The Corner

Time to Replace Debt-producing Austerity With Debt-reducing Austerity

I made the case last week that there are two types of austerity measures: The one that successfully reduces the debt-to-GDP ratio (a combination of spending cuts and structural reforms) and the one that fails to reduce debt (a combination of spending cuts and tax increases, also known as the balanced approach).

Sadly, even in a time of crisis (or especially in a time of crisis), lawmakers tend to make decisions for the sake of politics rather than good policy. Countries that are in fiscal trouble generally got there through years of catering to interest groups and pro-spending constituencies, and their fiscal adjustments tend to make too many of these same mistakes. As a result, failed fiscal consolidations are more the rule than the exception.

This has proven to be the case in Europe, where most countries — think of Spain and the U.K. — have chosen packages of small spending cuts and large tax increases, often as a result of being scared off by large deficits and angry interest groups. To make matters worst, while taxes usually do get raised, highly decried drastic spending cuts are often nowhere to be seen. Not surprisingly, the result has been quite disastrous. Not surprisingly either, everyone blames the spending cuts, rather the the tax increases, for the poor results, and austerity gets a bad name. This is why I think we need a new term to describe measures that actually cut spending and structurally reform the labor market or entitlement programs.

#more#Now enter the French. Socialist candidate François Hollande wants to replace what he calls austerity (in spite of the lack of spending cuts or serious reform) with pro-growth policies. Interestingly, pro-growth here doesn’t actually mean pro-growth but rather pro-taxes and pro-government spending — likely on infrastructure. Are we going to need a new word for pro-growth policies too?

In a very good piece in the Financial Times this morning, Gideon Rachman explains why increasing infrastructure spending in Europe is no way to produce growth:

In Europe, however, there are plenty of reasons to be sceptical. If building great roads and trains were the route to lasting prosperity, Greece and Spain would be booming. The past 30 years have seen a huge splurge in infrastructure spending, often funded by the EU. The Athens metro is excellent. The AVE fast-trains in Spain are a marvel. But this kind of spending has done very little to change the fundamental problems that now plague both Greece and Spain — in particular, youth unemployment.

Worse, in some ways, EU funding for infrastructure has created problems. In Greece, milking the EU for subsidies became an industry in itself: and political connections were a surer route to wealth than entrepreneurial flair.

I should note that, in the U.S., this misallocation (or political allocation) of money for infrastructure projects suffers from the same “survival of the unfittest” syndrome,

Now, we could have a debate over whether or not truly cutting spending will turn the financial outlook of these countries around quickly or not, and whether or not it will lead more rapidly to rising growth rates. Considering the scale of the problem, I doubt that any measures can produce a fast recovery and economies that are growing as much as we would like them to anytime soon. Basically, there is no silver bullet to save Europe. It took them many years to get into this mess; they won’t get out of it overnight. But that is certainly not a reason to stop cutting spending. In fact, none of the European countries suffer from lack of spending. On the contrary, these countries suffer from years of overspending, over-promising voters, and over-serving interest groups. Take the case of France, explains Rachman:

Even in France, the centre of the revolt against austerity, it is hard to argue that the problem is that the state is not doing enough. This is a country where the state already consumes 56 per cent of gross domestic product, which has not balanced a budget since the mid-1970s, and which has some of the highest taxes in the world.

As for Germany, I find it strange to read some many calls for more inflation, more spending by Germans on their neighbors, and more German solidarity/redistribution. Why should they do all these things? Because on paper that’s what seems to be the way to balance things and save Europe — an artificial construction that was bound to implode anyway?

It won’t be easy to let these countries deal with their problems (there is a risk that some countries will collapse and, in that case, spillover effects will reach Germany). However, it’s unlikely that more redistribution (whatever form it takes) would work anyway.

Also, Germans did their part and reformed their system years ago. They put their financial house in order (after having to stomach the gigantic costs of the German reunification — on their own). That’s what being a good European should mean. In fact, it is easy to forget why unemployment in Germany — especially for young Germans — is much lower than, say, Spain and France. Germany did the hard work and actually reformed its labor market by reducing many of the protections and benefits for its workers.

European countries won’t be able to spend their way out of debt. You don’t cure an alcoholic from his drinking problem by giving him more to drink.They won’t be able to tax their way to balance either. It is time to consider the real alternative to fake austerity, and start cutting spending.

Allez courage!

By the way, Italy has decided to cut more spending in order to avoid having to raise taxes further.


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