The recent elections in Greece and France were dominated by reaction to “austerity measures” — combinations of tax increases and spending cuts designed to reduce government budget deficits. Although we have not adopted such measures in our country for at least half a century, polls show much support for balanced budgets, and readers send me emails on the topic. Are austerity programs the right thing to do, either here or in Europe?
Economic history is clear on some things. Yes, raising taxes and cutting spending reduces budget deficits in most cases, especially when taken over the medium and long term. But when implemented during a recession, such measures can have the perverse effect of making deficits worse and thus growth in national debts higher.
This is because both raising taxes and cutting spending can slow economic activity, including consumer spending and business investment. Slower growth and higher unemployment further reduce tax revenues and increase government outlays in categories like unemployment compensation, food stamps and Medicaid, as more people become eligible for these programs. As a result, budget deficits grow, rather than shrink.
Moreover, the crucial ratio of annual deficits and national debt relative to the size of the overall economy gets worse, not only because the numerators, deficit or debt, grow, but also because the denominator, Gross Domestic Product, shrinks.
This is precisely what is happening in the United Kingdom, Spain and Greece right now. Particularly for the latter two, the probabilities are great that they are entering into an economic death spiral in which rising deficits force greater austerity that further slows output, thus pushing deficits even higher.
I think a large majority of economists would agree that these countries would have a better chance of economic recovery if austerity were less immediate and less severe. But for Greece, and perhaps for Spain, this would just change the outlook from “impossible” to “extremely unlikely.”
Some readers will likely protest that only Keynesian economists believe this, but that economists of other persuasions –such as supply siders or rational expectationists — would reject it.
That is not true. Yes, John Maynard Keynes and his followers argued that in case of inflation and an overheated economy, governments should raise taxes, lower spending and decrease the money supply. Facing recession, they should decrease taxes, increase spending and increase the money supply. Thus Keynesians do argue austerity is precisely the wrong thing at the wrong time.
Yes, critics, including Nobel winners like Milton Friedman, Robert Lucas and Edward Prescott, argued that such Keynesian policies were ineffective or counterproductive, especially in the longer run. But that does not mean that austerity measures don’t slow output and increase unemployment in the short run.
In the case of Greece, where there are fundamental underlying problems of unsustainable spending or ineffective taxation, most economists would agree that shunning austerity measures because of their short-term effects merely delays the inevitable and can make unavoidable adjustments even more traumatic. Better to swallow one’s medicine now than be forced to swallow an even larger, bitterer pill later.
That probably is true for Greece. It is not true for the United Kingdom and probably not for Spain.
However, you don’t hear these anti-Keynesian skeptics argue that hewing to austerity, come what may, will lead to rapid and pain-free adjustment. They know there will be a high economic and human cost.
But, like Andrew Mellon, secretary of the Treasury in the Hoover administration, they deem it necessary to “purge the rottenness out of the system.” They are like surgeons in the Civil War who knew that having a leg amputated without anesthesia involved human agony, but that it might be the only way to save a life.
Governments usually don’t choose such harsh remedies unless they are convinced there really is no alternative and that not acting will result in catastrophe.
However, as the recent elections show, in democracies it is not just governments but also electorates that must reach the same decision.
What is happening in Europe right now is important to our country, both because a recession in Europe will harm our own economy and because we face unsustainable budget deficits of our own.
But that is another topic.