Many politicians and commentators such as Paul Krugman claim that Europe's problem is austerity, i.e.,
there is insufficient government spending. The common argument goes like this: Due to a reduction of government spending,
there is insufficient demand in the economy leading to unemployment. The
unemployment makes things even worse as aggregate demand falls even more,
causing a fall in government revenues and an increase in government deficits.
European governments pressured by Germany (which did not learn from the supposedly fateful
policies of Chancellor Heinrich Brüning) then reduce government spending
even further, lowering demand by laying off public employees and cutting back
on government transfers. This reduces demand even more in a never ending
downward spiral of misery. What can
be done to break out of the spiral? The answer given by commentators
is simply to end austerity, boost government spending and aggregate demand. Paul
Krugman even argues in favor for a preparation against an
alien invasion, which would
induce government to spend more. So the story goes. But is it true?
First of all, is there really austerity in the
eurozone? 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, at unsustainable levels, as can been seen in the following chart that
portrays government deficits in percentage of GDP. Note that the figures
for 2012 are what governments wish for.
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A good picture of "austerity" is
also to compare government expenditures and revenues (relation of
public expenditures and revenues in percentage).
Imagine that a person you know spends 12 percent more
in 2008 than her income, spends 31 percent more than her income the next year,
spends 25 percent more than her income in 2010, and 26 percent more than her
income in 2011. Would you regard this person as austere? And would you regard this behavior as
sustainable? This is what the Spanish government has done. It shows itself
incapable of changing this course. Perversely, this "austerity" is
then made responsible for a shrinking Spanish economy and high unemployment.
Unfortunately, austerity is the necessary condition
for recovery in Spain, the eurozone, and elsewhere. The reduction of government spending makes real
resources available for the private sector that formerly had been absorbed by
the state. Reducing government spending makes profitable new private investment
projects and saves old ones from bankruptcy.
Take the following example. Tom wants to open a restaurant. He makes the following
calculations. He estimates the restaurant's revenues at $10,000 per month. The
expected costs are the following: $4,000 for rent; $1,000 for utilities; $2,000
for food; and $4,000 for wages. With expected revenues of $10,000 and costs of
$11,000 Tom will not start his business.
Let's now assume that the government is more austere,
i.e., it reduces government spending. Let's assume that the government closes a
consumer-protection agency and sells the agency's building on the market. As a
consequence, there is a tendency for housing prices and rents to fall. The same
is true for wages. The laid-off bureaucrats search for new jobs, exerting
downward pressure on wage rates. Further, the agency does not consume utilities
anymore, leading toward a tendency of cheaper utilities. Tom may now rent space
for his restaurant in the former agency for $3,000 as rents are coming down.
His expected utility bill falls to $500, and hiring some of the former
bureaucrats as dishwashers and waiters reduces his wage expenditures to $3,000.
Now with expected revenue at $10,000 and costs at $8,500 the expected profits
amounts to $1,500 and Tom can start his business.
As the government has reduced spending it can even
reduce tax rates, which may increase Tom's after-tax profits. Thanks to
austerity the government could also reduce its deficit. The money formerly used to finance the
government deficit can now be lent to Tom for an initial investment to make the
former agency's rooms suitable for a restaurant. Indeed, one of the main
problems in countries such as Spain these days is that the real savings of the
people are soaked up and channeled to the government via the banking system.
Loans are practically unavailable for private companies, because banks use
their funds to buy government bonds in order to finance the public deficit.
In the end, the question amounts to the following: Who
shall determine what is produced and how? The government that uses resources for its own
purposes (such as a "consumer-protection" agency, welfare programs,
or wars), or entrepreneurs in a competitive process and as agents of consumers,
trying to satisfy consumer wants with ever better and cheaper products (like
Tom, who uses part of the resources formerly used in the government agency for
his restaurant).
If you think the second option is better, austerity is
the way to go. More
austerity and less government spending mean fewer resources for the public
sector (fewer "agencies") and more resources for the private sector,
which uses them to satisfy consumer wants (more restaurants). Austerity is the
solution to the problems in Europe and in the United States, as it fosters
sustainable growth and reduces government deficits.
Lower GDP?
But does austerity not at least temporarily reduce GDP
and lead to a downward spiral of economic activity?
Unfortunately, GDP is a quite misleading figure. GDP is defined as the market value of all final goods
and services produced in a country in a given period.
There are two minor reasons why a lower GDP
may not always be a bad sign.
The first reason relates to the treatment of
government expenditures. Let us imagine a government bureaucrat who
licenses businesses. When he denies a license for an investment project that
never comes into being, how much wealth is destroyed? Is it the expected
revenues of the project or its expected profits? What if the bureaucrat has
unknowingly prevented an innovation that could save the economy billions of
dollars per year? It is hard to say how much wealth destruction is caused by
the bureaucrat. We could just arbitrarily take his salary of $50,000 per year
and subtract it from private production. GDP would be lower.
Now hold your breath. In practice, the opposite is
done. Government expenditures count positively in GDP. The wealth destroying activity of the bureaucrat
raises GDP by $50,000. This implies that if the government licensing agency is
closed and the bureaucrat is laid off, then the immediate effect of this
austerity is a fall in GDP by $50,000. Yet, this fall in GDP is a good sign for
private production and the satisfaction of consumer wants.
Second, if the structure of production is
distorted after an artificial boom, the restructuring also entails a temporary
fall in GDP. Indeed, one could only maintain GDP if production
remained unchanged. If Spain or the United States had continued to use their
boom structure of production, they would have continued to build the amount of
housing they did in 2007. The restructuring requires a shrinking of the housing
sector, i.e., a reduced use of factors of production in this sector. Factors of
production must be transferred to those sectors where they are most urgently
demanded by consumers. The restructuring is not instantaneous but
organized by entrepreneurs in a competitive process that is burdensome and
takes time. In this transition period, when jobs are destroyed in the
overblown sectors, GDP tends to fall. This fall in GDP is just a sign that the
necessary restructuring is underway. The alternative would be to produce the
amount of housing of 2007. If GDP did not fall sharply, it would mean that the
wealth-destroying boom was continuing as it did in the years 2005–2007.
Conclusion
Public austerity is a necessary condition for private
flourishing and a rapid recovery. The problem of Europe (and the United States) is not too much but too
little austerity — or its complete absence. A fall of GDP can be an indicator
that the necessary and healthy restructuring of the economy is underway.
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