Another Failed Austerity Defense

Discussing austerity policies with an Austrian economist is a little bit like discussing free-market capitalism vs. socialism with a leftist. Both compare an abstract ideal of their favorite theory to a poorly managed, diluted and distorted example of their opponent’s theory. There is a reason for this common character trait: both Austrian economics and socialism are exclusively theories with only inferential contact with the real world.

Unfortunately, a Keynesian economist cannot afford himself that privilege. He has to stand with both feet on the ground and begin his reasoning right there. The same goes for the free-market capitalist who is trying to propose policies that will let private citizens – be they consumers, investors or entrepreneurs – go about their business unfettered by government.

Some would object right there and say that there are no more fervent advocates for free-market capitalism than Austrian economists. Rhetorically, that may be true, but as soon as we get down to the policies that Austrians suggest, a divide opens up between them and the free-market capitalist whose cause they claim to be advancing.

This gap between Austrian theory and the real life is particularly obvious in today’s Europe, where Austrian economists have had lauded the current destruction of GDP and have had only one complaint: it’s not enough. The former point is made by economics professor Phillip Bagus and the latter comes from think-tank economist Veronique de Rugy.

As I have explained at length, both Bagus and de Rugy are wrong, morally as well as analytically. And perhaps the Austrian community is beginning to realize that they have ended up on the wrong side of the European crisis. Today a good friend sent a link to the latest issue of The Free Market, a monthly publication of the Mises Institute. There, Mark Thornton makes a case for what he calls “real” austerity, joining his fellow Austrians Bagus and de Rugy in a passionate plea for tough budget cuts all across Europe.

However, unlike his two comrades Bagus and de Rugy, Thornton actually takes time to try to elaborate his case. Therefore, it is my pleasure to counter his analysis with free-market Keynesianism.

First, a quick reminder of where I stand with reference to big government: the welfare state must go, permanently and forever – but it must do so in a way that does not cause undue harm to the most vulnerable of our fellow citizens.

With that in mind, let’s give microphone and spotlight to Mark Thornton:

Austerity has been hotly debated as either an elixir or a poison for tough economic times. But what is austerity? Real austerity means that the government and its employees have less money at their disposal. For the economists at the International Monetary Fund, “austerity” may mean spending cuts, but it also means increasing taxes on the beleaguered public in order to, at all costs, repay the government’s corrupt creditors. Keynesian economists reject all forms of austerity. They promote the “borrow and spend” approach that is supposedly scientific and is gentle on the people: paycheck insurance for the unemployed, bailouts for failing businesses, and stimulus packages for everyone else.

Three points.

1. “Real austerity means that the government and its employees have less money at their disposal.” Well, that is exactly what has happened in Greece, and is currently happening in Spain and, to a lesser degree, in Italy. Thornton better provide a more concise definition of Austrian-based austerity, or else we will have to assume that Phillip “Less GDP is good” Bagus has the final say on that matter.

2. The austerity policies that are currently being forced upon crisis-ridden countries in Europe has nothing to do with repaying “the government’s corrupt creditors”. I would not consider the regular middle-class family corrupt because it buys treasury bonds. Nor would I consider retirement funds, investing the same middle-class family’s long-term savings, to be corrupt because it buys treasury bonds.

The real reason why Greece, Spain, Portugal and Italy are raising taxes and cutting spending is that they are trying to close a budget gap. This budget gap, in turn, is the work of an overloaded, over-bloated welfare state.

3. Bailouts for failing businesses has nothing to do with Keynesianism. I challenge Thornton to provide one logically consistent example from the vast academic Keynesian literature that prescribes corporate welfare. This is a good example of how Austrian theorists bastardize Keynesianism to lower the analytical bar for themselves.

Austrian School economists reject both the Keynesian stimulus approach and the IMF-style high-tax, pro-bankster “Austerian” approach. Although “Austrians” are often lumped in with “Austerians,” Austrian School economists support real austerity. This involves cutting government budgets, salaries, employee benefits, retirement benefits, and taxes. It also involves selling government assets and even repudiating government debt. Despite all the hoopla in countries like Greece, there is no real austerity except in the countries of eastern Europe.

Mark  Thornton might want to talk to his fellow Austrian economist Phillip Bagus about this. In December, Bagus said:

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

Bagus then goes on to argue that so long as there is a deficit, governments are by definition not austere. When governments close their deficits, they are austere, he concludes. This definition is quite different from the one Thornton is putting forward, which couples tax cuts with spending cuts. The question, then, is: what role does the deficit play in Thornton’s definition of austerity?

I realize that any theory, be it Austrian, Keynesian, Rational Expectations or Marxism, is full of internal disagreements. Being only one of two libertarian Keynesians in the world (there is another one in Australia…) I know very well what it is like to clash with people who share your overall theoretical viewpoint. That said, the disagreement between Bagus and Thornton has nothing to do with fundamental theory or methodological principles. It is entirely on the application side, where things are conditioned by solid theory and methodology. Therefore, the question is: how deeply does this disagreement cut into Austrian theory?

Back to Thornton:

For example, Latvia is Europe’s most austere country and also has its fastest growing economy. Estonia implemented an austerity policy that depended largely on cuts in government salaries. There simply is no austerity in most of western Europe or the U.S. … The Keynesians’ magical multipliers have once again failed to materialize. Given that most of these economies have not achieved growth from stimulus, they should give the idea of true austerity a fresh look.

Let’s start with Thornton’s claim about Latvia. Here are the latest numbers from Eurostat on real GDP growth in Latvia:

2006 2007 2008 2009 2010 2011 2012 2013 2014
Latvia 11.2% 9.6% -3.3% -17.7% -0.9% 5.5% 4.3% 3.6% 3.9%

Needless to say, the numbers for 2013 and 2014 are forecasts, and as we know from the past few years any GDP growth forecast in Europe should be taken with a big grain of salt. Therefore, the only numbers worth looking at are the ones from 2006 to 2011; the 2012 figure is still an estimate, as it takes about one quarter of a year to process all data for last year’s GDP. But let’s be generous to Thornton and assume that the 4.3-percent growth number is accurate.

If you started out with $100 in 2006, and that money grew on par with GDP, you’d have $105.70 in 2012. That is less than one percent growth per year.

The same experiment on the U.S. economy, using the same database from Eurostat, allows the $100 to grow to $107.52. By Thornton’s own reasoning, this means that the U.S. policies of out-of-control debt spending, bank bailouts and completely irresponsible and wasteful stimulus packages is in fact a better strategy than what he defines as “real austerity”.

As for Estonia, here is my exchange with Michael Tanner where I refute the idea that Estonia has implemented some sort of “real” austerity.

There is one point, though, where I will give Thornton a thumbs up. He is absolutely correct about the multiplier and its failure to work in Europe. There are two reasons why it has failed (and neither is that the multiplier does not exist, which it does). First, there is a confidence component embedded in the multiplier, which econometricians – who do forecasting on suggested fiscal policy measures – consistently fail to recognize. A consumer will respond to an income increase with more spending if, and only if, he is confident that: a) the income increase is of a lasting nature, or: b) he won’t need the money in the bank for contingency purposes.

If a consumer is uncertain about the future, he will refrain from spending a dollar extra he has earned so that he can have money in the bank in case tomorrow turns out to be worse than today. The same goes for entrepreneurs, whose responses to certainty exhibit themselves in their investment and hiring decisions. A temporary increase in orders will not make a construction contractor hire more people on permanent payroll. A temporary rise in the demand for a certain car model will not be enough to motivate the manufacturer to invest in a new assembly plant.

Confidence, or its flip side which we know as uncertainty, is hard to quantify. The consumption functions that form the base for traditional multipliers do not come with specific confidence components. Mainstream economics still resists the very notion of distinguishing between risk and uncertainty, but in some heterodox circles, primarily Post Keynesian economics, there is a reasonably good body of literature on this. My own doctoral thesis is one of them.

There are ways to quantify the confidence component and embed it in the multiplier. However, those applications have not been absorbed by the mainstream economics literature, and are therefore – understandably yet regrettably – still not used in econometrics.

The second reason why the multiplier has failed in Europe has to do with a recently recognized asymmetry in the multiplier. The traditional view is that the multiplier mechanically works the same way for expansions and contractions in economic activity. This is still true under regular business-cycle circumstances, and when it comes to private-sector economic activity. When these two conditions do not apply, however, the multiplier starts acting up, throwing economists out of their comfort zone.

The IMF recognized this in a good, highly recommendable paper by Olivier Blanchard and Daniel Leigh. Concerned over the consistent errors that the IMF made in forecasting the effects of austerity policies in Europe, they set out to find the bug in their models. It turned out that the multiplier is stronger for contractions in economic activity than for expansions. While not explicitly spelled out by Blanchard and Leigh, their results indicate that the stronger reaction to a contraction has to do with the fact that the contraction is caused by government spending. The explanation could be that the reductions in spending hit low-income families more than others, whose economic margins are small or non-existent. As a result, they contract their spending more than higher-income families would.

Uncertainty and asymmetric response together explain why the multiplier has not kicked the European economy into higher gear. There is, however, a third one. Thornton seems to believe that just because there are persistent deficits in Europe, no spending cuts have taken place. This is a regrettable exercise of armchair theorizing; there is plenty of evidence to the contrary. Thornton might want to start with this piece.

Then, finally, we get to some specifics as to what Thornton himself wants to do about a nation in economic crisis:

Austerity applied … simply means that the government has to live within its means. If government were to adopt a thoroughgoing “Libertarian Monk” lifestyle, then government would be cut back to only national defense (withoutstanding armies and nuclear weapons), with Mayberry’s Andy and Barney protecting the peace.

A philosophical view I definitely share – I am strong supporter of Robert Nozick’s minimal state. But pointing to a star in the sky is one thing. Building the space ship that will get us there is an entirely different matter, one that Austrian theorists do their best to avoid discussing. They touch upon it in the passing, like Thornton:

The national debt would be wholly repudiated. This would involve certain short-run hardships, although much greater long-run prosperity.

Thornton is more than welcome to explain exactly what he means by “repudiating” the national debt. I was under the impression that Austrians considered contractual enforcement a cornerstone of a functioning, civilized economy.

As for the reference to “long-run prosperity”, I am curious: how long is that run? The only concerted effort at estimating that long run, based on Say’s law, that I can remember ever seeing actually places the end of the long run at 100 years. The proof offered (by Swedish economist Assar Lindbeck) is that there is no trend in unemployment  over that period of time. This would echo Keynes’s famous comeback that “in the long run we’re all dead”.

Another question is what the “short-term hardships” actually involve. Does Thornton recommend immediate turn-off of the welfare faucet? An immediate shut-down of tax-funded, government-run hospitals?

I like the challenge that Austrian theory presents, partly because it is often of high analytical quality. But so long as its advocates won’t even waste a single breath on specific policy recommendations, their theory amounts to little more than fiscal sophistry. Unfortunately, Mark Thornton confirms this impression.

But more than that, the steady stream of calls for even more spending cuts, even harder reductions in entitlement spending, and a faster execution of them, puts Austrians in rather ugly moral company. They come across as little more than sophisticated Ayn Randians, their policy ambitions darkened by the shadow of overt egoism and disrespect of the poor and weak.

Mark Thornton and his Austrian fellows should also keep in mind that their dismissive attitude toward the suffering that tens of millions of European families are now enduring does – in some people’s eyes (not mine) – qualify him for even more ominous friendships.

In contrast to Austrian armchair theorizing, I offer a facts-based, empirically workable, Keynesian route to limited government. It is built on reality, solid analysis, recognition of human nature and a steadfast moral commitment to not let the poorest and weakest among us pay the price for the damage that big government has done to our economy.