The Austerity Deniers

by: Shareholders Unite

There seems to be a new trend in the anti-Keynesian camp, who have been making predictions like:

  • Large government deficits will lead to much higher interest rates and crowd out private expenditures
  • Quantitative Easing (QE) will lead to large increases in inflation

Neither of these predictions have materialized in any way, or look like they're anywhere near materializing anytime soon, so they've now turned their attention elsewhere, apparently. However, the Keynesians have made predictions of their own by arguing that cuts into public spending and/or tax hikes will significantly contribute to the economic malaise under the current economic conditions.

We stress the "current economic conditions" part, because that's essential. At heart, the Keynesian analysis is remarkably simple. The private sector suffered large losses in wealth due to the housing crash. As a result, it reduced borrowing and spending and increased savings (or were forced to do this by creditors).

The problem is that on the level of the economy as a whole, where my spending is your income, if everybody (or at least a large number of people) start to do this, the economy can easily spiral down, and this is exactly what happened. This process can easily feed on itself, people spending less, companies cutting back production, investment and employment, leading to further spending cuts.

Especially if bank balance sheets are also affected badly, when more people get into problems, more assets are forced to be sold at distressed prices (like foreclosures) putting more pressure on asset prices and bank balance sheets, curtailing credit further, etc.. Luckily, the U.S. nipped at least this process in the bud from the beginning, forcing banks to recapitalize themselves on the markets. Europe would have been much better off if it would have done the same.

The process can be seen as the private sector moved from a financial deficit (S-I<0) to a large surplus as savings rose and investment fell.

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Keynesians simply argue that when the private sector suddenly starts to spend a whole lot less, the public sector must counterbalance this with more spending to keep this process from feeding on itself (like in the 1930s). There is really nothing more to it. In normal times, lowering interest rates by central banks is sufficient to get people spending again, but not this time.

The essence of this crisis is that households, in order to repair their damaged balance sheets, will not be induced to borrow and spend more no matter how low interest rates go. Even QE just floods the banks with reserves, but if households don't borrow more, this isn't all that powerful.

The cutback in private spending also affect public finances. The state has to pay out more in stuff like food stamps and unemployment benefits, and receives less in tax revenues as these are proportional to profits, wages, employment and spending. Hence the public deficit rises automatically as economic conditions worsen, which to a certain extent helps stabilize the economy (hence the term "automatic stabilizers").

Austerity

Here and now it's getting crucial, Keynesians argue that during such a balance sheet recession, the public sector should do more and use discretionary policy tools to increase spending (either directly or indirectly through the private sector). It's this discretionary policy (that is, deliberate policy measures that lead to changes in public spending and tax rates) that figures in the austerity debate.

Austerity simply means taking measures that either reduce public spending and/or increase tax rates, that is, it is discretionary (involving policy measures) and contractionary (reduced spending, increased tax rates). This is a simple concept explained in economics101, so anyone fudging this either doesn't have any economics background or is deliberately fudging the issue to score some point. Enter the austerity deniers.

We have Paul Gregory, writing in Forbes, and a (much) shriller version of Rick Moran writing for the "American Thinker." Both articles start off with something remarkable:

The official figures show that PIIGS governments embarked on massive spending sprees between 2000 and 2008. During this period, their combined general government expenditures rose from 775 billion Euros to 1.3 trillion - a 75 percent increase.

A couple of observations:

  • This is the pre-crisis period. Nobody is arguing that there was much, if any austerity then.
  • There was a general boom in the PIIGS (Portugal, Italy, Ireland, Greece, Spain), insofar as this was caused by increased public spending, it actually confirms the causal relation between expansionary fiscal policy
  • But from these figures, we simply can't tell. It could be that the economies were booming, leading to an influx of tax revenues, which led to increased spending, that is, we simply don't know anything about causation from these figures.
  • For instance, countries like Ireland and Spain(!) had budget surpluses and low public debts on the eve of the financial crisis, they hardly went on a public spending spree
  • Citing these figures makes no distinction between nominal and real variables, a substantial part of the increase could simply be the result of higher prices, that is, not substantial increase in real government expenditures might have gone on.

Basically anyone who's trying to make a point on the basis of these detached, nominal figures is highly suspect. In order to tease out the level of austerity from overall changes in public expenditures and taxes, one has to confront it with, price changes, economic growth and the state of the economy.

Or alternatively one can focus on policy decisions taken by governments that impact spending and taxes. The question then becomes whether policy decisions have led to decreased spending and/or increased taxes (contractionary policy, which is "austerity") or have they led to the opposite. Here is the second relevant bit from both articles cited above:

Between the onset of the crisis in 2008 and 2011, PIIGS government spending increased by six percent from an already high plateau.

By this, the austerity deniers have us believe that no discretionary policy measures have been contractionary. First, since the euro crisis only hit in 2010 in Greece, and only then gradually moved beyond Greece, most austerity hit only after this 2008-11 period. Also, the figure itself proves absolutely nothing. For starters, it doesn't distinguish between real and nominal values.

More importantly, it doesn't distinguish between discretionary and automatic public spending. The latter will increase automatically (as explained above) exactly as a result of the crisis, the so-called automatic stabilizers. An economics professor like Paul Gregory is well aware of this, no doubt.

Third, it doesn't allow for the state of the economy to affect the figures in other ways (apart from automatically changing tax income and public spending). Public deficits and debts are invariably expressed as a percentage of GDP. If the latter shrinks, deficits and debts become larger.

Now here's the thing. Austerity under conditions where monetary policy cannot offset the contractionary effects actually has a tendency to reduce GDP quite a bit (that is, there are large multipliers involved, even the IMF has concurred). So it is entirely possible that austerity affects GDP rather negatively, and indeed, under these conditions it does:

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The austerity reduces GDP growth or it could even shrink GDP (especially when inflation is low), and that could very well lead to higher, not lower public sector deficits and debts, as a percentage of GDP. The result is countries chasing their own tail with more austerity. Apart from these dramatic real effects, relying on spending/GDP or public deficit/GDP figures is then totally misleading, needless to say.

Yet, as we were just about to wrap this article up, that's exactly what another austerity denier, Salim Furth from the Heritage Foundation has done (amongst other things). This isn't pretty, and he was politely rebuffed by Senator Whitehouse:

I am concerned that your testimony to this committee has been meretricious. I am contesting whether you have given us fair and accurate information.

Indeed. To counterbalance this, one better divide public sector deficits and debts by potential GDP, that is, the output a country would generate if it would employ all factors of production. This way, a recession doesn't skew the figures in such a way that countries embarking on austerity show hardly falling public deficits and debts as ratios of GDP, or even rising ones, because the recession shrinks the denominator (that is, GDP).

But make no mistake, there is real austerity going on in Europe

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In fact, austerity is in no way limited to Europe.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.