Austrian Economist Applauds Shrinking GDP

Despite the terrifying consequences of austerity policies across Europe, there are still those who claim that austerity is in fact good and something desirable. My response to Veronique de Rugy’s irresponsible claim that there is not enough austerity in Europe caused quite a stir, and motivated some people to organize an entire conference about European austerity at the Cato Institute.

Today another Austrian theorist joins the austerity appreciation choir. Phillip Bagus, professor of economics at King Juan Carlos University in Madrid, Spain, bizarrly tries to argue that the current crisis, especially the decline in GDP, is actually good for Europe:

Many politicians and commentators such as Paul Krugman claim that Europe’s problem is austerity, i.e., there is insufficient government spending. The common argument goes like this: Due to a reduction of government spending, there is insufficient demand in the economy leading to unemployment. The unemployment makes things even worse as aggregate demand falls even more, causing a fall in government revenues and an increase in government deficits. European governments … reduce government spending even further, lowering demand by laying off public employees and cutting back on government transfers.

The problem is not insufficient government spending. The problem is insufficient spending. It is correct that we who analyze the crisis from a regular macroeconomic perspective identify reductions in government spending as an aggravating circumstance. It is also true that reductions in government spending have caused the Greek recession to escalate into a depression. But it is a non-sequitur that the remedy would be to increase government spending. It would be better for the economy on all accounts that private sector demand increased.

That said, it is an indisputable fact that if you remove $100 worth of government spending and those $100 are not replaced with private spending, the economy suffers a net loss of $100 worth of spending. It follows that government spending cuts are not always good for short-term macroeconomic activity.

Back to Bagus:

What can be done to break out of the spiral? The answer given by commentators is simply to end austerity, boost government spending and aggregate demand. Paul Krugman even argues in favor for a preparation against an alien invasion, which would induce government to spend more. So the story goes. But is it true?

The good professor needs to look beyond Paul Krugman. Just because one economist is overly simplistic and sometimes outright stupid, it does not mean that another can do the same and retain his credibility. But instead of recognizing this Bagus goes on an eclectic flea-killing hike through the landscape of semantics:

First of all, is there really austerity in the eurozone? One would think that a person is austere when she saves, i.e., if she spends less than she earns. Well, there exists not one country in the eurozone that is austere. They all spend more than they receive in revenues. In fact, government deficits are extremely high … . A good picture of “austerity” is also to compare government expenditures and revenues (relation of public expenditures and revenues in percentage). Imagine that a person you know spends 12 percent more in 2008 than her income, spends 31 percent more than her income the next year, spends 25 percent more than her income in 2010, and 26 percent more than her income in 2011. Would you regard this person as austere?

In addition to dressing up the term “austerity” in an erstwhile French definition with no connection to modern economics, Bagus also makes the classic mistake of comparing an individual to a government. I am intrigued by the frequency with which Austrian economists do this. It is as though they purposely want to deny that governments have entirely different lines of credit than private citizens, and that those credit lines fundamentally change the case for government deficit spending.

Then Bagus makes an analytical somersault worthy of a circus acrobat:

This is what the Spanish government has done. It shows itself incapable of changing this course. Perversely, this “austerity” is then made responsible for a shrinking Spanish economy and high unemployment. Unfortunately, austerity is the necessary condition for recovery in Spain, the eurozone, and elsewhere.

In effect, Bagus says that Spain would have been better off if government had spent less or taxes had been higher. His analysis is entirely static, completely void of recognition that economic activity takes place in time. He also treats austerity as if it was an accounting balance, not a policy strategy.

His somersault continues:

The reduction of government spending makes real resources available for the private sector that formerly had been absorbed by the state. Reducing government spending makes profitable new private investment projects and saves old ones from bankruptcy.

Given the context, this is one of the most uninformed statements I have ever heard from an economist. The only way to mitigate its severity is to implicitly assume that Professor Bagus is injecting an implicit axiom into his argument. If so, he would be in good company. There are allegedly 126 implicit axioms in Spinoza’s Principia Ethica. However, implicit axioms do not solidify economic analysis. They blow holes in it.

The mere notion that a cut in government spending leaves more resources available to the private sector sets the good professor up for a lengthy lecture on public finance. In order to spend a dollar, government has to either tax a dollar or borrow a dollar. That is where government takes resources away from the private sector. If government takes a dollar in taxes or in the form of a loan, and then spends it, then it actually returns the money to circulation in the economy. It is less efficient – often a lot less efficient – than if the private sector could make the decision on how to use that dollar, but it is nevertheless returned.

If on the other hand government takes that dollar from the private sector but then refuses to spend it, how does that put the dollar back in the hands of the private sector?

If Professor Bagus bothered to look, he’d see that in every crisis-ridden country in Europe, spending cuts are coupled with tax increases. When government cuts its spending by one dollar, it still takes that dollar from the private sector – plus another dollar. The private sector is left with less, not more as Professor Bagus tries to tell us.

Here is how he tries to deny these basic facts:

Take the following example. Tom wants to open a restaurant. He makes the following calculations. He estimates the restaurant’s revenues at $10,000 per month. The expected costs are the following: $4,000 for rent; $1,000 for utilities; $2,000 for food; and $4,000 for wages. With expected revenues of $10,000 and costs of $11,000 Tom will not start his business. Let’s now assume that the government is more austere, i.e., it reduces government spending. Let’s assume that the government closes a consumer-protection agency and sells the agency’s building on the market. As a consequence, there is a tendency for housing prices and rents to fall. The same is true for wages. The laid-off bureaucrats search for new jobs, exerting downward pressure on wage rates.

This is economic sophistry. The rent for a restaurant is not going to go down because government sells an office building. Likewise, government bureaucrats are not the first in line to apply for waiter jobs at a restaurant. But if Professor Bagus has a lot of examples of that to show us, he’s more than welcome.

It gets better:

As the government has reduced spending it can even reduce tax rates, which may increase Tom’s after-tax profits. Thanks to austerity the government could also reduce its deficit.

All of a sudden Professor Bagus has magically made the unemployed government bureaucrats disappear. Their lost income, which led to reduced private consumption and thus less demand for restaurant dinners, has conveniently not become a problem for the good professor. The increased cost for unemployment benefits when the bureaucrats are laid off is also gone with the wind.

The world looks simple and two-dimensional if you close one eye.

It looks even simpler if you disregard the fact that there are people out there who have been lured into dependency on government for their livelihood, who would suffer tremendously if we did what Austrian economists like Professor Bagus suggest, namely to simply and quickly terminate entitlement programs:

In the end, the question amounts to the following: Who shall determine what is produced and how? The government that uses resources for its own purposes (such as a “consumer-protection” agency, welfare programs, or wars), or entrepreneurs in a competitive process and as agents of consumers, trying to satisfy consumer wants with ever better and cheaper products (like Tom, who uses part of the resources formerly used in the government agency for his restaurant).

Notice how he slips “welfare programs” into his argument, as if they were nothing more than expenses for utilities for a government office building.

The fundamental problem with government is not that it sucks up resources that could be better used by the private sector. That happens, and it has to stop at some point, but that is only an ancillary problem. Far more serious is the problem we have with people who have lost, or given up, all other options in life than government dependency. These are the people in Spain who live off welfare and still have to resort to food scavenging to survive. These are laid-off workers in Greece whose unemployment benefits have been so drastically cut they can barely even feed themselves on a daily basis.

We are talking about retired people who believed government all their working years, when government promised to provide health care and a pension when they retired. Now government is cutting down on both and they have no money to go anywhere else. But even those who have some cash in the bank find it next to impossible to go anywhere else: government has monopolized such large segments of the welfare sector that private alternatives barely even exist anymore.

When Professor Bagus cuts or eliminates welfare, these are the people he will leave out in the street to fend for themselves. The good professor chooses to rely on the free market forces to reduce the cost of living for small businesses so they will hire all those thrown out of welfare programs. But unless the professor can prove otherwise, I will compare the deflation effect from spending cuts to the distance a mouse can move a rock by pushing on it with its nose.

It is necessary for the future that we eliminate government-provided welfare programs, but it must be done in an orderly fashion. Those who depend on government must be given a road out of their dependency without suffering immediate financial hardship in the bargain. It can be done, but unlike the uninformed, irresponsibly simplistic approach of Professor Bagus, the real solution takes hard work and ingenuity.

Overall, Professor Bagus gives the impression of being out to simply score a few quick points on a rather serious subject. But I cannot escape the feeling that he might actually believe what he says. This feeling is reinforced by his amazing reasoning regarding GDP:

But does austerity not at least temporarily reduce GDP and lead to a downward spiral of economic activity? Unfortunately, GDP is a quite misleading figure. GDP is defined as the market value of all final goods and services produced in a country in a given period.

What is so misleading about that? Has Professor Bagus developed a national accounts system that works better than the one that gives us GDP?

Hold on to your hat now:

There are two minor reasons why a lower GDP may not always be a bad sign. The first reason relates to the treatment of government expenditures. Let us imagine a government bureaucrat who licenses businesses. When he denies a license for an investment project that never comes into being, how much wealth is destroyed? Is it the expected revenues of the project or its expected profits? What if the bureaucrat has unknowingly prevented an innovation that could save the economy billions of dollars per year? It is hard to say how much wealth destruction is caused by the bureaucrat. We could just arbitrarily take his salary of $50,000 per year and subtract it from private production. GDP would be lower. Now hold your breath. In practice, the opposite is done. Government expenditures count positively in GDP. The wealth destroying activity of the bureaucrat raises GDP by $50,000. This implies that if the government licensing agency is closed and the bureaucrat is laid off, then the immediate effect of this austerity is a fall in GDP by $50,000. Yet, this fall in GDP is a good sign for private production and the satisfaction of consumer wants.

This reasoning makes me wonder if Professor Bagus is even vaguely familiar with the national accounts system. He tries to make the case that wealth somehow belongs in our annual sum total of our economic activity (what is commonly known as GDP). But GDP does not measure wealth, nor is it designed to do so.

Here is an analogy that the good professor hopefully understands. GDP measures the amount of water that flows from your shower. Wealth, on the other hand, is the amount of water standing in your bath tub. One if a flow, the other is a stock. Or consider the difference between your monthly income and the money sitting in your savings account. One is a flow, the other is a stock.

Even more ludicrous is the idea that you compare the hypothetical value of an economic transaction that never took place with the value of actual transactions that have taken place. This comparison violates the very foundations of economics as a science; it is as though a demographer would compare today’s American population to what it would have been if all my unborn brothers would have been born.

I certainly hope the good professor is making this comparison only to score a careless rhetorical point.

And now for the final Austrian punch – the notion of “artificial” economic activity:

Second, if the structure of production is distorted after an artificial boom…

Definition, please. An analytically useful one.

…the restructuring also entails a temporary fall in GDP. Indeed, one could only maintain GDP if production remained unchanged.

Still no definition of “artificial” economic activity. Professor Bagus offers a hint, though:

If Spain or the United States had continued to use their boom structure of production, they would have continued to build the amount of housing they did in 2007. The restructuring requires a shrinking of the housing sector, i.e., a reduced use of factors of production in this sector. Factors of production must be transferred to those sectors where they are most urgently demanded by consumers. The restructuring is not instantaneous but organized by entrepreneurs in a competitive process that is burdensome and takes time.

As I have explained, the Spanish economy did indeed see a housing boom that was helped along by government regulations (similar to those that caused problems on the U.S. housing market). However, if this is what Professor Bagus defines as an “artificial” boom in the economy – the artificial component being regulations governing the mortgage loan market – then any action taken by any government by definition causes artificial economic activity. If we spend money on the U.S. Supreme Court and the Court hires law clerks for the justices, then the money that those clerks spend is an artificial stimulus of the Washington, DC local economy.

The “Austrian” response to this would be that:

  • All government economic activity is artificial because it hampers private economic activity, and
  • In a perfect world it is so small it won’t cause any booms and busts.

The first point is false. Spending on law and order and on the enforcement of contracts is good for the economy. It creates a stable economic infrastructure for private entrepreneurs to work and operate within. In its absence the economy would actually perform worse.

Empirically, it is possible to show that government spending on infrastructure can have positive effects on the economy. Would Austrians define such spending as “natural” or “artificial”? My guess is the latter, as Austrians habitually reject empirical evidence.

The second point is meaningless unless our Austrian friends can come up with an empirically workable definition of “artificial” economic activity.

It would be interesting to see how Professor Bagus would explain his final punch to the people in Greece who are now in their fifth year with a contracting GDP:

In this transition period, when jobs are destroyed in the overblown sectors, GDP tends to fall. This fall in GDP is just a sign that the necessary restructuring is underway. The alternative would be to produce the amount of housing of 2007. If GDP did not fall sharply, it would mean that the wealth-destroying boom was continuing as it did in the years 2005–2007.

There is absolutely nothing that says GDP has to fall for these reasons. Professor Bagus argues as though there is no restructuring going on during regular economic times. But the fact of the matter is that there was a significant migration of jobs and capital between sectors of the American economy during the long, 20-year expansion period during the Reagan and Clinton presidencies. From 1980 to 2000 the number of private-sector employees in the American economy increased by 50 percent, but the number of employees in manufacturing remained unchanged. Yet this significant shift in favor of a service-based economy took place while unemployment trended down from double digits to four percent.

I am sure Professor Bagus is a good guy, but his economic analysis leaves a lot to wish for. Sadly, many friends of limited government believe Austrian theory as gospel. The consequences can be just as disastrous as the ones that come out of bastard Keynesian policies that relentlessly grow government.

Which, ironically, puts Professor Bagus in the good company of the esteemed economic airhead, Dr. Paul Krugman.