Austerity: Not Just How Much but How
Europe should beware the wrong kind of debt reduction.

British journalist Polly Toynbee


If you listen to those on the political left, you will think that the ongoing meltdown in the euro zone proves that spending cuts are driving the world into another Great Depression. Paul Krugman called the fiscal retrenchment “criminal folly,” while the famous British journalist Polly Toynbee affirmed that “the great austerity experiment has failed.” Adopting this view, at their recent Camp David summit meeting, leaders of the G8 nations agreed to pursue growth and job creation ahead of deficit reduction.

On the other side of the ideological divide, there are those who say that austerity did not fail, because it was not tried in the first place. That’s because to date we have seen very little in terms of absolute cuts in public spending. Rather, due to automatic stabilizers, spending has increased in absolute terms since 2008, although probably not by as much as it would have without some of the deficit-reduction programs.

This controversy, however, misses the deeper point of whether Europe is on the right track to get its debt under control. The devil is in the details, and what matters for the success of consolidation programs is not the amount of debt reduction but its structure.

Specifically, what matters is whether deficit reduction relies on spending cuts or tax increases. As a number of leading experts on public finance — including Alberto Alesina of Harvard and Roberto Perotti of Milan’s Bocconi University — point out, a look at fiscal adjustments over the past 40 years is unambiguous: The only fiscal adjustments that ultimately lead to permanent stabilization of public budgets are those that consist of spending cuts, not increases in tax revenue.

Furthermore, it turns out that consolidations through spending cuts are much less contractionary than those that rely on tax increases. The idea of stimulative austerity is not just some right-wing fantasy; there is solid evidence that credible consolidations driven by spending cuts reduce long-term interest rates and increase stock prices.

The story of the Nordic countries in the 1990s presents a stark example. After the crisis of 1991, their governments went ahead with programs of spending reduction and structural reform. Between 1993 and 2007, the share of government spending in Sweden went down from 71.7 percent to 51 percent of GDP, and the average rate of economic growth almost doubled compared with the previous decade. Similar developments took place in Finland, Norway, and Denmark. These countries also privatized on an unprecedented scale, introduced competition in public services, and liberalized their markets.

But the present austerity in Europe is not having the same effects, and the reason is its flawed structure. According to the European Commission, tax revenue is expected to rise by 0.7 percent of GDP across the euro zone, while spending is expected to fall by only 0.5 percent. That means that roughly half of the observed fiscal retrenchment is driven by tax increases.

That’s very bad news, as Europe as a whole is probably at the top — if not beyond the top — of its Laffer curve. Back in 2004, economist Edward Prescott published his celebrated paper “Why Do Americans Work So Much More Than Europeans?” He concluded that differences in effective tax rates went a long way toward explaining the divergence in labor supply between the United States and Europe.

But hang on, it gets worse. For the countries in trouble — including Italy, Spain, and Portugal — many of those tax increases consist of tax hikes for high-income earners. In Greece, a new property tax is being put in place. But, as any student of public finance remembers, to tax very elastic bases heavily is not a good idea.

At present, wealthy and productive individuals — regardless of whether they are investors or highly talented people — need a very good reason to invest or work in the debt-ridden countries of the Mediterranean. Just try to remember when you’ve heard of anyone moving to Spain or Greece — not to retire, but to work, invest, or start a business.

The likes of Mr. Krugman and Ms. Toynbee are right to point out that European austerity has not borne much fruit. The reason for that is that the measures that have been tried rely too heavily on squeezing additional revenue from already heavily taxed economies. The only austerity that will work — which we are still waiting to see in Europe — is one that consists of credible cuts to unproductive public spending, combined with reforms that will turn the continent into a good place to do business. And, after listening to the conclusions of the recent G8 summit, I am not holding my breath.

— Dalibor Rohac is an economist at the Legatum Institute in London.