Keynes was right: you cannot fight a budget deficit with austerity. He never boiled his economic theory down to those succinct words, but he gets pretty close in the opening of Chapter 16 of the General Theory. Combined with his analysis of what motivates consumption, and his eminent explanation of the marginal efficiency of capital, Keynes presents a strong macroeconomic foundation for the so called paradox of thrift.
Hayek agreed with Keynes on the paradox: they both concluded that once an economy falls into a recession it cannot be saved with further reductions of economic activity. The policy implication from this is that once you are in a recession, you cannot generate, or even facilitate, GDP growth by cutting down on government spending.
The same theory clearly states that you cannot fight a budget deficit with tax hikes either. Both measures, spending cuts and higher taxes, have the same destructive effect on economic activity: less aggregate demand, fewer jobs, fewer taxpayers, more entitlement-dependent citizens and as a result a wider budget gap.
Despite the fact that two of the greatest economists of the 20th century agreed on such a fundamental macroeconomic principle, politicians and some ill-informed economists still tout the idea that shrinking economic activity – be it via spending cuts or tax hikes – can cure a recession-driven budget deficit. The political practice of this is austerity, a practice that – as readers of this blog are very well aware – is driving European countries into a destructive spiral of dwindling GDP, rising unemployment, growing poverty and ultimately social unrest and political instability.
The primary expression of austerity has been pure spending cuts, but some countries have combined them with higher taxes. The packaging really does not matter, as more and more countries in Europe are experiencing. You still end up on Square One again. But this has not stopped voters in some countries from shifting foot, from supporting policies with spending cuts as their primary focus to putting more emphasis on tax hikes. Earlier this year the Dutch prime minister was toppled in a parliamentary vote after he had pushed austerity-driven spending cuts too hard. The socialist opposition made headway with public opinion on an anti-austerity agenda, an agenda that was partly adopted by other parties as the September election drew closer.
In June, French voters pulled out the tax whip and started beating themselves over the back. In an expression of weariness with spending cuts they gave both legislative and executive powers to the tax-hiking socialists. Yesterday we reported that the Hungarian government is trying to do the same, and today we hear from the EU Observer that voters in Lithuania are shifting foot from spending cuts to tax hikes:
Parliamentary elections in Lithuania on Sunday (28 October) look to have unseated Prime Minister Andrius Kubilius’ austerity-driven government to make way for a coalition of left-leaning opposition parties. The vote comes amid a deepening recession and an exodus of young people seeking work in other countries. … The trio of opposition parties, led by the Social Democrats, has promised to reverse the trend and increase government spending in a move to spur the economy and create jobs. Raising the minimum wage, increasing the tax burden on the wealthy, and delaying euro entry to 2015 were among the opposition’s campaign promises. Exit polls from 94 percent of polling stations on Sunday show the Social Democrats with 38 seats in the 141-seat parliament. Kubilius’ Homeland Union Christian Democrats came in second with 32 seats. But a coalition between the Social Democrats and the left-leaning Labour and Order and Justice parties would give them a total of 79 seats.
How about that – Labour, Order and Justice. An aptly chosen name of a conglomerate of socialists…
That aside, the Lithuanians are going to experience the same kind of macroeconomic backlash to tax-hiking policies as the Hungarians have: higher inflation, less growth, more people out of work… Increased government spending is also a bad idea, especially since in most instances this amounts to little more than raising entitlement checks. Such policies only redistribute from those who work and pay taxes to those who don’t work and are being discouraged from doing so.
There is only one way out of Europe’s deep crisis: abandon the welfare state. Give people back the control over their own finances, let them build their own financial security, independently of government promises. Let the free market provide health care and education.
After the Berlin Wall fell, Eastern Europe and the Baltic states pursued economic freedom. Their thirst for that which made America great helped them elevate themselves from socialist poverty to prosperity comparable to many Western European countries. In the bargain, though, they have also adopted the Western European welfare state and joined the burdensome, bureaucratic and costly European Union.
A generation after the Soviet Union collapsed and Europe was reunited, it is time for Europe to once again reinvent itself and re-learn the lessons of Keynes – and Hayek.