Europe’s austerity disaster is not just a matter of reckless policy decisions by arrogant leaders in the EU, although that is ultimately where the buck stops. Many others have been involved in explicitly or implicitly, directly or indirectly, keeping the crisis going. Among them are assorted economists in various positions whose forecasts have reinforced the desires among political leaders: while the politicians want austerity to work, economists have predicted that it would work.
There is just one problem. Austerity does not work. While it has taken economists quite a while to begin to realize this, others have raised questions for some time now. Among them are business leaders: two years ago British corporate executives began expressing concern about the soundness of continuing EU-imposed austerity policies. The seeds of that doubt have grown, so much in fact that a few days ago Britain’s Chancellor of the Exchequer found it necessary to make a plea to business leaders to stay on board with Britain’s own austerity program. The Guardian reports:
George Osborne has asked business leaders to hold their nerve and continue backing the government’s austerity measures after the Bank of England gave the first signal since the financial crash of a sustained economic recovery. The chancellor told the CBI annual dinner on Wednesday night that the business community should ignore critics of his economic policy who advocate a stimulus package to spur growth and reduce unemployment. … His speech followed a series of forecasts from Threadneedle Street showing the UK recovery strengthening and inflation falling over the next three years. Sir Mervyn King said the outlook had improved, with growth likely to reach 0.5% in the second quarter of 2013, after the 0.3% registered in the first three months.
This is a good example of how the desires of politicians conspire with unrefined forecasts by economists. Anyone who reads a “strengthening recovery” into a 0.2 percent of GDP uptick in growth, from 0.3 to 0.5 percent, is either sloppy or desperate. Since the difference between 0.3 and 0.5 percent is little more than a margin-of-error change to GDP growth, I am inclined to conclude that at least some of the involved economists are sloppy.
One reason for this is that there have been forecasts of an improvement at the time of the announcement of every new austerity package in Europe over the past few years. I am planning a larger research paper to expose these errors; in the meantime, it is important to ask why economists think that the current austerity policies will have any other effect than the others that have been implemented since 2009.
More on that in a moment. It is important that we do not let the political leaders off the hook. I am firmly convinced that they are desperately looking for any sign that austerity is working – and that their desperation has reached such levels that they are inviting to a conspiracy of the desperate and the willing. It is interesting, namely, to see all the optimistic forecasts that are surfacing now. Politicians who should know better than most of us that austerity does not work, give a surprising amount of attention to those forecasts.
Their desperation is cynical yet understandable. Almost every political leader in Europe has invested his entire political career in supporting austerity. Now he is witnessing more and more critics lining up with The Liberty Bullhorn, pinning the unfolding social disaster on austerity advocates.
The obvious reaction should be to question austerity. After all, I cannot be the only one to ask how much farther the EU is willing to push its member states. For example, how much more can Greece take before the country explodes?
Europe’s leaders are no doubt aware of how close some parts of the continent are to social unrest. So long as austerity-minded politicians cannot provide people with an economic recovery, they know they are accountable for whatever happens.
As an alternative, they use forecasts of willing economists to convince people that the recovery is just about to happen, no matter how microscopic it might be. The Guardian again:
The modest improvement in output over recent months comes against a backdrop of rising unemployment, the lowest wage rises on record … According to the Office for National Statistics unemployment rose by 15,000 to 2.52m in the three months to the end of March. Wages were 0.8% higher in March than a year ago and only 0.4% better if bonuses are taken into consideration, which is the lowest rise in incomes since records began in 2001.
Again, calling this a “strengthening recovery” is clear signs of desperation. There were times when any growth under two percent set off alarm bells, among economists as well as politicians. Now, numbers a fraction as high are raised to the skies as signs of a “strengthening” recovery. From the Sydney Morning Herald:
The dogged recession across the eurozone has snared key economy France, with the latest EU figures released Wednesday [May 15] showing a full year-and-a-half of contraction as tens of millions languish in unemployment. In Brussels, French President Francois Hollande tipped ‘zero’ growth on the national level, blaming an EU-wide, German-led austerity trap — and hitting out at banks for holding back on lending as he and fellow leaders battle to unlock taxable assets hidden in offshore bank vaults or breathe life into training programmes for Europe’s disillusioned youth.
And his recipe is to take it all out in the form of higher taxes instead. Yep. That will really make things better… The fact of the matter is that France desperately needs a complete reversal of its economic policy, with long-term credibility to go with it. The same holds for the entire euro zone, which according to the Sydney Morning Herald is in deep trouble:
official figures showed a 0.2 per cent contraction between January and March, in the longest recession since the single currency bloc was established in 1999. EU data agency Eurostat said output across the 17 states that share the euro — which are home to 340 million people — fell by 1.0 per cent drop compared to the same quarter last year. France notably slid into recession with a 0.2 per cent quarter-on-quarter contraction, with unemployment already running at a 16-year high.
French president Hollande blamed the bad economic news…
on “the accumulation of austerity politics” and a “lack of liquidity” within the banking sector leading to a euro-wide loss of confidence. Fresh from winning France a two-year period of grace from the Commission to bring its public finances back within previously-understood EU targets, Hollande argued that nascent plans to divert state and private investment towards projects intended to get Europe’s youth working would make a difference.
In other words, more government programs on top of government programs that don’t work. If government was the answer, there would not be a crisis in Europe today.
Instead, as the Sydney Morning Herald reports, Europe is heading for yet more of the same, though some economists seem stubbornly unwilling to accept the permanent nature of the crisis:
Following a string of disappointing survey results in recent weeks, Ben May of London-based Capital Economics warned: “We doubt that the region is about to embark on a sustained recovery any time soon.” The latest official European Commission forecast for 2013 published earlier this month tipped a 0.4-per cent contraction, but May said that was way off course with “something closer to a two-per cent decline” likely. His firm’s pessimism was backed by Howard Archer of fellow London-based specialist analysts, IHS Global Insight. “We expect the eurozone to suffer gross domestic product (GDP) contraction of 0.7 per cent in 2013 with very gradual recovery only starting in the latter months of the year,” said Archer.
What reason does he have for expecting a recovery? This is the standard mistake that mainstream economists and econometricians make: they rely heavily on models that are inherently prone to draw the economy toward long-term full employment equilibrium. When they “inject” a change to economic activity, such as an austerity package, their model automatically makes the assumption that this sudden and uncharacteristic change – called a “shock” – will be absorbed and the economy will move on.
Every new austerity package is treated the same way, both by the econometricians who design the models and by the economists who provide the analytical framework. Their take on the European crisis is therefore a series of individual shocks, not a systemic re-shaping of the entire economy. As a result, they always predict a recovery and return to some long-term stable growth path.
To the best of my knowledge there is not a single macroeconomic model out there that has yet incorporated the systemic effects of austerity. Therefore, the economics profession will continue to make systemic forecasting mistakes – and advise politicians based on those mistakes.
Don’t get me wrong. I am not blaming economists for the errors that politicians end up making. But our profession must begin to recognize its almost chronic inability to deal with economic crises. Our forecasting methods can handle regular recessions but are frustratingly inept at dealing with situations that become inherently unstable, such as the current European disaster.
In fairness, I am not the only economist with an unequivocal criticism of austerity. On March 5, Joseph Stiglitz explained in Economywatch.com:
While Europe’s leaders shy away from the word, the reality is that much of the European Union is in depression. Indeed, it will now take a decade or more to recover from the losses incurred by misguided austerity policies – a process that may eventually force Europe to let the euro die in order to save itself.
Strange conclusion. The euro is not the cause of the crisis. But Stiglitz is probably letting his ideological preferences get in the way of good economic judgment. Otherwise he would do the same analysis has I have and conclude that the crisis is caused by the welfare state.
That said, Stiglitz is eloquent in his criticism of austerity:
The loss of output in Italy since the beginning of the crisis is as great as it was in the 1930’s. Greece’s youth unemployment rate now exceeds 60 percent, and Spain’s is above 50 percent. With the destruction of human capital, Europe’s social fabric is tearing, and its future is being thrown into jeopardy. The economy’s doctors say that the patient must stay the course. Political leaders who suggest otherwise are labeled as populists. The reality, though, is that the cure is not working, and there is no hope that it will – that is, without being worse than the disease.
Well said. But what alternative is Stiglitz proposing? Certainly not that the welfare state must go:
The simplistic diagnosis of Europe’s woes – that the crisis countries were living beyond their means – is clearly at least partly wrong. Spain and Ireland had fiscal surpluses and low debt/GDP ratios before the crisis. If Greece were the only problem, Europe could have handled it easily.
I don’t know where Stiglitz gets his data but here are the debt/GDP ratios for Ireland and Spain in 2003-2008:
In terms of actual euros, the general government debt in Ireland shot up by almost 84 percent from 2003 to 2008. In other words, it was only thanks to strong growth in current-price GDP that the Irish did not see their debt ratio grow faster than it did. They were expanding their government as fast as they could, and certainly more than was healthy for the economy: in 2010 the debt-to-GDP ratio had reached 87 percent, i.e., close to double what it was two short years earlier.
The Spanish situation followed a similar pattern, though with less dramatic numbers than the Irish. The lesson to be learned from this is not that these economies could afford their big governments, but that their big governments survived only because there was enough current-price GDP growth to pay for them. As soon as GDP slacked off, the cost of the welfare state quickly became completely unbearable.
Stiglitz refuses to see this. He goes on to advocate even more government, without a hint of explanation of how the world’s already highest-taxed nations would be able to pay for that:
Europe needs greater fiscal federalism, not just centralized oversight of national budgets. To be sure, Europe may not need the two-to-one ratio of federal to state spending found in the United States; but it clearly needs far more European-level expenditure, unlike the current miniscule EU budget (whittled down further by austerity advocates). … There will also have to be Eurobonds, or an equivalent instrument.
More welfare state spending, more government, more debt, more of the same that brought about the crisis in the first place.
Instead of wanting more of the same and providing politicians with rosy outlooks, practitioners of economics should re-examine the results of their own contributions over the past few years. The ability of hundreds of millions of people to maintain their current standard of living, even support their families, depends on it.
It has been said that those who cannot remember the past are condemned to repeat it. It has also been said that someone who repeats the same action over and over, expecting different results, is an idiot.
If so, the EU Commission is a bunch of condemned idiots.
Sorry for the colorful opening, but just when the Commission has started talking about backing off austerity, they are forcing Greece to put to work perhaps the most devastating austerity package to date. Without even a hint of remorse over the past, blaming instead the negative results of previous packages on “mistakes” by the Greek government, the Commission charges ahead with demands that Greece cut away 6.5 percent of its GDP in the next austerity round.
I am not even going to attempt to predict the social, economic and political fallout of this complete fiscal madness, though it might be a good idea to remember that in last year’s Greek election the Nazis returned to the European political scene. I will say this, though: the Germans tried a decade of austerity during the Weimar Republic. Greece is now six years down the same path.
Before we get to the report on more Greek austerity, let us first note a new report from Pew Research Center. It presents some seemingly bizarre data, showing that a majority of Europeans still support austerity:
The countries still backing cuts over spending included Italy and Spain, which are both in the grip of prolonged recessions made worse by their efforts to bring down government borrowing. On average, 59% backed further austerity in the survey, against 29% in favor of more spending to stimulate the economy.
You would expect the victims of austerity to demand something better. But in order to do so the Europeans would have to know of an alternative – and it does not exist in their world view. For a good decade now, the public policy debate in Europe has been almost entirely lopsided in favor of austerity. Everyone from leading economists to political leaders to business leaders have been telling the public for years that the alternative to austerity is Hell on Earth.
When people see no alternatives, then after a while they tend to believe that there are indeed no alternatives.
Besides, the very issue of austerity is technical in nature and not likely to stimulate the average Joe to go off looking for alternative views on his own.
One would think that the hardships suffered in, e.g., Greece and Spain would be enough to make the general public back off from austerity. After all, the benefits they have been promised from austerity never seem to materialize. This is a valid point, but at the same time, history is full of examples of man’s ability to accept and endure hardships in the name of some abstract goal. It will probably take an entire generation before Europeans start questioning the changes for the worse that they are now living through.
With this in mind, it is easier to understand why Greece – ground zero of European austerity – is entering yet another cycle of fiscal torture. From Fox Business:
Greece is on track to meet its budget targets this year and next but may have to make further cuts in 2015 and 2016, the European Commission said in a report that will provide the basis for a decision Monday on whether to release more bailout loans for the country. The report sums up the findings of the three institutions overseeing Greece’s bailout–the Commission, the International Monetary Fund and the European Central Bank–which sent a team of auditors to Athens earlier this spring to review the country’s finances.
As I explain in Austerity: Causes, Consequences and Remedies, a country will always see a reduction of its government deficit the year after an austerity package is implemented. Then, as the negative multiplier effects of austerity kick in, the budget improvement is reversed. That is why the European Commission is forecasting more austerity in 2015 and 2016. However, you only need to take a quick look at macroeconomic data from Eurostat to realize that the notion of no budget cuts in 2014 is optimistic.
And now, Fox News delivers the big number:
It is the first time in Greece’s three-year-old aid program that the country is deemed to have met its goals. In past years, a deeper-than-expected recession and government missteps led Greece to miss its targets. The draft notes that the Greek government has followed through on most of the austerity measures it promised for 2013 and 2014–also in sharp contrast with previous assessments of Athens’ efforts to ease its crushing debt load. ”The very large and highly front-loaded package of fiscal consolidation measures for 2013 and 2014–totalling over 6.5% of gross domestic product–agreed in the previous review has been largely implemented,” the report says.
Six and a half percent of GDP.
Let’s leave the technospeak behind for a moment. An austerity package of 6.5 percent of GDP means that government is going to increase what it takes from the private sector by 6.50 euros for every 100 euros that people earn. Not for every 100 euros it currently takes in – it is 6.50 euros for every 100 euros of GDP.
The 6.5 percent number is a net tax increase on the Greek economy. It does not matter what the combination is of spending cuts and tax increases: the Greek government is telling its taxpayers that it is going to raise the price of whatever it provides them by 6.5 percent of all the money that all taxpayers earn.
If all of the austerity comes in the form of spending cuts, and taxes do not go up, then government is saying “we are going to sell you a 2011 car at 2013 prices”; if all of the austerity comes in the form of tax hikes, and spending is not cut, then government is saying “we are going to sell you a 2013 car at 2015 prices”.
Either way, government will increase its net drainage from the economy by 6.5 percent of GDP, and front load the plan so most of it shows up in one year. All this in a country that has already lost 25 percent of its GDP in five short years, all due to austerity.
I would not want to set my foot in Greece over the next year.
Apparently, the EU Commission has an eerie feeling that something bad might come out of this. According to Fox Business they are quick to add fine print to their optimism:
Beyond 2014, the outlook is uncertain and depends “on the strength of the recovery and improvement in taxpayer capability to service their tax obligations,” the commission says. It estimates the country’s budget gap at around 1.8% and 2.2% of GDP in 2015 and 2016 respectively.
This is B.S., Barbara Streisand. They have made similar predictions in the past, all of which have turned out to be outlandishly optimistic. So long as they believe that austerity somehow will improve the performance for the Greek economy, they will continue to believe that the first-year effect of an austerity program will become permanent.
I would not want to be a Greek politician saddled with implementing this chainsaw massacre of an austerity program. Perhaps some of the elected officials in Athens are on the same page, or why else would they according to Fox Business be so eager to promise that “there will be no more belt-tightening”?
Fox Business does not elaborate on this. Instead they conclude their report with a couple of notable factoids:
The country is in its sixth year of a deep recession made worse by waves of austerity. Unemployment, already over 27%, is expected to continue rising.
So if they acknowledge that the waves of austerity have made the recession worse, then why doesn’t Fox Business ask the EU Commission why this particular austerity package would do the trick?
In case anyone is still in doubt what this new austerity package will do to the Greek economy and to Greek society, please re-read the statement above about unemployment.
The Greek government is sitting on one side of an open powder keg. On the other side the EU Commissioners are sitting, smoking big fat cigars. The Greek government is holding out an ashtray where the Commissioners are supposed to kill their cigars. It’s dark, so it’s hard to see the ashtray.
There’s the future of Greece for you.
Yesterday I explained:
inflation-adjusted GDP growth is forecast to be 0.4 percent this year, though that will probably be adjusted downward in the next few months. EU institutions that publish economic forecasts have a tendency to downgrade their forecasts as the present catches up with the future. At the same time, total general government debt in the 27 EU countries is heading the other way: from 2010 to 2012 those countries added 1.4 trillion euros to their total debt. In terms of growth rates, EU-27 have added debt at frightening rates over the past few years: 2008: 6.1 percent; 2009: 12.8 percent; 2010: 12.3 percent; 2011: 6.7 percent; 2012: 6.7 percent. Due to an almost total absence of GDP growth, the ratio of debt to current-price GDP has grown at stunning rates…
In 2008 the debt-to-GDP ratio for the 27 EU member states was 62.3 percent. In 2012 it was 86.9 percent, rising steadily in open defiance of every conceivable austerity measure.
These numbers tell us clearly and indisputably that the European economy is in just as bad a shape as it was when the crisis broke out. More and more Europeans are beginning to realize this; today the Daily Telegraph reports:
Responding to this prolonged slump, the European Central Bank cut interest rates on Thursday. Having last acted 10 months ago, the ECB lowered its main rate by a quarter point to 0.5pc, while signalling it was prepared to go even further. “We remain ready to act if needed,” said the ECB President, Mario Draghi. The eurozone has now finally joined the Anglo-Saxon economies in arriving at “ultra-low” base rates. The Bank of England slashed its main interest rate to 0.5pc back in March 2009, in the immediate aftermath of the sub-prime crisis, soon after the US Federal Reserve went all the way down to 0-0.25pc at the end of 2008.
At these low interest rates, there is so much liquidity floating around in the economy that you could fill every mattress in Europe with ten-euro bills. Let us not forget that the purpose behind austerity is to end government borrowing and thus bring interest rates down. The lower interest rates would then encourage private entrepreneurs to invest more, and thus get the economy moving again. But the central banks have already done the job of cutting interest rates – they have in fact cut them to such levels that if any entrepreneur out there wants to invest, he can practically get free money to fund his project.
So why aren’t they investing? Easy: there is not enough demand for their products. Even a loan at virtually zero interest rate must be paid back, and it is actually not that easy to get hold of “free” money even in times of very low interest rates. After all, there is something call “credit risk” that the bank has to take into account.
Back to the Telegraph:
While eurozone rates were gradually reduced to 1pc in mid-2009, inflation-conscious Germany strongly resisted following the rate-slashing actions of other “leading” central banks. Under pressure from Berlin, the ECB actually raised rates a couple of times in 2011. Since the European economy renewed its nose-dive, though, rates have steadily been cut. With eurozone inflation at 1.2pc, its lowest since February 2010, ECB policy-makers argue they have “room” to cut.
It is ludicrous to believe that increased money supply in the midst of a recession will automatically cause inflation. If that extra liquidity is going to drive prices up, there must be some kind of transmission mechanism between the extra liquidity and the real sector where prices are set.
One such transmission mechanism is entitlements: if government uses newly printed money to pay for welfare checks, housing subsidies and similar cash entitlements, then the newly printed money will indeed fuel inflation. People will be able to go out and spend that new cash without there being any corresponding increase in production. Another transmission mechanism is cheap consumer loans, doled out with little or no regard for credit ratings.
Thus far there are no signs that any transmission mechanism from money to prices is active in the European economy. It is safe to write up the German worries about inflation to armchair theorizing.
A much more important variable to consider is unemployment, which the Telegraph mentions:
In March, the single currency region registered a jobless total of almost 20m people, a record 12.1pc of the working age population. This terrible composite figure hides, of course, a multitude of extremes. While Germany has unemployment of just 5.1pc, in Portugal some 17.5pc of the labour force isn’t working. In Spain and Greece, the figures are 26.7pc and 29.1pc.
Yet someone thought it was a great idea to create one and the same monetary policy for all these countries. And then they added a one-size-fits-all fiscal policy on top of that. Yep. But hey – the economists involved in developing this currency union all have degrees from prestigious schools, so they must have been right. Right…?
The fact of the matter is that the crisis is not over. It is becoming permanent. A major problem for the European economy in general is that it has suppressed private consumption to disturbingly low levels. Private consumption is the driving force of all economic activity – ultimately, all resources we produce will be directly used by consumers, or indirectly used toward their needs. As a result, when private consumption is reduced as share of GDP, it will inevitably pull down GDP growth as well.
Austerity policies are very effective in suppressing private consumption. Perhaps, therefore, it is not surprising that in a country like Spain the private-consumption share of GDP is around 55 percent, compared to approximately 70 percent in the U.S. economy. In the Irish economy the private consumption share is even lower: 45 percent.
The Greek share is high for a crisis country but falling steadily: it started at 72 percent in 2008 but is now 68 percent. This is a notable drop, as these shares are very stable over time. In actual (inflation-adjusted) numbers, the Greek economy has lost 34.5 billion euros worth of consumer spending in four short years. If the average private-sector job costs 50,000 euros to maintain (probably a high number by today’s standards), this means that the Greek economy has lost private consumption spending equal to 690,000 jobs. This accounts for the bulk of the 800,000 Greeks that have lost their jobs since 2008 (when almost 4.6 million Greeks had a job to go to). Even if many of them have been laid off from government jobs, the drastic drop in household spending has made it impossible for them to find a new job in the private sector.
Europe’s crisis started as a sub-prime crisis. Out-of-control government borrowing and credit downgradings of Europe’s most troubled welfare states added a serious escalation to the crisis. Austerity and weak private consumption vouch for a continuation of the crisis. It has been going on for such a long time now that I am convinced Europe will never come back from it. There will be exceptions – Britain among them – but the EU and common currency projects have their best days behind them.
Especially from an economic viewpoint.
Recently I have reported on the changing tone among Europe’s political leaders when it comes to austerity. The change came after the French government basically declared that it would not be able to unite around the same kind of job-destroying policies that the EU so viciously had forced upon France’s southern neighbors. But rather than admitting that their austerity policies have been a disaster for Europe, the Eurocrats simply shifted foot, declaring plainly that austerity had done its job.
Given the death of jobs and destruction of prosperity from the Aegean Sea to the Iberian peninsula, this is more than a little arrogant. It is political elitism coupled with a disdain for the lives of regular citizens.
It is, in one word, Eurotarianism.
If the EU Commission really cared about the citizens whose taxes are paying for their lavish lifestyle, they would pay a lot more attention to mundane things like, oh, the GDP growth rate of the euro zone. As technical and yawn-inspiring as that figure might be, it is still one of the best indicators of whether or not austerity is working. (Let’s not forget that Greece, Italy, Spain and Portugal are still enforcing austerity policies, despite the new words hot-airing out of the mouth of some Eurocrats.)
A good place for them to start learning about reality would be a recent article in Euractiv about the sluggish – to say the least – European economy:
The eurozone economy shows little sign of recovering before the year-end despite an easing of financial market conditions, European Central Bank Mario Draghi said … after interest rates were left at a record low. The ECB held its main rate at 0.75%, deferring any cut in borrowing costs … .
The common belief among parishioners of the Austrian school of economics is that so long as a government balances its budget a so called natural interest rate will emerge that will encourage entrepreneurs to invest and expand their production capacity. Regardless of the budgets of EU’s member states, if it was true that a low interest rate encourages investments, then a rate of 0.75 percent should have entrepreneurs all over Europe flocking to the banks.
Do you see that happening?
Neither does Euractiv, which reports that the ECB is also ready to keep interest rates down through its bond buying program:
The central bank has said it is ready to buy bonds of debt-strained governments such as Spain and Italy once they sign up to a European bailout programme with strict conditions, under a programme dubbed Outright Monetary Transactions (OMTs). So far no request has been made, but the announcement alone has calmed markets.
And is thereby keeping interest rates down. How surprising. The ECB has explicitly said that “we will use our money printers to churn out whatever trillions of euros it takes to buy every single treasury bond from Spain, Italy, Greece and Whateveristan, from now until Sweden freezes over”. When owners of even the junkiest of euro-denominated treasury bonds know that they can always get their money back, no matter how bad things get, then of course they will rest easier.
The problem is of course that at some point they will have had to print so much euros that owners of bonds outside the euro zone will want to secure the exchange rate of the currency. That becomes increasingly difficult if the ECB is going to flood the world with euros just to save its member states from the financial junk yard.
No one can say for sure when that point will come. Doomsday preachers have cast a spell on the U.S. dollar for years, yet it still stands relatively strong. That does not mean the doomsdayers are wrong – all it means is that we simply do not have enough examples of collapsing currencies to predict where either the Federal Reserve or the ECB will have printed too much money for their own good.
But long before we find that out, we will find out that the low interest rates the come with excessive money supply are not going to get the wheels turning in the economy. There is a very simple reason for that, which we will get to in a second. First, back to Euractiv:
Gloomy data this week indicated the eurozone economy will shrink in the fourth quarter, which the ECB could eventually respond to by cutting rates. Recent survey evidence gave no sign of improvement towards the end of the year and the risks surrounding the euro area remain on the downside, Draghi said. He signalled the ECB would downgrade its GDP forecasts next month, describing “a picture of weaker economies”, and said inflation would remain above the ECB’s target for the rest of the year, before falling below two percent during in 2013.
It is interesting that inflation is above two percent in an economy – the euro zone – that is at a complete standstill when it comes to GDP. While we will have to wait for the micro data behind the inflation number to know exactly where it comes from, my bet is that it is caused by tax increases and terminated government subsidies in austerity-ridden countries. The private sector is always quick to pass on such explicit and implicit tax hikes, even in tough economic times.
Pricing in modern economies is typically done on a mark-up basis where producers and seller review prices about two times per year. (If your microeconomics professor told you anything else, then I’m sorry for the rude awakening…) This means that if we have austerity measures being put into place this spring with a direct effect on consumer prices, we will see repercussions in inflation data for the rest of the year.
That said, inflation above two percent and interest rates at rock-bottom levels is actually – according to standard economic theory – a good recipe for investments. You see consumer prices on a slow upbound trajectory, which tells you that if you lock in your costs today you have good reasons to expect profit margins in the future. At the same time, with very low interest rates you have good reasons to believe that you will lock in those low costs.
So why aren’t they investing?? Patience, my young padawan. Uncle Keynes will give you the answer in just a moment.
Before making any decision to cut rates further, the ECB will focus on making sure that its looser policy reaches companies and households across the eurozone, a mechanism that has been broken by the bloc’s debt crisis. The new bond purchase plan is the ECB’s designated tool but it can only be activated once a eurozone government requests help from the bloc’s rescue fund and accepts policy conditions and strict international supervision.
Which is technospeak for “more austerity”. Despite the hot air from Barroso, nothing has changed in the conditions that the ECB attaches to its bail-out program for debt-mired member states. Governments in already-suffering countries know that if they try to push more tax hikes and spending cuts on their citizens they will have an armed revolution on their hands – or be booted out of office in the next election and replaced by Nazis or “Bolivarian” communists. They obviously don’t want this to happen.
The problem for the ECB is that their bond-buying pledge has now calmed the markets, but the member states have not accepted the terms of the program. This means that in effect, the program is worthless. In order to avoid losing credibility the ECB is going to have to relax the conditions attached to the program, not now but in a year or two. The reason is that the countries in Europe’s dungeon of debt will not recover from their current crisis.
Why won’t they recover? Because their fiscal policies are still geared entirely toward balancing the budget in the midst of zero or negative growth and very high unemployment. With too few taxpayers and too many entitlement consumers indebted governments continue to run deficits – and therefore continue to try to close those gaps with the same policies that brought about the depression in the first place.
In order for those economies to start growing again the hopelessly indebted governments must give the private sector room to spend money. So long as consumers are pushed to the end of their finances by high taxes and unemployment they won’t spend. If they don’t spend there won’t be any demand for consumer products, services, houses, cars, food, clothes, haircuts, vacation travel services, books, plumbers, painters, carpenters, restaurants, recreational services like spas and gyms…
Which brings us back to why entrepreneurs are not taking advantage of virtually free money. They have no reason to believe that they will get their money back in the form of sales revenue.
People have cut their spending today, which according to the pastors of the Church of Mises and Menger means that they will increase spending by the exact same amount at 1:20PM on Monday. Keynes, however, had a more sober analysis. Here is how he opened Chapter 16 of his General Theory of Employment, Interest and Money:
An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand,— it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.
Only Keynes can save Europe. It would take an enormous load of work, though, to allow his theory of effective demand to actually go to work in the European economy. While economically possible, I seriously doubt that there is enough political will power to allow that to happen. It would mean that those who have gained enormous political power both in the Eurocracy in general and among the austerity merchants, will have to take more than a few steps back.
I frankly don’t think this is politically possible. I am fairly certain that Europe has gone so far down the path of austerity and big government that it won’t ever come back again. But this message from Uncle Keynes could serve as an excellent reminder for American lawmakers to get their own house in order – the right way.
The Keynesian way.
My apologies for a long article, but this is a very important topic.
When someone titles his article “The Bankruptcy of Governments” it attracts interest from every friend of economic freedom. If the piece is well-written, it makes a valuable contribution to the intellectual battle over the future of Western Civilization. We need more of intellectually sharp contributions and less of ill-founded demagoguery. Our followers on the political side of the arena are inspired by us, bring our arguments and our analysis to the legislative hallways and try to get laws and budgets passed that will change economic policy and the role of government in the better direction.
If we get it right, all the way from good analysis to good policy decisions, we win – and more importantly: everyone else wins when we all benefit from more economic freedom. The wealthy can invest and improve businesses under more liberty; the poor and needy get more opportunities to improve their lives; creative, entrepreneurial people get more opportunities to build new businesses.
However, if we get our analysis wrong our cause is badly hurt. In theory, it does not matter where the mistake is made in the chain from analysis to legislation, but the closer the error is to the analytical starting point, the more serious the mistake is. Policies that are built on flawed legislative work will have repercussions that are limited to the legislative process; analysts and policy advocates can still do their work without having put their future credibility in jeopardy.
When the error is in the analytical foundation, the entire chain unravels. Bad analysis contaminates analysts, policy advocates, grassroots and activists, as well as elected officials. We who create the analytical foundation therefore have to hold ourselves to the standard that we can’t miss once.
In fact, as I explain in my book Ending the Welfare State, with the big welfare state we have today we will in reality only get one chance to restore economic freedom. If we stumble on the reforms or execute them in such a way that it causes a lot of hardship for many people, we will lose the battle for at least a generation. By that time there won’t be much of a prosperous, industrialized world to save.
For precisely this reason it is crucial that we freedom scholars and analysts do not waste our time – and other people’s time – on analytical constructs that lead to pain, suffering and a certain death for the cause of freedom. This is also why I engage other scholars and analysis whose ambition it is to promote economic freedom, but whose analysis I disagree with.
In the field of economics there is one school that meets all the criteria of purportedly supporting freedom but in reality doing a lot of harm to the cause. That school is, hardly surprisingly, Carl Menger’s Austrian tradition of economics. I have already on a few occasions written about the flaws in Austrian economics and I will continue to do so until its role in the freedom movement has been marginalized to the point of no influence.
This side of Marxism, Austrian economics is the most ill-conceived theory currently at use in the public policy arena. When it was put to work in Russia after the collapse of the Soviet Union, the result was a decade of economic waste, deprivation, abject poverty and collapse of almost every social institution except the Orthodox Church. The demise of a bankrupt government did not automatically, through some spontaneous order, give rise to a well-ordered society with a minimal government. When big government disappeared chaos, anarchy and mob rule took over.
With this experience in mind we have to know exactly what we are doing when we lay out a path to limited government. The article mentioned earlier, ”The Bankruptcy of Governments”, has a promising title but unfortunately turns out to be yet another example of flawed Austrian thinking. It is an important example to discuss, though, precisely because it so well illustrates the fine line between good and bad analysis.
The author, Alasdair Macleod with the British think tank The Cobden Centre, starts off well:
For a long time governments have been redistributing peoples’ income and wealth in the name of fairness. They provide for the unemployed, the sick, and the elderly. The state provides. You can depend on the state. The result is nearly everyone in all advanced countries now depends on the state. Unfortunately citizens are running out of accessible wealth. Having run out of our money, Governments are now themselves insolvent. They started printing money in a misguided attempt to manage our affairs for us and now have to print it just to survive.
That is not entirely true. The excessive money printing did not start until the Great Recession broke out in 2009. Up until that point EU governments in particular were very good at maxing out taxes on their citizens. But Mr. Macleod’s point about governments printing money just to survive financially is a good one, and falls well in line with my analysis.
However, this statement…
The final and inevitable outcome will be all major paper currencies will become worthless.
…is a bit on the excessive side, to say the least. Austrians have been crying about American monetary inflation for years, yet it has not happened. The reason is that their analysis does not recognize the existence of transmission mechanisms between the monetary and the real sectors of the economy. In order for newly printed money to drive up prices in the real sector there has to be some movement of activity in the real sector to motivate price setters to mark up their prices at hyper-inflation rates. In a recession like the current one those transmission mechanisms are weak – consumer credit demand is weak and it is tough for small businesses to get bank loans for investments. As a result, the newly printed money stays in the monetary sector of the economy, where it has no contact with prices.
This does not mean that a modern economy in a recession cannot succumb to high inflation pressure. We know numerous examples from Latin America where government has used its own spending to push newly printed money out in the economy. This is in part how Venezuela under Hugo Chavez got stuck with 30 percent inflation. So far this has not happened in the United States, but that is no guarantee it won’t happen. While the simplistic Austrian prediction is wrong, the facts on the ground are not sufficient to completely dismiss their argument. More evidence is needed, especially on the nature of the transmission mechanisms.
Alasdair Macleod disagrees. True to the Austrian school he dismisses the use of empirical evidence and quantitative reasoning in economics:
Modern economists retreat into two comfort zones: empirical evidence and mathematics. They claim that because something has happened before, it will happen again. The weakness in this approach is to substitute precedence for the vagaries of human nature. We can never be sure of cause and effect. Human action is after all subjective and therefore inherently unpredictable.
Does this mean that Macleod never drives? After all, he apparently cannot be sure that his fellow Brits will drive on the left side of the street tomorrow just as they did today.
Macleod’s statement about the “inherently unpredictable” nature of human action is of course rather silly. It is, however, typical for the Austrian school. One of its key tenets is the denial of empirical analysis, which of course begs the question why they even bother with economics. But by taking the attitude that human action is inherently unpredictable they also suggest that we as humans are not rational. Rationality means, among other things, repeating successful behavior in order to assure your own survival. In terms of economics this means repeating successful trade and other exchange relations with other rational individuals.
I should not have to explain this to someone who is in the game to change public policy. But Alasdair Macleod appears to be one of those activists/analysts who have been seduced by the supposedly refined nature of Austrian theory without seeing its public-policy consequences. If he did he would realize that a theory that starts out with suggesting that human action is inherently unpredictable will have a hard time convincing legislators that they can trust people to make the right decisions on their own. Quite the contrary, in fact: if we all behave unpredictably there is no chance for a society with a minimal government to survive, let alone thrive; the only way to create a stable, predictable society would be to have government organize and regulate it.
Macleod is of course wrong on the fundamental nature of human action. So is the Austrian theory. May I recommend some reading on the role of uncertainty in economic analysis. Austrian theorists might also want to disseminate Armen Alchian’s classic but very dense essay on uncertainty, evolution and economic theory.
Because of their disdain for empirical evidence and quantitative reasoning, Austrians have a hard time constructing workable analytical arguments on their own. Instead they often spend their time producing pure rhetoric, often directed at competing theories. Mcleod is no exception, going after the man Austrian theorists dislike almost as much as Karl Marx:
Keynes was strongly socialistic. In the concluding remarks to his General Theory, Keynes looks forward to the euthanasia of the rentier (or saver) and that the State will eventually supply the resources for capital investment.
This statement is not only false, but also very telling of the difference between Austrian theory and Keynesianism. Austrians prefer the armchair as the foundation of their analysis, while Keynesians work inductively to constantly evolve and enhance the proficiency of their theory and their ability to interact with the public policy arena. The statements by Keynes that Macleod has cherry-picked are from chapter 24 of the General Theory, where Keynes has left his theoretical work and is speculating about what role economic policy could play, and how government would fit in to that role.
It is important to note that in the preceding 23 chapters of his General Theory Keynes barely even touches upon government, even as a subject of conversation. Already for this reason, Macleod’s statement about Keynes being a socialist is false. But there is also a deeper and from a policy viewpoint more important reason. When Keynes got to the end of his book he had examined the “mechanics” of a modern industrialized economy – he had in effect laid the groundwork for what we now know as macroeconomics. With this pioneer work Keynes challenged a great many prejudices held by Classical economists, but he also opened for the potential of an entirely new era of economic policy.
First and foremost, Keynes’s work allowed for a new understanding of what brings about recessions – and, even more importantly, depressions. Never before had anyone systematically proven that when you try to starve an economy out of a recession, you make matters worse. But to produce and explain this proof, Keynes had to spend almost the entire volume we know as his General Theory; as he was finishing it, he only had time for brief, speculative thoughts about what role government could play in defending or restoring full employment.
This is what Austrians do not get. Keynes’s analysis was systematic. He built a macroeconomic theory, induced from evidence, that allowed him and anyone else who takes it seriously to do an open-ended analysis of what role government might play. Unlike closed systems like Marxism or Austrian theory, the Keynesian analysis is open in that its conclusions are not deductively produced – or, to be blunt, dictated – by the theory.
Herein lies the problem with Austrian theory. Because it refuses to recognize the role of evidence, it refuses to open itself to the probable – as opposed to uncertain – nature of human action. Because there is no room for probability, there is no open end to the analysis an Austrian produces. His conclusions are dictated beforehand.
This leads to major problems when theory is brought in to the public policy arena. More on that in a moment. First, let me wrap up Macleod’s point about Keynes being a “socialist”. In chapter 24 of the General Theory Keynes suggests a death tax as one possible policy measure to help build economic policy in favor of full employment. The tax would be used to fund investment activity when private-sector activity is unable to reach full employment. Keynes speculates on the possibility of having government be a permanent agent in this way, which he suggests would mean that the economy would be operating at or very close to the point of full employment.
Keynes’s theory of investment equates full employment to a point where the so called marginal efficiency of capital is virtually zero. The practical meaning of this is that there is no more profit opportunity left in expanding the economy’s capital stock – it is operating at its economically viable maximum. This is accomplished, Keynes suggests (but does not firmly conclude), when private-sector investment is supplemented by government investment, funded by a death tax
Obviously, a death tax, even at 100 percent, would never lead to government replacing private investment funding. Yet Macleod makes the critical mistake of thinking that the point where the marginal efficiency of capital is zero is also the point where private credit is eliminated. He misreads Keynes’s idea about “euthanising the rentier” as the elimination of privately funded investment. In reality, this statement means that funding for investment is so abundantly available that it ceases to be scarce. Thereby no one can make money on credit in response to systemic uncertainty. Individual risk factors still remain, though, as Keynes makes clear in his elaboration of his theory of investment and the concept of the marginal efficiency of capital.
In short: government eliminates systemic uncertainty while the private sector handles uncertainty and risk at the market level.
I disagree with Keynes’s speculation about the death tax. But I do agree with him that the free market is unable to incorporate and manage systemic uncertainty. How that is best done is a matter for further scholarly work; my own doctoral dissertation was devoted entirely to finding the demarcation line between the roles of government and the private sector in managing uncertainty. What I learned from Keynes is that there is indeed a role for government to play there; the exact nature of that role is still an open question, especially because the attempts made thus far at organizing government to eliminate systemic uncertainty have had a lot of side effects.
I apologize for the wordiness of this article, but it is important to understand the depth of the problem with Austrian theory. One good way to do that is to contrast it toward its arch enemy, Keynesianism.
Speaking of which, it is almost amusing to witness the obsession that many Austrian theorists have with Keynes. As Alasdair Macleod demonstrates, this obsession sometimes gets so bad that they throw out the only analytical tool they themselves cherish, namely logic, just to get another chance to go after Keynes:
The misconceptions of Keynesianism are so many that the great Austrian economist von Mises said that the only true statement to come out of the neo-British Cambridge school was “in the long run we are all dead”.
Let’s put this in its proper Austrian context. In December last year one of the Cobden Centre’s academic advisors, Phillip Bagus, applauded the shrinking GDP that some European countries were experiencing. Bagus was jumping up and down with joy over the fact that Greece had lost a quarter of its GDP and suggested merrily that this elimination of economic activity would free up resources that would create new investments and new jobs. He suggested that it was a home run for the economy that people were laid off from jobs right and left and forced to scavenge for food because an austere government was not providing the poverty relief people had been promised.
Bagus is a prime example of what Austrians do when they enter the public policy arena. They are completely locked in to their theory, without a single open window to the outside world and its empirical evidence that when they are confronted with the worst economic crisis since the Great Depression they suggest that the world needs more of the same. To them there is no such thing as hesitation and caution among private entrepreneurs and consumers. Their static and rigid theory says that consumers and entrepreneurs fail to produce full employment for the economy because government takes away resources from them. There is a great deal of truth in this part, but what the Austrians forget is that there is a second leg to this analysis: they conclude that all you need to do is fire government bureaucrats and they will all get jobs in the private sector. All you need to do is shut down a government agency and someone else will take over their office.
The problem is, as we witnessed in Russia during the 1990s, the private sector may hesitate to step in and absorb idle resources formerly employed by government. The one tiny detail that Austrians forget is that an entrepreneur will not make an investment unless he has reasons to believe that he will be able to pay off the loan he funded the investment with. Furthermore, the banks won’t lend him money toward the investment unless he can make a good case for the profitability of that investment.
Keynes knew of this problem very well. That is why he speculated that government should supplement private investment in times of uncertainty, in order to eliminate systemic risk factors. While I disagree with Keynes’s particular suggestion, I am wholeheartedly with him on the nature of the problem. Individuals can be held back by uncertainty and thereby, in the aggregate, hold back the entire economy.
Austrians do not believe in uncertainty. They recognize its existence but they do not incorporate it into their analysis. Instead, they assume that all that needs to happen for the economy to be perpetually in full employment is that the so called “natural” rate of interest can prevail. They assume the existence of this “natural” interest rate without ever providing proof of its existence. This assumption, again entirely theoretical, allows them to create a perfect intertemporal allocation of resources – in other words, to eliminate uncertainty.
When you ask an Austrian theorist when this natural interest rate will come about, he will give you an answer that resembles something like “in the long run”. In other words, in the long run the economy will always be in a perfect state of equilibrium and full employment.
Keynes always criticized Classical economists for relying on the long run to fix all sorts of problems. When Austrian theorists take the same view on the long run as Keynes did, they jeopardize the very foundation – flawed as it is – of their own theory. Either they have to resort to illogical reasoning or they have to make up their mind: do they agree or disagree with Keynes on the role of uncertainty in the economy?
Alasdair Macleod, needless to say, does not see this lack of logic in Austrian theory. He marches on like nothing happened. The rest of his analysis is unfortunately as simplistic as the Austrian theory he relies on. He echoes a commonly held belief among Austrians that there have never been economic crises before big government:
The misallocation of economic resources which is the result of decades of increasing government intervention cannot go on indefinitely. Businesses have stopped investing, which is why big business’s cash reserves are so high. Money is no longer being invested in production; it is going into asset bubbles. Dot-coms, residential property, and now on the back of zero interest rates government bonds and equities. These booms have hidden the underlying malaise.
Although I disagree with John Kenneth Galbraith on virtually everything under the sun, I have to give Galbraith credit for his book A Short History of Financial Euphoria. There, Galbraith takes the reader on a journey through speculative bubbles that have occurred throughout history – the ones we know of – and done so at times when there was no big government.
I have discussed the nature of today’s crisis at length in other articles. Very briefly, I do agree with Macleod that government has played a bad role in exacerbating this crisis – my conclusion is that our banking system would have absorbed the shock from the real estate crisis were it not for the fact that those same banks had also invested heavily in government bonds. During 2011 and 2012 more and more of those bonds turned into bad assets, effectively destroying an otherwise sound balance on banks’ balance sheets.
The implication of a sound analysis of today’s crisis is that we need to get government out of the economy, but that we need to do it in a structurally sound way and by showing great respect for two groups of citizens:
- Those who already live on the dole because they have lost their jobs and been let down by government;
- Those who still work but have become dependent on government to make ends meet.
The true challenge for freedom-minded public policy scholars is to design a path for our economy out of the welfare state without causing undue hardship for either of these two groups. It can be done. The problem is that we are not getting much help from Austrian theorists here: all they suggest is the destruction of the welfare state so that Phoenix may rise from the ruins.
Macleod is no exception. He makes a good observation about the role of government…
Take France. Government is 57% of GDP. The population is 66m, of which the employed working population is about 25m, 17m in the productive private sector. The taxes collected on 17m pay for the welfare of 66m. The taxes on 17m pay all government’s finances. The private sector is simply over-burdened and is being strangled.
But then, instead of helping pull the economy out of this entitlement quagmire, Macleod resorts to the favorite Austrian pastime, namely to bash the printing of money:
The progressive replacement of sound money by fiat currency has destroyed economic calculation, and has destroyed private sector wealth. These policies were deliberate. We have now run out of accessible wealth to transfer from private individuals to governments. That is our true condition. Governments will still seek to save themselves at the continuing expense of their citizens, and in the process destroy what wealth is left.
He never gets to the usual advocacy for a gold standard, but he comes pretty darn close. However, as a brief look at Galbraith’s book will show, we have had crises even during the heydays of the gold standard.
The problem is not big money. The problem is big entitlement. It would be nice if Austrians could put down their Scriptures and help us get rid of the welfare state in a sound, stable way that encourages people to be optimistic about the future. If they are not interested in that, may I suggest they withdraw to their academic chat rooms and stop pretending to be concerned.
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.
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:
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.
One of the main flaws with Austrian economics is that it pays absolutely no attention to the actual working of an economy. From its founder, Carl Menger, and on leading Austrian theoreticians have worked hard to thoroughly isolate their theory from reality. As a result of this effort to keep the world at bay, they have become exceptionally useless as policy advisors; the Russian disaster decade, from the fall of the Soviet Union to the turn of the millennium, followed a strict implementation of Austrian theory as brought to the Russian leaders by two Swedish economists.
I recently reported on another example of how Austrian theory falls to the ground when confronted with reality. Phillip Bagus, professor of economics at the King Juan Carlos University in Madrid, Spain, claimed that a shrinking GDP is actually desirable. This notion that things get better in the long run when everyone is made poorer today (and tomorrow, and the next day) is widespread among Austrian theoreticians. Conveniently escaping the question “when” the “long run” comes about, they jump through economic hyperspace and make ridiculous arguments about how austerity is good and Europe needs more of it.
Austrian theoreticians rely heavily on the so called Say’s Law. Put simply, this law dictates that any new investment in production capacity will automatically generate demand for whatever that capacity can produce. This is why they believe that austerity, which destroys economic activity today, will benefit everyone in the long run (though to get the full theoretical chain worked out one has to add their surreal theory of the interest rate).
The problem for the Austrians is that whenever their theory has been practiced, it has failed utterly. The aforementioned Russian decade of destruction is a great example – it took ten years before the Russian economy was producing on par with what the poorly managed, inefficient Soviet economy was able to crank out at the end of its life. Countries that did not take the destructive Austrian route from Communism to economic freedom did much better: East Germany, Czekoslovakia (later split into two nations) and Hungary are the best examples.
The Chinese economic success rests in part on the choice to actively and patiently transition from one system to another.
But it is not just in the realm of active destruction that Austrian theory can do harm. It has played a role in the definition and execution of austerity in several European countries over the past few years. Aforementioned economist Phillip Bagus from Spain raves about his country’s austerity.
When reality checks in, with tens of millions of people being hurled into poverty, misery, financial despair, hunger and hopelessness, the Austrianites are nowhere to be found. They have gone both scholarly and morally AWOL, which should be a wake-up call for anyone and everyone interested in economics and economic policy. An economist who is not willing to take moral responsibility for the effects of his policy advice should go look for another career.
As a contrast, I want to once again express my respect for Olivier Blanchard, chief economist at the IMF, for his courageous mea culpa after the IMF got it so wrong on the effects of austerity in Europe.
While the Austrian theoreticians vanish from reality, others step in and paint a picture of the waste and destruction that follows in the footsteps of austerity. The latest contribution is from Caritas, the charitable arm of the Catholic Church. A new report from Caritas Europa conveys the image of an economic wasteland:
The prioritisation by the EU and its Member States of economic policies at the expense of social policies during the current crisis is having a devastating impact on people – especially in the five countries worst affected – according to a new study published today by Caritas Europa. The report finds that the failure of the EU and its Member States to provide concrete support on the scale required to assist those experiencing difficulties, to protect essential public services and create employment is likely to prolong the crisis.
What Caritas is saying here is precisely the same thing as I have been pointing to ever since I published my book Remaking America three years ago, namely that in times of crisis, governments that take to austerity will always default on promises to those who depend on government. This is really not very difficult to understand, but politicians from all over the industrialized world fail utterly to understand this.
Some are motivated by Austrian theory to turn a blind eye to the effects of austerity. Others do it because they are under the false impression that a balanced budget is more important than to keep government promises.
They all have one thing in common, though: they believe in short-term, immediate solutions to long-term, complex problems. More on that in a moment. Right now, let’s go back to Caritas:
The report “The Impact of the European Crisis“ is the first to provide an in-depth examination of the impact that current policies are having on people in the five EU countries worst affected by the economic crisis. It presents a picture of a Europe in which social risks are increasing, social systems are being tested and individuals and families are under stress. The report strongly challenges current official attempts to suggest that the worst of the economic crisis is over. It highlights the extremely negative impact of austerity policies on the lives of vulnerable people, and reveals that many others are being driven into poverty for the first time.
This is the truly troubling, two-pronged effect of austerity: first, it leaves the most vulnerable people out in the cold – the very citizens for whom the welfare state was constructed in the first place; then it devalues the standard of living of a large portion of middle-class working families. Unlike the poor, who are left to basically fend for themselves at the mercy of whoever passes their street corner, the middle class still has resources to prioritize from. They also pay taxes. When they see that they get less or nothing from government when they really needed it, and when they see that their taxes are as high as before – or even higher – they drastically change their economic behavior. They refrain from long-term spending commitments, such as a new house, a new car, appliances for their home, etc. Private spending is depressed, causing more job losses and solidifying the crisis.
The devaluation of the middle class is one of the most important features of Europe’s transformation from post-industrial prosperity to industrial poverty. It is refreshing to find well-done research on this in the Caritas report (get the full 68-page version here).
The report’s conclusions are based on the unique grass-roots perspective of Caritas organisations working with people experiencing poverty. Its principal conclusion is that the policy of prioritising austerity is not working and that an alternative approach should be adopted. It points out that the authorities have choices that they can make in deciding what policy approaches to use, and how various measures are targeted. It calls for a fair solution to the debt crisis to be found.
This is where Caritas goes wrong. Their policy recommendations are essentially focused on reinforcing, not to say reinvigorating, the welfare state:
Economic and social policies must be integrated at EU level to a much greater extent
Stronger leadership is required at EU level for groups at risk of poverty, focusing on child poverty and youth unemployment
Social Monitoring should be put in place for countries in EU/IMF Programmes
EU Funds must play a bigger role in addressing poverty
The EU must increase the involvement of Civil Society Organisations in Governance
The answer to Europe’s crisis is not more government. It is less government. However, rolling back government is almost an art in itself. Done wrong – as in austerity – it causes more problems than it solves, without any prospect of any kind of recovery on the horizon. While an Austrian economist would tell the deteriorating European middle class that their private finances are going to improve “in the long run”, a Keynesian economist would insist that the Austrian present even a shred of evidence for his claim.
The cold, hard truth is that Austrian theory relies critically on the notion that a dollar less spent today is a dollar more spent tomorrow. The reallocation over time is governed, they say, by the natural interest rate. However, they have no method for defining the “natural” interest rate that will also allow them to prove that this intertemporal reallocation actually takes place.
In practical terms: the Austrian theorist who lends credibility to austerity policies has no way of explaining to a middle-class family, whose livelihood is in jeopardy due to that very same austerity policy, when and how they will be able to turn a corner. Granted, the free market is a spontaneous institution, but spontaneity is not the same as lack of evidence, foresight or structure.
Furthermore, history offers many credible examples of how an orderly transition from big government to economic freedom can actually work. The European section of the former Soviet sphere offers, again, plenty of examples of how that orderly transition can take place. It applies, obviously, to the transition from a Communist command-structure economy to a traditional European welfare state. But it also applies to the transition from that welfare state to full economic freedom: the key is always to provide a predictable pathway, where economic institutions change in a way that does not cause uncertainty but instead encourages private citizens to become consumers and entrepreneurs.
In my book Ending the Welfare State I explain what policy models can help us make this transition into economic freedom. I make a big point out of designing the transition so that the poor and needy:
a) do not suffer immediate financial hardship as government terminates its programs; and
b) are given a good chance to provide for themselves, on their own terms, in the new system.
The choice between reckless Austrian-based austerity and a sound, Keynesian path to economic freedom is not just one for Europe to make. The European crisis can tell us a lot about what we should and should not do here in America. Even though our economic outlook right now is notably better than it is in Europe, that does not mean our fiscal crisis is over. The federal budget deficit is still staring us in the eyes every morning, with irresponsible spending cuts and tax hikes on the horizon.
We need to make a different choice than Europe. We need to create a credible, sustainable path to limited government – and then stay the course.
Never bark at the big dog.
Last spring I published a research paper explaining how Europe’s austerity policies would take the economy from a bad crisis to a worse crisis. Recently I have specified what this next stage will look like: a permanent decline where large parts of the continent turn into an utter economic wasteland, and industrial poverty becomes the new way of living in Europe.
I have been right all along. Already in October last year Gulfnews.com saw the new downturn coming:
Dwindling new orders and faster layoffs marked a worsening decline for euro zone companies last month, according to business surveys that dent hopes the economy will return to growth before 2013. Wednesday’s purchasing managers indexes (PMIs) suggested it was almost inevitable the euro zone returned to recession in the third quarter. A good gauge of economic growth, Markit’s Eurozone Composite PMI fell to 46.1 in September from 46.3 in August. … “Rather than clearing, the cloud of uncertainty hanging over business investment and spending got notably darker in September,” said Chris Williamson, chief economist from Markit, which compiles the data. “There therefore seems little scope for a return to growth in the fourth quarter.”
Then in December Bullfax.com reported:
Eurozone factory output continued its steep fall in autumn this year, underscoring the feeble domestic demand that risks prolonging the bloc’s recession. Industrial production in the 17 countries sharing the euro fell 1.4% in October after falling sharply in September … That was much worse than the modest growth expected by economists in a Reuters poll. Factories had proved surprisingly resilient over the European summer, posting two months of moderate gains, but the new data supports forecasts of a third quarterly contraction in the eurozone’s economy in the October-to-December period. After three years of a debt crisis that has driven unemployment to a record level and pushed governments to slash spending, the economy is caught in a spiral: households are not spending and so companies are not selling, forcing them to cut staff which then further weakens consumption.
A week ago 4-traders.com claimed they saw a light in the tunnel:
Business activity in the euro zone shrank at its least severe rate in 10 months in January, adding to signs that while the crisis-hit economy is still weak, it may have passed its worst point. Resilience in the currency bloc’s economy was largely thanks to solid growth in Germany, a survey from data firm Markit showed Tuesday, whereas activity among French businesses fell at its sharpest rate in almost four years. “The euro zone is showing clear signs of healing, with the downturn easing sharply in January and the region moving closer to stabilization in the first quarter,” said Chris Williamson, Markit’s chief economist.
Today, though, it looks like the light in the tunnel is an oncoming train. The EU Observer reports:
Eurozone economic data due this week is set to show the worst quarterly decline in output for almost four years, reports Bloomberg, citing GDP estimates that the economy shrank 0.4%. It would be the biggest decline since the first quarter of 2009, when GDP fell 2.8%.
We will of course take a close look at those numbers as soon as they are available. For now, suffice it to say that the outlook for Europe is not good, and that the continent as we know it won’t survive another deep economic crisis.
New Eurostat numbers confirm a growing macroeconomic divide between Europe and America. In only a few years, the same $100 could be worth a lot more in the United States than in Europe. For this to happen, a fair amount of things have to go “right” Stateside, but not much needs to go “wrong” in Europe. In fact, the IMF is now expressing strong concern about the course of the European economy. From the EU Observer:
International Monetary Fund (IMF) chief Christine Lagarde has said that eurozone leaders should “keep the momentum” of reforms like the banking union, as recession is now forecast to linger on in 2013. “2013 will be a make or break year. The biggest risks are in the developed countries – Japan, the eurozone and the US, there are threats if they don’t keep up the momentum,” Lagarde said on Wednesday (23 January) during her speech at the World Economic Forum in the Swiss resort of Davos.
She is right about the eurozone, for sure, probably also about Japan. The United States is a wild card: if the Obama administration gets the fiscal policy it wants we are going to dive straight down into the zero-growth zone where Europe has been dwelling for a few years now. Taxes will go up, massively, and there will be more government spending programs that get in the way of productive, private enterprise. If on the other hand Obama takes a more passive route and concentrates on being a ceremonial king instead of a policy maker, there is some real chance for good fiscal policy coming out of Washington, DC.
With more and more states putting up a fight against Obama on fiscal issues, and with a re-energized Republican party coming out of policy conventions the past two weeks, the latter scenario is a bit more likely than the former. If the American economy benefits from a president who is more interested in playing golf than raising taxes and a Congress where the Democrats are finally scared fiscally straight by a re-energized GOP, then the U.S. economy will be chugging along at fairly decent growth rates in the next few years.
This is reflected in Eurostat’s latest national accounts numbers for GDP growth. They forecast that the EU as a whole will see inflation-adjusted growth (year 2000 index) at -0.3 percent for 2012, a microscopically positive 0.4 percent in 2013 and a tiny 1.6 percent in 2014. By contrast, Eurostat’s forecast for the U.S. economy is, respectively, 2.1, 2.3 and 2.6 percent.
In plain terms, this means that if you made $100 in the United States in 2011, you’d make $107.12 in 2014, while in Europe the same $100 income would only rise to $101.75.
The gap is likely to grow even bigger, as the Europeans have not yet given up on austerity. Having said that, the “flip side” scenario would be one where:
- Europe acknowledges past mistakes, stops raising taxes and executing irresponsible spending cuts and instead allowed the private sector to pull the economy out of its seemingly perennial recession; and
- The Obama administration together with Congressional Democrats and Republicans were struck by fiscal panic and started repeating the European austerity mistakes – or even took Obama’s favorite route of raising taxes and spending.
If this happened the above-reported numbers might very well be flipped. However, this is a very unlikely scenario, primarily for political reasons. The Republicans would never accept Euro-style austerity in America, despite whatever wet dreams of such policies are harbored by some libertarians on the Tenderfoot Coast between Times Square and Tyson’s Corner.
But wait, there is more to this. While it is relatively easy to give macroeconomic validation to the forecast that Eurostat has for the American economy, it is much more difficult to justify a turnaround in the European case. The IMF hints at this, as reported by the EU Observer:
Earlier that day, the IMF revised its global growth forecast, giving a more pessimistic outlook than three months ago: instead of a 0.1 percent increase in the eurozone this year, the Washington-based lending body now predicts a recession of 0.2 percent.
This follows on the heels of previous downward adjustments that among others the IMF has been doing, following in their view surprisingly negative growth effects of austerity. The IMF, which courageously and respectably acknowledged its prior mistakes, is now trying to catch up with its own new insights as it maps out the fiscal future for Europe. It is likely that we are going to see further downward revisions of the numbers for the EU.
That does not mean the IMF has come to full grips with its own policy recommendations. As the EU Observer reports, the IMF boss still believes in so called fiscal consolidation, which is fancy dinner talk for more austerity:
“Fiscal consolidation, however painful it may be in some areas of the eurozone, must continue, as well as a clear focus on jobs,” Lagarde said. She repeated what top economists at the IMF admitted in a study earlier this month – that “policy makers did not pay enough attention to inequality” and focused too much on spending cuts at the expense of the most vulnerable in the society.
In other words, the multiplier is stronger among low-income consumers than among high-income consumers. The problem for Europe’s welfare states is that the low-income consumers are their biggest customers. Therefore, when you cut spending along the slash-and-burn principles of austerity – as opposed to sound, long-term structural cuts – you will have the destructive effects that the IMF has of late become aware of.
As a matter of fact, the very difference between destructive austerity cuts and sound structural spending cuts could become the guideline that distinguishes America from Europe in the next 5-10 years. There is a growing awareness, and a growing political willingness, among moderate, conservative and libertarian Americans – who together make up roughly half the voting population – that government can no longer keep growing, but must shrink permanently. The GOP has a cadre of strong governors, controlling 30 of the 50 gubernatorial seats, with a new generation of fiscally conservative friends of limited government building their executive resumes.
Europe, on the other hand, has lost its overall course, intellectually as well as economically. I am increasingly convinced that Europe is actually entering a permanent state of industrial poverty, where children grow up with the prospect of, at best, having as prosperous a life as their parents. More likely, though, will be that they will have to sacrifice some of the living standards that their parents enjoyed – without getting anything in return from government.
There is much at stake in the coming years, on both sides of the Atlantic. If I had to bet a large amount of money on which side will come out strong, prosperous and free, it would be the United States (and Canada, let’s not forget them). But that does not mean the fight to secure our children’s future is over.
It has barely even begun.
For those of us who live or have lived in the reality created by austerity, this is nothing more than armchair sophistry. But even a pure theoretician or a strict academic economist should be able to conclude that austerity is thoroughly bad. Some do, actually, with a sincere mea culpa, which is obviously welcome.
That, however, does not stop some politicians from persisting in their belief that something good can come out of having government take more of people’s money while giving less back. From the EU Observer:
Blanket criticism of austerity policy misses the positive effect it has on market confidence, EU economic affairs commissioner has said in the face of negative statements by the International Monetary Fund (IMF). Referring to a report out last week in which IMF economists said the growth-dampening effects of spending cuts had been underestimated, Olli Rehn at a think-tank event in Brussels on Friday (11 January) said “one cannot draw, on the basis of this study, strong policy conclusions.”
Really? The report says that for every percent of austerity there has been an extra percent of GDP contraction that they did not account for. One percent of GDP typically means a full percent higher unemployment than otherwise. If you tighten the belt in an economy like Greece by one percent per year, you cause five percent higher unemployment by means of the under-estimation effect alone. Then you have to add the multi-year multiplier effects from each discretionary round of spending, which could very well be close to parity.
In plain English, this means that you can probably explain ten percentage points of unemployment in Greece just with the under-estimation of the negative multiplier effects of austerity.
If that does not give Mr. Rehn pause and make him rethink your policy conclusions, then he really needs to rethink his job.
The EU Observer again:
“In the political debate, what has often been forgotten is that we have not only the quantifiable effect – which is something that the economist like to emphasize – we also have the confidence effect,” he added. Taking Italy as an example, he asked “what would have happened” if Rome had decided to loosen fiscal policy in November 2011, when technocrat Prime Minister Mario Monti took the reins and started introduced spending cuts? “From November onwards, we have seen more consistent and prudent fiscal consolidation by Italy and we are seeing much lower bond yield for Italy, which brings savings to Italian tax papyers [sic] and facilitates return to economic recovery,” Rehn said.
First of all, the bond yield has nothing to do with the commitments to austerity. They are the result of the pledge by the European Central Bank to purchase an unlimited amount of treasury bonds from any euro-zone country in crisis. If a central bank offers to print an unlimited amount of money to buy an unlimited amount of treasury bonds, then of course other buyers of those bonds are going to feel confident that they can get their money back the day they wish to sell their bonds. The underlying fiscal policy trend becomes entirely irrelevant at that point.
Secondly, the “consolidation” has not led to a single new job in the Italian economy. All it has led to is an improvement of the national government’s budget balance in the year immediately following the austerity package – a trivial effect since that is the very purpose of higher taxes and less spending. But Mr. Rehn has yet to witness the repercussions of that new round of austerity on the Italian economy. Just like in Greece, this latest round of Italian austerity will lead to a decline in employment, growth and prosperity.
An IMF official last spring criticised the pace and depth of the budget cuts demanded from Greece, while Christine Lagarde, who heads the Washington-based institution, late last year said Athens needs more time to get its house in order. Rehn refused to accept the criticism on austerity, but he acknowledged that “the coming months will see tough times and social tensions,” because EU citizens will see improvements in their day-to-day lives “only with some delay.”
That’s what the Eurocrats and the IMF promised for Greece five years ago when they first imposed austerity on Greece. Five years later the country has lost one fifth of its GDP and youth unemployment is close to 60 percent.
At least the IMF has had the decency to admit (what we knew all along here at the Liberty Bullhorn, where Keynesian economics is the guideline) that they got it wrong. Now it remains to be seen whether or not the Eurocrats in Brussels will wise up.
Mr. Rehn’s stubborn support for austerity is a rather clear hint that they won’t.