Two Ways, But Where To?

Electoral fear may be the only medicine

By Anthony de Jasay

Having for a pulpit a regular column in the New York Times, Paul Krugman speaks to us as one who is really sure about what is what. He is also thoroughly exasperated by the pigheaded blindness of those of us who have their hands on the levers of policy and are responsible for the astronomical waste and needless pain inflicted on the economies on both sides of the Atlantic and especially on the Eurozone. His thesis is that we are actually in a state of genuine depression, involving a loss of potential output that hardly bears thinking about. The depression is of our own making and is unnecessary, serving no purpose. It ought to be and could be terminated forthwith.

Its cause is the misguided attempt by the majority of Eurozone states to tackle their indebtedness by reducing the rate at which it has been increasing as a proportion of GDP for the last two or three decades. For the average Eurozone state, this proportion rose from 30 to 90 per cent of GDP. It is now rising each year at 3.5 or 4 percentage points for Italy and France and at 8 percentage points for Spain—to speak only of the countries that are not on intensive care like Greece, Portugal and Ireland, nor in reasonable health like the Teutonic group. All 17 states signed up to the Golden Rule that would limit their "structural" budget deficit to 0.5 per cent of GDP, but it is far from evident that all will succeed or even genuinely try, to achieve this in the foreseeable future. The agreement they signed, though not yet ratified, provides for "sanctions" by the European Court of Justice, but serious sanctions cannot realistically be applied. Meanwhile, the order of the day is austerity, mostly by cutting expenditure as in Spain, increasing taxation as in France, and curbing tax evasion as in Italy.

Many economists, with Paul Krugman and George Stiglitz in the lead, argue that dealing with indebtedness by austerity, though a commonsense remedy for a household, is self-defeating at the level of an entire economy, for austerity stifles economic growth, hence it reduces tax revenues and worsens the budget deficit that the austerity was meant to improve. The argument is enthusiastically seconded by politicians who expect to win votes by promising maintained or increased government spending on welfare, subsidies and other popular items, some of which may even have genuine merit, but cannot be afforded.

Krugman's mantra is "my spending is your income". If I spend more, your income rises, hence you spend more and the money I have spent comes back to me. We are both better off. It is simply foolish not to see that this is the obvious and wide open way out of the depression that austerity has brought about.

Austerity, to be sure, operates by a variety of measures, some of which are dictated by the laws of least resistance and are inefficient or harmful. They are biased to raising taxation rather than reducing spending, and also to multiplying the bewildering tangle of regulatory and fiscal interventions, each of which designed to serve some good purpose but whose aggregate is oppressive and strangles the normally expansionary impulse in the economy. How good an alternative is the Krugman way?

The "my spending is your income" mantra is true enough in a closed economy, but false in an open one. You may not spend the income you receive from me on what I have for sale, but rather on what a Taiwanese manufacturer of electronic gadgets has for sale. Your extra income does not flow back to me, but "leaks" into inputs. It is not surprising, then, that Krugmanites often show some more or less disguised sympathy for protectionism in some fig-leafed-covered form. Worse than the leakage into imports is the effect on both the willingness to invest and consumer confidence. David Ricardo saw that government debt depressed private demand as business and consumers take account of the future taxes they will be made to pay to service the debt. A similar but wider effect of increasing government debt is that it brings closer the day when the threat of sovereign default simply forces the adoption of the most cruel austerity. It is as if the Keynesian multiplier took on a negative value, decreasing aggregate demand when government dissaves and increasing it when government saves.

Consider a scenario where three not-so-solid Eurozone countries, France, Italy and Spain decide to take the Krugman way out of the stagnant or gently declining economic conditions the present austerity creates for them. Tentatively, though with limited confidence, we may suppose that if they open the valves of government spending their annual deficit rises to 7 per cent of GDP for France and Italy and 9 per cent of GDP for Spain; that this deficit is maintained for three years; and that at the end of this period, the economies of these countries enter into such a growth phase that they can without austerity obey the Golden Rule and run a balanced budget. (Ignore the strong likelihood that in a democracy, a balanced budget would provoke a pressing demand for more welfare, more subsidies and lower taxes that the government would find electorally impossible to resist). Under this assumptions, by the time reasonable growth began, the proportion of debt to GDP of the three countries would be roughly 22 to 28 percentage points higher than at the outset. At unchanged interest rates, the service charge on the national debt could require an extra 1 to 1.5 per cent of GDP forever after, a handicap whose weight looks easy when seen from afar but a heavy servitude when it is borne year after year.

This handicap may perhaps be brushed aside as bearable. There is, however, a far more disturbing implication of the putative return to growth via higher government spending. In fact, apart from the assumption that it lifts the economy out of depression, it is impossible to tell where the Krugman way would lead it. One possible arrival point would be highly dangerous. Uplift by easy government spending and easy times would leave these economies as inefficient and inflexible at the end of three years as they were at the outset. However, growing at 2.5 per cent they would certainly import more and may well export less than at a growth rate of 0 or 0.5. Their current balance of payments, already negative, could become dramatically weak. The semi-permanent sovereign debt "crisis" they now live with would become a mother of all balance of payments crisis. There are currently persistent demands for Germany to take on the sovereign debt crisis on the transparent pretext that as separate national currencies have been replaced by the euro, separate national debt obligations must now be replaced by a mutual common obligation, the Eurobond. Germany has up to now declined the honour of supporting a Eurobond, and is very unlikely to accept the honour of supporting the Latin countries' balance of payments deficits. One alternative is the breakup of the euro, a reversion to the franc, the lira, and the peseta and a mother of all devaluations until the Mediterranean countries become more competitive at the cost of worse terms of trade. Where else the Krugman way may lead is a puzzle.

The alternative to spend-and-borrow is austerity. It takes two forms: spend-less-and-maintain-taxes, or raise-taxes-but-maintain-spending. State-of-the-art economic research as well as the OECD and the IMF have no hesitation to say that reducing public spending is the more effective form of austerity. Indeed, when 57 per cent of national output, produced by individuals, is pre-empted and disposed of by collective choice, as is the case in France, the holder of the world record in the matter, it is hard to say how maintained collective spending (central and local government and compulsory old age, health and unemployment insurance ) could be a viable solution.

However, the political odds are against less spending. Keeping expenditure high and raising taxation higher is the odds-on favourite in democratic states. The reason is that electoral majorities punish governments more severely for reducing public services and nominal incomes than for raising taxes. In fact, taxing the "rich" and "privileged" and also banking and oil, is positively welcomed by majorities. Taxing the poor by consumption taxes is electorally quite well tolerated, and it is this that brings the big money into the state coffers.

The typical upshot of adopting austerity in order to bring deficits under control is politically easier but economically not very suitable.

What are the chances then, of a regime of austerity bringing about, not only a better budget and external payments balance, but also an economic system which is allowed to breathe more freely and which regains its underlying tendency to grow (if it were not kept down by the twin burden of the public sector and excessive regulation)?

It does not flatter us and our manner of government, but seems nonetheless the case that the only time a majority will forget its short-term urges and allows realistic long-term objectives to prevail, is when it is driven by fear. It was a scared electorate that mandated Margaret Thatcher in Britain in 1979 and Ronald Reagan in the United States in 1980 to try to reverse the decline of these countries. There is some hope that if today opinion-makers in Europe look at Greece and say "there, but for the grace of God, go we", intelligent governments may be allowed to reform some of the perverse structures and dismantle to obstacles that contort the economy. Burning all but a few of the 3,000 pages of a code of labour law would do wonders for job creation at the expense of job protection. It would be ironical but poetic justice if, by a desperate but bold change of course, austerity would finally bring back more prosperity for all in a more liberal order that majorities love to hate and vilify.