When it comes to the Euro Crisis, will austerity work?
Let's consider a simplified form of a domestic government budget constraint.
Government spending is equal to tax revenue taken in
plus the amount of money borrowed.
Note that the term austerity can have multiple meanings.
Austerity could refer to a decrease in government spending
or it could also refer to an increase in tax revenue and/or tax rates.
When people write about austerity, they're not always clear about what they mean.
Be careful.
Let's first consider raising tax rates.
In the short run and indeed in the long run, this is usually bad for an economy.
It damages productive activity and it also hurts
what macroeconomists call aggregate demand.
That is consumers have less money to spend
and capitalists may also be less eager to invest.
Sometimes raising taxes may be necessary
but it's not really going to bring about a solution to the Euro crisis
because it means shrinking economies and shrinking economic growth.
There's also the problem that raising tax rates
doesn't always bring in more tax revenue.
If either taxes are already quite high, as is the case in France,
or the tax collection apparatus is fairly ineffective, as is the case in Greece,
then trying to increase taxes is not always an effective policy lever,
even it's something you might like to do.
The second approach to austerity is to cut government spending.
This too has some economic problems, in this case especially in the short run.
It also hurts aggregate demand.
It may mean, for instance, that public sector employees are laid off
and then they have less money to spend.
It may lead to civil unrest and more uncertainty surrounding investment.
And finally, depending on where the spending is cut,
it may lower the investment in an economy's future.
For instance, there may be less spending on education.
A lot of economists believe that the spending which ought to be cut
is transfer payments, often transfer payments to the relatively wealthy.
But in practice what often tends to be cut is discretionary spending.
So government spending cuts are very often
not done in the most effective or efficient ways.
As with tax increases, government spending cuts
bring some risk of a downward spiral, portrayed here.
For instance, imagine that taxes are going up
and government spending is going down.
That means that in the short run GDP is falling.
That means in turn that less tax revenue is being collected, that's falling too
and that can worsen a country's budget deficit
which in turn requires further tax increases
or further cuts in government spending,
therefore leading to a kind of vicious cycle.
You don't have to be a Keynesian economist to worry about this kind of problem.
Let's say you take a view which is really quite cynical of a lot of
government or public sector spending
and you think that a lot of it goes, not say to educating children,
but that a lot of it is wasted.
Shouldn't we cut that spending?
Well, in general, yes we should cut that spending
but keep in mind the particular position of a lot of the Eurozone economies today.
They do not have flexible labor markets
and they're undergoing a lot of credit contraction.
So in a well-functioning economy,
it might be the case that we could cut wasteful government spending
and that would pretty quickly lead to an increase in private sector output.
But if the labor market is not working well
and if credit markets are not working well,
what may happen instead is that when we cut government spending
we simply get GDP going down
and the private sector really doesn't have the kind of uptick we might like it to.
There is economic literature on
what are the best adjustments to a financial crisis,
but most analysts agree, what's good is to have a falling exchange rate,
through depreciation or devaluation,
to balance your budget in large part by spending cuts,
cutting spending on the wasteful items,
to go relatively easy on tax hikes,
and for your economy to have decent fundamentals
and perhaps a fairly loose monetary policy.
But if you look at the Eurozone,
not all of this is going to be possible.
The falling exchange rate, well that's determined by the Eurozone as a whole,
and you can't get a falling exchange rate
relative to your trading partners within the Eurozone
because you have the same currency.
Spending cuts and tax hikes in most of the Eurozone economies,
there have actually been a lot more tax hikes than spending cuts.
Spain, for instance, has done a lot to increase taxes,
but not that much to cut government spending.
Greece is one country that has made some real cuts to government spending.
And finally, at this point in time,
there really aren't decent fundamentals in place for a lot of these economies.
So the adjustment is going to be tough.
If you'd like to read more
on this general topic of how to adjust to financial crises,
I recommend this piece which is available online and free.
So in these situations, austerity can work but it's actually a pretty painful path.
For one thing, wages must fall.
This can come through a mix of tax hikes, lower benefits,
or sending more money to a nation's creditors.
It also means that consumption must fall.
Note that wages falling and consumption falling
can tend to restore a nation's trade balance by cutting back on imports.
Government spending must fall and some government benefits must fall.
When you put all those things together, you can see it's not very popular.
Let's now go back to the three fundamental economic problems of the Eurozone
as identified by the video of that name.
We saw they were a banking crisis,
capital imbalances, and a government budget crisis.
What austerity does is, it does address capital imbalances
by limiting imports.
It also, to some extent,
may help a government budget crisis by raising taxes and cutting spending.
But it turns out that it usually worsens number one.
That is. it gives you a greater banking crisis
because you have falling output and that makes banks less solvent.
And that leads to more bank runs and more capital flight.
And that, in turn, damages output and may require some more austerity.
Well, if austerity is so painful, what are the alternatives?
One of them is external aid,
and of course, there's been a good deal of that in the Eurozone,
but note that external aid often just postpones problems.
And in a lot of cases that aid is loans and it still has to be paid back.
In the meantime, a country may prefer making difficult but necessary decisions.
The second alternative is to simply default on one's debt,
as say Argentina has done.
One thing to note about default is that it may cause a European,
or maybe even a global, financial crisis.
But a second problem with default is that once you default
it's much harder to borrow money again.
And if you can't borrow money,
well, there may still be a budget imbalance,
and very often austerity still comes.
So defaulting need not get you out of the austerity trap.
It may just mean you live through that trap
in a situation where you cannot easily access international capital.
Finally, you can borrow more, spend more and hope for the best.
That can work if rapid growth will resume,
but right now we don't see too many signs of that in the Eurozone.