Estonia and Austerity: Response to Michael Tanner

Updated – see the bottom of the text.

Cato Institute Senior Fellow Michael Tanner is a sharp guy. He has been a leading figure in the fight for health care freedom for many years. He is a very good writer and his book Leviathan on the Right is a must-read.

His latest piece in the National Review Online (NRO) is a contribution to the sprawling debate about austerity in America. So far, the austerity debate has been confined to the European continent where the concept has a relatively clear meaning, both in theory and in fiscal practice. Over the past two decades at least a hundred million Europeans have suffered under different regimes of austerity.

It is good to see Tanner join this debate. However, his piece adds at least as much confusion as it clears away. His main selling point is that “austerity works”, but in order to reach that conclusion he misrepresents some facts and therefore draws an unwarranted conclusion. Since the topic is of epic importance to our time, and we will essentially only get one chance to save this economy and this country from the Greek disaster, I find it necessary to engage Tanner on the points where he goes wrong.

Here is what he writes:

As Greece, and now Spain and Italy, struggle with the crushing burden of debt brought on by the modern welfare state, perhaps we should shift our gaze some 1,200 miles north to see how austerity can actually work. Exhibit #1 is Estonia. This small Baltic nation … had been one of the showcases for free-market economic policies and had been growing steadily until the 2008 economic crisis burst a debt-fueled property bubble, shut off credit flows, and curbed export demand, plunging the country into a severe economic downturn.

Is Tanner referring to deregulation and business-friendly taxation? Probably, because as far as government spending is concerned it is hard to talk about Estonia as a free-market economy. Eurostat reports that in 2006 general government expenditures were 33.6 percent of GDP in Estonia. In 2009 that share had increased to 45.2 percent. In 2010 it dropped back to 40.6 percent, ostensibly due to a small spending cut in ’09, but that cut was only a temporary deviation from a trend of otherwise strong growth in government spending.

From 2006 to the draft budget for 2011, total government spending in Estonia increased by 8.2 percent per year on average. In 2009 spending actually fell by 3.1 percent, though by 2011 the annual increase was already at five percent again.

The contents of the budget of the Estonian government raise more questions about where the free market principles are in their spending. In 2006 Estonia spent 59.7 percent of its government budget on welfare-state programs under the titles “Education and Research”, “Culture”, “Economic Affairs and Communications” (largely but not entirely comparable to corporate welfare plus spending on public transit) and “Social Affairs”. This share increased to 65.1 percent in 2009 and 65.9 percent in 2010. Budget projections for 2011 point to 64.1 percent of total government spending being allocated for welfare-state programs.

In other words, over the past five years the Estonian government has grown its spending at least as fast as the U.S. government. This does not mean that Estonia has not tried to cut its spending: as I have explained earlier, the wrong kind of spending cuts can (in part through something called “the paradox of thrift”) actually lead to an increase in government spending. Greece is an example of this.

There is some indication that this may be true for Estonia. Turning again to Eurostat, this time for data on social benefits expenditure, we find that the Estonian government spend an equivalent of 12 percent of GDP on social benefits in 2006. By 2009 that share had increased to 19 percent, one of the sharpest increases in Europe. This could indicate that Estonia has tried what Tanner suggests, namely austerity-style spending cuts, and that those cuts have backfired, just like they did in Greece.

The problem is that there are no traces of such policies in the Estonian government’s budgets from 2006 and on. I therefore draw the conclusion that their government simply has kept the core functions of its welfare state intact and that the recession in 2008-2009 loaded up the welfare state with people asking for entitlements.

Again, available data is somewhat inconclusive. But this does not mean that Tanner is right. It means that he rushing to conclusions. To make matters worse, his conclusion is also based in part on a misrepresentation of economic facts. There are no data to show that Estonia has cut government spending the way Tanner claims. Back to his NRO piece:

However, instead of increasing government spending in hopes of stimulating the economy, as Krugman has urged, the Estonians rejected Keynesianism in favor of genuine austerity. Among other measures, the Estonian government cut public-sector wages by 10 percent, gradually raised the retirement age from 61 to 65 by 2026, reduced eligibility for health benefits, and liberalized the country’s labor market, making it easier for businesses to hire and fire workers.

If you raise the retirement age today for people retiring tomorrow, it is not going to have any effect on government spending until tomorrow, at the earliest. As for health care expenditures, the budget for 2011 reports an increase in health care expenditures.  These are claimed to be, primarily, in the form of investments in hospitals and other health provision facilities. But even if Tanner’s reported cut in eligibility for health benefits is correct (and I assume that he is right in this) it has yet to show up as a genuine cut in government expenditures. Therefore, we have no way of telling whether or not their alleged austerity policies have worked as intended.

Perhaps more importantly, the benefit cuts he reports are of the kind we have seen in single-payer health care systems all over Europe. These cuts come without corresponding tax cuts and without deregulation to allow people to opt out of the government system. As a result, people get less back for the same – or sometimes higher – taxes, which in fact means a net increase in government intrusion on the private sector. This is a typical sign of classic European austerity.

Which brings us to a terminological point. Tanner uses the term “austerity” as if it simply means “cut spending”. But there is an enormous difference between spending cuts depending on their purpose and their fiscal context:

  • Spending cuts that aim to balance the budget (purpose) are typically coupled with constant or higher taxes (context) and lead to an increase in government’s net drainage of resources from the economy, thus less growth and perpetual budget problems;
  • Spending cuts that aim to shrink government (purpose) are typically coupled with tax cuts and deregulation (context) and will almost always lead to significant improvement in economic growth.

Greece is notorious for having relied on the first kind of spending cuts. Other examples of failed cuts of the first kind are Sweden in the 1990s and Denmark in the 1980s. Tanner seems to be claiming that the Estonian cuts are of the same kind. If so, the sharp rise in social-benefits spending would again be a symptom of these cuts – and an indication that those cuts have not worked as intended.

As another argument to the conclusion that austerity has worked in Estonia, Tanner claims that: “Today, Estonia is actually running a budget surplus”. But I cannot find a budget surplus for 2011. According to preliminary data for that year, the Estonian government ran a deficit equivalent to four percent of total spending. If he is referring to forecasts for 2012, he should clarify that.

My concerns with Tanner’s analysis are not that I disagree with his ambitions to shrink government. On the contrary, that is an absolute necessity both here and in Europe. My concerns are instead with Tanner’s attempt at drawing conclusions based on a misrepresentation of what is actually going on in Estonia. If Estonia has executed Greek-style spending cuts, and Tanner wants similar cuts in America, then the evidence contradicts Tanner’s conclusions.

If on the other hand he is claiming that there have been structural, long-term cuts to the Estonian welfare state, then yes, I would like to see those here as well. Structural reform is the only way forward. The problem for Tanner is that there is not yet any evidence of such structural reforms in the Estonian budget.

From the data available, I am inclined to believe that if they try to cut spending, it is to preserve, not reform away their welfare state.

Perhaps Tanner and others who hold up the Estonian example as something to follow could be a bit more specific as to what exactly they are looking at. I am all for using foreign examples to inspire American reform – but those examples must be accurately represented. We will only get one chance to cut away the American welfare state, and we darn well better make sure we do it the way Toyota builds cars - get it right on Day One – and not the way GM does it – hit and miss.

Statists can hit and miss (and they miss almost all the time). We can’t miss once. If we do – if we cut government the way they did it in, e.g., Denmark, Sweden and Greece - we will not only drive our economy into the ground, but we will also give limited government a bad name for decades to come. We simply cannot afford that.

Update: During an interesting and productive exchange with Michael Tanner on Facebook, he drew my attention to the following: “One small point conta your post, according to the Estonia Department of Finance document, ’2012 Stability Programme’ Estonia ran a 1% of GDP surplus in 2011.” This appears to be a report on actual spending and tax revenues, which is different from the budgeted deficit I referred to above. This difference is important, so thanks to Michael for pointing to this. When actual government spending and revenues produce a better budget balance than the budget for that same year did, it is usually a sign that the tax base – ultimately GDP – is doing better than forecasters had initially expected. This indicates that the Estonian economy is indeed growing solidly, which makes it even more important to go back and review the country’s economy when we have a bit more data at hand.