Growth versus Austerity

A Phony Debate

by Pater Tenebrarum
The Aggregation Fallacy

We have recently mentioned an article in the WSJ that focuses on a point we have always regarded as very important.

The popular press continues to frame the debate over Europe's crisis in terms that suggest that 'austerity' is the antonym of 'growth'. In other words, if the government spends less, the economy cannot grow, or so the story goes. You can see similar thoughts expressed in this 'chart of the day' comment at Business Insider. 'This is what's crushing GDP!' Krugman fan Joe Weisenthal exclaims. 'This' being a reduction in government's consumption spending.

So let's get this straight: an economy can not grow unless the government spends more? Really?

The WSJ article notes:

“Growth or austerity? That's the choice facing Europe these days—or so the Keynesian consensus keeps saying. According to this view, which has dominated world economic councils since the 2008 crisis began, "growth" is mainly a function of government spending.
Spend more and you're for growth, even if a country raises taxes to pay for the spending. But dare to cut spending as the Germans suggest, and you're for austerity and thus opposed to growth.

This is a nonsense debate that misconstrues the real sources of economic prosperity and helps explain Europe's current mess. The real debate ought to be over which policies best produce growth.“

We couldn't have said it better. As we have often pointed out here, we believe that to burden tax payers with bank bailouts is both immoral and a policy that is going to have quite negative long term economic consequences.

It rewards irresponsible behavior by lenders and borrowers and keeps malinvested capital on life support, while coercing innocent bystanders into paying for said life support.

The army of zombies that is thus allowed to populate the economy as long as the central banks and governments 'paper over' the problems, delays and hinders all attempts at genuine recovery. Getting the economy to embark on sustainable growth under such circumstances is akin to trying to get a marathon runner to win a race while strangling him with a garotte. 
Government debts as a share of GDP, via the WSJ. As Roger Garrison notes in 'Time and Money', it may actually make more sense to correlate them with savings.

Moreover, in spite of the fact that a few small economic reform steps have been taken in several euro area member nations in the meantime, the so-called 'austerity policy' in many cases consists mainly of raising the tax burden on citizens. There is very little being done in terms of actually cutting spending. Governments are not willing to relinquish control over the the part of the economic pie they regard as being 'theirs'.

This creates a double-whammy for the economy. When government spending is cut, resources are freed up for use by the private sector. However, keeping government spending high while attempting to lower budget deficits by increasing the tax burden means that not only are no resources thus freed up, but the private sector is put under even more pressure, just as the future economic situation is already subject to great uncertainty.

Given the manner in which 'GDP' accounting works, Weisenthal is in a way correct: since government spending is added to GDP, a reduction in government spending will ceteris paribus lower the official GDP growth number.

But what is this really telling us about the economy? The answer is: nothing at all.

The big mistake in the Keynesian recipes to get economic growth going is that they insist to view the economy as consisting of blobs of aggregates. From this perspective, all spending is 'good'- this is to say, spending is spending and output is output in the Keynesian view, regardless of what it actually consists of. The Keynesian aggregations make it easy to construct mathematical models of the economy, none of which are actually saying something useful. Robert Higgs once called this approach 'the intellectual equivalent of a baby toy'.

A number of Western economists (such as Paul Samuelson) were still wondering in the late 1980's when the Soviet Union would finally overtake the West economically. Shortly before the SU collapsed in a heap in 1990, it became known (due to Gorbachov's 'glasnost' policy) that of 277 'essential consumer goods' 234 were simply missing from the Soviet distribution system – and yet, GOSPLAN, the Soviet central economic planning agency, always reported that the 'economic plan was exceeded' – which presumably was the reason for Samuelson's ruminations ('see, they exceeded the plan. X tons of steel were produced and Y tons of copper. They're going to overtake us!')

Now, the reason why nothing seemed to work was of course that a socialist economy can not calculate, as it lacks market prices. However, we don't want to discuss this aspect here. We merely want to point out that 'GDP' as such tells us about as much about the economy as the fulfilling of the 'plan quotas' of the GOSPLAN agency. It is essentially a meaningless number.

The economy does not really produce some uniform blob named 'output'. In the real world, millions of raw, intermediate and final goods are produced and are interrelated in a complex web of countless individual production and consumption plans. What, where, how much and how to produce, which choices to make and which ones to set aside, are all questions millions of actors in the market economy are confronted with and trying to solve daily. It follows that when such a complex latticework is disturbed by interventions, things can very easily go wrong.

The effects of interventions take some time to percolate through the economy. Production takes time, so until the various processes that are set into motion come to fruition and a final account of profit and loss can be made, things may still appear to be going well. This is why people often fail to make the connection between cause and effect in the economy. The business cycle may thus often appear like an accident, the busts that are following booms like a visitation from an angry god, basically the economic equivalent of an earthquake or a hurricane. This is also why it is e.g. possible for Ben Bernanke to deny that the Fed had any responsibility for the housing bubble, as absurd as this claim must sound to anyone with even a smattering of understanding of market processes.

Europe Searching for 'Growth'

The WSJ article linked above continues:

 “In the 1980s, the world learned (or so we thought) that the way out of the malaise of the 1970s were reforms that encourage private investment and risk-taking, labor mobility and flexibility, an end to price controls, tax rates that encouraged capital formation, and what the World Bank now broadly calls "the ease of doing business." Amid this crisis, Europe has tried everything except these policies.”

So what about Germany? As the author remarks, the grim Teutonic task- and paymasters of Europe actually did undertake a number of successful reforms:

 Then-Chancellor Gerhard Schröder, a Social Democrat, surprised the world, to say nothing of his own voters, by pushing through the labor-market reforms that paved the way for the current relative prosperity. The changes cut welfare benefits and gave employers more flexibility in reaching agreement with their employees on working time and pay.

The Schröder government, and later the coalition under Angela Merkel, also cut federal corporate income taxes to 15% from 45% in 1998. Include state taxes, and the effective corporate rate today is close to 30%, down from 50% or more in the 1990s. These reforms made Germany more competitive, attracted investment and jobs, and paved the way for the country's economic resurgence and an unemployment rate currently at 5.7%.

Mrs. Merkel's government did the world an additional favor in 2009, amid the financial crisis, by rejecting calls from the International Monetary Fund, then British Prime Minister Gordon Brown, President Obama, Treasury Secretary Tim Geithner and the same dominant Keynesian consensus to join the global spending party.

"They've already pumped endless amounts of money into the economy," said German Finance Minister Wolfgang Schäuble in 2010 about U.S. policy. "The results are dismal."

Germany's resurgence might have been even stronger if Mrs. Merkel and her coalition partners hadn't reneged on their tax-cutting campaign promises and raised VAT and other taxes in a bid to stay close to budget balance. Still, Europe is lucky that its largest economy remains strong and creditworthy.

Yet now Mrs. Merkel is widely berated for avoiding the policy errors that led to the debt crisis and for having the nerve to encourage other countries to emulate the reforms that worked in Germany. The Keynesians will never forgive the Germans for being right. […]

Europe's voters have already swept several governments from office, and they seem ready to sweep out more. But what really needs to be swept away is the dominant and debilitating consensus that government spending can conjure prosperity.

Now, we wouldn't go that far. It is true that Germany was successful in introducing essential labor market and tax reforms and has in this way laid the foundation  for the country's economic resurgence. However, Germany is still far from being a shining example of an unhampered free market economy or a place where faith in government's ability to 'conjure prosperity' has been completely abandoned. However, as many observers have noted, Germany is increasingly 'isolated' today with its tough stance regarding fiscal and monetary policy. This is not too surprising: no politician wants to be in power while the short term pain that it is necessary to endure to achieve long term recovery and prosperity is playing out.

Meanwhile, ECB chief Mario Draghi urged European politicians to adopt a 'growth pact' last week. Oddly enough, politicians holding diametrically opposed views saw themselves vindicated by his call.

“A chorus of European leaders on Wednesday called for strategies to bolster the region's faltering growth, in comments reflecting the growing unease about the austerity medicine being applied to heal the region's economic woes—but their similar rhetoric hid widely divergent policy prescriptions.

European Central Bank President Mario Draghi embarked on the theme by saying euro-zone nations needed a "growth pact" to complement their existing agreements to enforce fiscal discipline, saying nothing that suggested he would support loosening budget restrictions.

His comments were seized upon by Chancellor Angela Merkel of Germany and French Socialist presidential candidate François Hollande as vindicating their arguments.

However, they did so from opposing standpoints: Mr. Hollande is pushing for much less budget stringency while Ms. Merkel's government remains the euro zone's foremost advocate of austerity.

So how would Mr. Hollande go about 'boosting growth', aside from imposing enormously higher income taxes in France and perpetuating institutional unemployment by raising the minimum wage? It turns out he is exactly what we thought he was: a central planner to the bone.

“Mr. Hollande, the favorite to be elected in the second round of the presidential election on May 6, said the comments about growth backed his own.

"The fact that the ECB president has also added his voice to others' confirms that the commitment I have made will make the French election a decisive moment for Europe," he said. Michel Sapin, a former finance minister and a senior member of Mr. Hollande's campaign team, said the candidate had helped change the shape of the debate in Europe. "There has been an evolution in people's thinking," he said. "François Hollande is no longer isolated." [if true, then that's highly unfortunate, ed.]

Mr. Hollande, giving his first news conference after topping Sunday's first-round vote, said if he were to be elected he would send a memorandum to European leaders explaining his plans for infusing more growth policies into Europe.

He would call, among other things, for euro-zone bonds to finance industrial and infrastructure projects; and the creation of a financial-transaction tax.

Oh, OK – yet another tax to 'boost growth'!  We swear you couldn't make this nonsense up if you tried. 'Industrial and infrastructure projects' financed by government spending are to be blunt about it usually known as 'white elephants' that will never make a dime of profit. How can they? They are not the result of voluntary decisions of market actors. It will be impossible to determine whether they are profitable or loss making with any certainty, but odds are that the opportunity costs involved will vastly exceed whatever gains can later be attributed to them. As to euro bonds, the less said the better. Let us just repeat here, the use of a common medium of exchange does not depend on entering into a 'fiscal union'.

Rise of the 'Énarqués'

Hollande is a fairly typical exponent of the French political system. Essentially he is a man who has never held a 'real job' in his entire life, similar to Tim Geithner.  What we mean by that is that he has never in his life actually served consumers – he was groomed from day one to serve as a minion of the State and has indeed been a life-long bureaucrat. The so-called 'énarques' are people that have graduated from France's École Nationale d'Administration. According to Wikipedia:

“The main reason for entering ENA is that it has a legal quasi-monopoly over access to some of the most prestigious positions in the French civil service. [..]

French law makes it relatively easy for civil servants to enter politics: civil servants who are elected or appointed to a political position do not have to resign their position in the civil service; instead, they are put in a situation of "temporary leave" known as disponibilité.

If they are not re-elected or reappointed, they may ask for their reintegration into their service (see Lionel Jospin and Philippe Séguin for examples). In addition, ENA graduates are often recruited as aides by government ministers and other politicians; this makes it easier for some of them to enter a political career. As an example, Dominique de Villepin entered politics as an appointed official, after serving as an aide to Jacques Chirac, without ever having held an elected position.

The énarques were criticised as early as the 1960s for their technocratic and arrogant ways. Young énarque Jacques Chirac was, for instance, lampooned in an album of the Asterix series. Such criticism has continued up to present times, with the énarques being accused of monopolizing positions in higher administration and politics, without having to show real efficiency.

In this context, we recently came across an article by Fred Sheehan that is well worth reading in its entirety. Here is are a few excerpts:

“The French are a free people, who will not allow their future to be determined by the pressure of markets or finance."

French presidential candidate François Hollande, Ecole Nationale d'Administration (ENA), class of 1980, April 19, 2012

Hollande expressed an ardent belief of every ENA graduate (popularly known as énarques, a popularity not often witnessed beyond the campus gates). Economics professors from Harvard, Princeton, and Oxbridge also dismiss markets.

They went so far as to claim all markets identify the right price all the time, thus avoiding the need to understand them. Markets are there to be used: a means to institute public policy. Such policies are imposed by the ruling few.

The Bretton Woods gold standard constrained the ambitions of superior persons. When President Nixon defaulted on the United States' gold payment obligation in 1971, he opened the floodgates to Policy Making without Consequences. […]

Discovering markets were no longer constrained by the gold fulcrum; politicians, government bureaucrats, and academic opportunists conducted their social experiments with greater liberty.Previously, governments could only spend so much before the markets said "enough." Coming to understand their new dispensation slowly, then in a hurry, the technocrats found the costs of their experiments on populations could be absorbed by the rising tide of debt. Restraint in policy reformation, as in most every other human endeavor, was fading in the western world.

Government debt has accumulated year-after-year, akin to regulations imposed from Brussels and Washington. The comparison is not gratuitous. Impositions; crony handouts; and abstract, social improvement programs that should have been quarantined in the Ph.D graveyard; carry costs. According to the OECD, the government net financial liabilities had risen to 52.2% of GDP in Germany by 2010. In France, the figure was 58.9%; in Austria, 44.0%; in the Netherlands, 34.4%. Since budgets had been in balance, these numbers rose from approximately zero in 1970.

The percentage of debt-to-GDP might be likened to a dependency ratio of the bureaucracies. They have been more than willing to use the bond markets to finance their indulgences, but now are turning against them. Other European politicians and Brussels bureaucrats have also blustered about and interfered in stock, bond and credit-default swap markets. (The U.S. énarques have imposed their pricing model in every market, another terminally ill construct.) […]

Presidential candidate François Hollande, as is true of Federal Reserve Chairman Ben Bernanke, believes he can order nature around. Both have lived inside the fishbowl their entire adult lives.”

The penultimate sentence is actually the central point: 'They believe they can order nature around'. This is precisely what is revealed in their words and deeds. The classical age of economic liberalism in the 19th up to the early 20th century, to which we owe such a great debt in terms of the capital and wealth accumulation it made possible, was a result of economists discovering that were economic laws and that politicians, no matter how powerful they were, could no more order around economic and market forces than they could order around the sun or the wind.

In the modern-day world, after decades of unbridled debt expansion, this realization has given way to the faith expressed by the likes of Hollande: namely that markets don't matter. Government is indeed held to be able to conjure up prosperity as though it possessed a magic wand. A Fibonacci 21 years after the collapse of the Soviet Bloc, here is yet another politician who professes that central economic planning will work. It definitely won't and if Hollande really implements all his plans that should become painfully obvious soon enough.

The question we have is this: why do have to go through all these silly experiments imposed by these arrogant economically illiterate people? Why does it still have to be explained that nothing is better at delivering genuine economic progress and  prosperity than an unhampered free market economy?