laid-off government workers will receive no other benefits from government than their unemployment checks. As a result, the 295.2 million that government saved by firing these workers have now been removed from the economy. Previously, the government workers spent the money; now they don’t.

This removal of spending has consequences. Even if these workers did not do a cent’s worth of work as employees of the government-run health care system, government bureaucracy, schools, etc., they still had more money to spend than before they were laid off. (If they actually did work that was at least moderately valuable, their layoffs cause a larger loss to the economy than their spending money.) Therefore, in order to assess the consequences of this austerity program we need to recognize that there is a loss of consumption in the Greek economy. The loss is obviously barely a scratch on the surface of total private consumption, but it is nevertheless a loss.

Established GDP data (see Eurostat, the OECD or the UN statistical database) says that consumers spend approximately 70 percent of their money on food, shelter, clothing and daily travels. Data for the United States differs a bit thanks to our higher standard of living, but this number is a good proxy for Greece. Suppose that the aforementioned government workers lived paycheck to paycheck, thus spending 100 percent of their net tax earnings. Given Greek income tax rates and the 70-percent rule of thumb for spending on basic items, we can conclude that each laid off government worker will reduce his consumption by 10,380 euros per year. The total reduction for our 15,000 workers is  155.7 million euros.

This amount is taken out of the current-expenses economy, which we can assume will have direct implications for retail and basic consumer-services businesses (think hair dressers). Using again ILO data, we can estimate the average earnings in the affected segment of the labor market to 18,000 euros per year. If we divide the lost spending by this amount, we end up with sales losses for retail and basic services businesses that amount to 8,650 workers. If they, too, end up looking for work unsuccessfully, the total cost of unemployment compensation from the original spending cut rises to 102.2 million euros.

In other words, what started out as an original reduction in government spending of 360 million euros is now down to 257.8 million euros.

If we implement a similar spending cut in a country where unemployment compensation is a percentage of the laid-off person’s earnings, the net cut is even smaller. If the Greek unemployment insurance fund had compensated at 60 percent of earnings, the net savings from the initial cut would be a meager 140 million euros (all other things equal). If, in addition, there would be other social protection programs in place to mitigate the income loss for the laid-off government workers, the net savings amount would shrink even further.

And let’s keep in mind that we have not even calculated the tax revenue losses throughout this process.

The lesson to be learned from this is not that we should not shrink government. On the contrary – government is the root cause of Greece’s problems: the political robber barons who take people’s money under the guise of the welfare state are the ones who have sunken half of Europe into a dungeon of stagnation, proliferating poverty and perennial unemployment.

No, the lesson to be learned here is that panic-driven, slash-and-burn, “just cut spending, damn it” policies are the wrong way to reduce government. Such policies have repercussions that erode or even nullify the original purpose. Instead, you have to proceed along the lines of a structural removal of the welfare state. This model requires more space to explain in detail than this article permits, but for the interested I have outlined the architecture of a structural reform in my book Ending the Welfare State.

Greece is, again, beyond rescue. Let’s learn from their mistake and avoid the same kind of austerity policies here in America. Let’s go straight for the structural reforms that permanently remove the welfare state.