Austerity — How it Works
and When It Does Not
Apr 8, 2019
Antony P. Mueller
Trying to
overcome a financial crisis with more debt is ineffective and a scheme of
deceit. It would be just another step closer to final bankruptcy. In order to
overcome a financial crisis, policies in favor of private business are
required. Austerity need not be painful when the contraction of the public
sector is accompanied by the expansion of the private sector. This way, the
recipe for making austerity work requires to do away with the interventionist
burdens and to ignite the entrepreneurial spirit. The challenge for the
policymakers is not to quarrel about spending cuts but to determine what must
be done in order to make the private sector expand while the public sector
shrinks.
Failed Policies
As Austrian
economics explained long ago,
austerity and not more spending is the way out of a depression. A new empirical
study of 16 advanced economies has fully confirmed the thesis that austerity
works. The research found that
the sizable reduction of a country’s deficit and the stabilization of the
public debt is the way for the economy to recover and regain economic growth.
Reducing the obese state through fiscal retrenchment leads to economic
expansion.
Yet the popular
belief says that the debt which comes with more deficits would be financed by
more tax revenue because government spending “stimulates” the economy.
Politicians earn applause with this false thesis. Yet these advocates ignore
that the emergence of a debt crisis is in itself the evidence that the
so-called fiscal multiplier of
public expenditure has not worked as promised. The materialization of a debt
crisis means that the wonder drug has failed.
When a debt
crisis emerges, governments try to ignore the truth as much as they can. The
population anyway does not want to hear that the spending spree should be over.
Political candidates gain their job in government as salesmen of apparently
free goodies. Consequently, the politicians are inept to elucidate the
necessity of less public spending. It runs against the nature of those who live
by the government that less and not more governmental activity is the solution.
Even when the
public debt crisis has grown into a national emergency, the usual firework of a
rhetoric of illusions will not stop. It is much more likely that the tradition
of negligence that has brought about the debt crisis will also dominate politics
when the debt crisis has arrived. A country can call itself lucky when
austerity gets a chance.
A debt crisis
shows that now, instead of promoting the state, one must liberate the private
sector. When the expansion of private production compensates the contraction in
the public sector, the country’s debt burden will fall. Not more public
spending finances the debt, as the deficit spenders claim, but to curtail
public spending and to make room for the expansion of the private sector will
save the economy.
Those who favor
more government expenditures in the face of a public debt crisis suggest that
the very same strategy that has led to the calamity would also be its solution.
Yet how could the debt crisis justify borrowing more when borrowing has been the
cause of the debt crisis? The fact of the debt crisis shows that too much debt
has been accumulated. In order to overcome the crisis, not less but more
savings are needed.
Austerity Without Remorse
The recovery
after World War II in the United States and in Western Europe provides an
impressive confirmation of the thesis that spending cuts will stimulate
economic activity when they are made in combination with improvements of the
investment climate.
The reduction of
public spending at that time, when the American war machine had to be reduced,
happened in an atmosphere which had become favorable again for private
business. While regime uncertainty and
the economic policy of President Roosevelt kept
the private economy down in favor of the public sector and of
government employment during the Great Depression and in the war years, a new
period dawned for free enterprise in the United States and the other countries,
such as West Germany and Japan, that joined in.
In the United
States, the reduction of the debt burden after World War II occurred in
combination with the promotion of free market economics. Consequently, the
public debt burden was brought down in an environment of high growth rates
(Figure 1).
Figure 1
United States.
Public debt per gross domestic product and annual economic growth rate,
1935–2017
Annual economic growth rate (left hand side), full
line — Public debt in percent of gross domestic product (right hand side),
dotted line
Source: tradingeconomics.com
Since the
beginning of the 1980s, the debt quotient of the United States has been on the
rise again. Yet economic growth has been week. The sharp increase of relative
public debt after 2008 did not lift the economic growth rates. On the contrary,
since this period, the average economic growth rate is below the level of the
1990s and considerably lower compared to the period from 1950 to 1980.
An interesting
show case is Ireland, which has recovered swiftly from the debt crisis of 2008,
reducing sharply its debt burden, fostering free market policies and regaining
formidable growth. Ireland is the case in point where fiscal retrenchment
brought economic expansion (Figure 2).
Figure 2
Ireland. Public
debt in percent of gross domestic product and annual economic growth rates,
2008–2018
Annual economic growth rate (left hand side), full
line — Public debt in percent of gross domestic product (right hand side),
dotted line
Source: tradingeconomics.com
Quite different
has been the post-2008 policy in Italy. The government has done little to cut
the obese state in favor of free markets. Consequently, economic growth has
been extremely low and is now approaching negative territory again (Figure 3).
Figure 3
Italy. Public
debt in percent of gross domestic product and annual economic growth rate,
2008–2018
Annual economic growth rate (left hand side), full
line — Public debt in percent of gross domestic product (right hand side),
dotted line
Source: tradingeconomics.com
An instructive
example is to contrast the policies of the United Kingdom after the end
Napoleonic Wars to those that were adopted after World Wars I and II (Figure 4
Figure 4
Public Debt of
the United Kingdom, 1692–2011
In the wake of
the Napoleonic wars at the beginning of the 19th century, British public debt
had grown to over two hundred and fifty percent of its gross domestic product.
In the century that followed the war, which had ended in 1815, the United
Kingdom brought down its debt consistently and experienced its most glorious
period of economic prosperity. In contrast, the British economy experienced
prolonged periods of economic stagnation both after World War I and World War
II.
The economic
policies of these periods couldn’t be more different. While in the 19th
century, Britain practiced an economic policy molded after the ideals of
classical liberalism, the country adopted interventionist policies after World
War I and did the same after World War II until the late 1970s. While Britain
gained wealth and prosperity in the 19th century, it earned economic decline
and stagnation in the 20th century.
Likewise, the
massive expansion of public expenditure in Japan over the past
decades did not lift the economic growth rates. In sharp contrast to the period
before 1990, when public debt was low, Japan has experienced a long period of
low economic growth since then. At the same time, when public debt relative to
the gross national product has been constantly rising (Figure 5).
Figure 5
Japan. Public
debt in percent of gross domestic product and annual economic growth rate,
1980–2017
Annual economic growth rate (left hand side), full
line — Public debt in percent of gross domestic product (right hand side),
dotted line
The Next Crisis
In the USA, the
debt burden (public debt in percent of the country’s gross domestic product)
has been rising since 2008 from 82 percent to 105 percentin 2016. This
figure is bound to explode when the next recession hits or interest rates rise.
Japan has been mired in debt for more than two decades. In this period, the
nation’s debt burden has risen to over 250 percent. Japan provides a striking example
that huge public spending programs and zero-bound interest rate policies are of
no avail when the statist system is not replaced by radical free-market
reforms.
Whatever the
specific circumstances of the next financial crisis will be, it will come
together with a crisis of the public debt. In fact, many countries of the world,
not only Greece a few years ago or currently Brazil, are in a debt crisis. The
United States, Japan, many European countries, — a
crisis of public debt looms in almost each of the advanced economies. The
crisis has not yet become acute in these countries because the central banks
have been buying public debt at an unprecedented pace and implemented extremely
low interest rates. Now, these policies are reaching their limit. The next
recession will also be the next big debt crisis.
When times are
normal and when there is business as usual, investor can regard government
bonds as good as currency. Holding bonds is a profitable alternative to savings
in currency. Instead of lending one’s money to commercial banks in a savings
account, the saver lends his funds to the government. When the bond market is
liquid, and the market for bonds is usually one of the most liquid financial
market, bonds are a full substitute to currency with the additional advantage
of earning interest.
As long as the
interest on the bonds compensates the loss due to price inflation, the investor
can feel save. Yet what happens when price inflation exceeds expectations? In
this case, the calculation that was made when deciding to buy bonds, does no
longer hold. The more the newly formed expected inflation rate surpasses the
earlier level, the less favorable will it be to keep on holding bonds. Bond
investors begin to sell, and new investors will only buy bonds at a higher
interest rate. The equivalence of bonds to currency breaks down. Then it turns
out that the assurance of the Modern Monetary Theory that
the government can spend without regard to its receipt, that “deficits don’t matter”,
becomes a false promise.
Once, inflationary
expectations begin to rise and the projections find their confirmation, the
government becomes an ordinary debtor and as such is only as creditworthy as it
can make believe being able to honor its debt. The privilege of the state as
the issuer of the currency as the nation’s sovereign money comes to an end.
This phenomenon is popularly called “loss of confidence”. In economic terms
this means that investor do no longer regard government bonds as good as
currency.
Conclusion
When will
governments recognize that there is no alternative to austerity for a country
which has reached its debt limit? When will governments recognize that
austerity does not need to be painful when spending cuts are made in
combination with an improvement of the economic environment of the private
sector? The choice between a cut of government expenditure or an increase of
public spending runs down to the choice between accepting a period of adversity
or to go on with the illusionary joy ride. In the end, the truth will win
anyway. Only a childish attitude would opt for more spending just to make
matters worse. However, simply reducing public expenditures is not enough. What
needs to be done is to combine spending cuts with a convincing policy of
promoting free enterprise without any reservation.
Dr. Antony P.
Mueller is a German professor of economics who currently teaches in Brazil.
Write an e-mail. See his amazon author page.
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