Why Austerity Is a Dangerous Idea

by Mark Blyth

 

The current debt and deficit panic is nothing new. It’s been a staple of American politics since the Republic’s inception. But this season it has taken a new turn. Congress, the fiscal arm of the government, is engaged in asymmetric siege warfare. On one side the Republicans want only cuts, on the other the Democrats want both cuts and tax increases. Both agree however that cuts are absolutely necessary; the only question is the timing and magnitude involved. Unfortunately, budget cuts are exactly the wrong thing to do at this moment. And before anyone throws up their hands and says “Keynesian claptrap,” there is nothing necessarily Keynesian in what I am about to say. Simple logic and arithmetic will suffice.

 

Austerity, the policy of cutting state spending to solve debt and growth problems, sells itself to us through a strange combination of morality and seduction. Its moral claim lies in the love of parsimony over prodigality that characterizes economic thought from Adam Smith onward. In this morality play, saving leads to....
investment, and investment leads to growth. Spending, in contrast, leads to consumption, and consumption leads to debt, especially when the government is involved. What we see in Greece therefore is simply the most egregious example of a secular trend toward overspending. We must cut to restore ourselves and not become Greece. So the story goes.

 

Austerity suggests that you can have your cake and eat it too, but only when you cut the cake first. Cuts are seen to be growth enhancing, not growth retarding. They restore that all-important “business confidence” necessary for the economy to function.

 

There is however a rather big problem with this line of thinking. The first is that for people to save, they need to have income from which to save. So if you are, for example, a state in the euro zone today, and every similar state saves at the same time by cutting spending, the result is the shrinkage of everyone’s economy since they are one another’s trading partners and sources of income. Perversely, their debt goes up, not down, relative to their (shrinking) GDP, which is what has happened to every European country that has undergone an austerity program since 2010. They now have more debt, not less.

 

Austerity, when everyone tries it at once, makes the debt bigger, not smaller. The E.U. is one of the two largest growth centers of the global economy. If the U.S., the other big one, decides to join in this “austerity binge” the result will be more, not less, U.S. debt and an even bigger growth crisis for the global economy.

 

So why then did so many countries in Europe do this? It’s about money all right, but not in the way you think. As we found out in the mortgage crisis in the U.S., you can’t have overborrowing without overlending, and core European banks (which are twice the size and three times as levered up as their “too big to fail” American counterparts) overlent to southern Europe on an epic scale, spending northern European savings in southern European bond markets and stuffing their balance sheets with those bonds in the process. Now that these bonds have gone bad, deprived of national currencies with which the governments responsible for these banks could bail them out (a side effect of the euro) European states are reduced to cutting, adding liquidity and praying while the situation goes from bad to worse. Cutting in such a world turbocharges the already bad shrinkage problem.

 

What about the theory that cuts will lead to greater confidence if only we lose our fear of the cuts and really go for it? The technical, and very non-Keynesian idea here is called the expansionary fiscal-consolidation hypothesis. It goes like this: when the government cuts spending in the middle of a recession, despite the economy falling about our ears with jobs and income evaporating around us, we will know that years ahead the state will be smaller and so we will pay less taxes relative to our lifetime income. Buoyed by this knowledge we will spend more today, despite the recession, thereby curing it. This is the mechanism that is supposed to make us all more confident and spend more. If you know anyone in the world who actually behaves like this, don’t lend them any money.

 

Given then that cuts lead to more debt and less confidence, does it follow that we can have whatever level of debt and deficit we like with no consequences? Absolutely not. And this is where a Keynesian idea is appropriate: that the time for austerity is the boom, not the slump. Countries that have successfully reduced debt have done so when others are expanding and their own economy is booming, which makes perfect sense.

 

This is why austerity is a dangerous idea: it doesn’t work in the world that we actually inhabit. In the imaginary world of austerity, cuts always happen to someone else. Sadly, as Europe is proving all too well, in the world that we actually inhabit there is no “someone else” to pass the costs on to as we all try to shrink to grow.

 

SOURCE: http://ideas.time.com/2013/04/18/why-austerity-is-a-dangerous-idea/#ixzz2RTGhAzJR