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Austerity isn’t failing, big government is

July 18, 2016
in Blog

Bill Emmott at Project Syndicate claims that austerity is failing—just look at the poor European recovery after the financial crisis and the weak Japanese economy. Austerity is not working and therefore it is time to turn fiscal and increase government spending.

This is the core of Emmott’s argument. Don’t forget, however, that he considers the Eurozone as a “world’s leading champion of austerity”. In fact, the piece closes by arguing that something similar to the Marshall Plan, but self-funded, is needed. It is not that evident, however, that it is austerity that is failing. If we look at total government expenditures in terms of GDP for the Eurozone, there is a clear fall in the year after the financial crisis. But after this fall, the expenditures (in terms of GDP) remained at a constant level.

In other words, there is no clear austerity plan after the crisis, rather there is fall in spending because of the crisis.

There are other reasons, however, why the Eurozone economy might not be recovering as expected in the presence of an austerity plan. One of these reasons is the high tax burden of the Eurozone, which remains at levels around 40% of GDP. Such a tax burden prevents a quick recovery. According to Eurostat, in France the tax burden reached a value of 47.9 in 2014. Germany reached 39.5 in the same year. In a word, the tax burden of being in the Eurozone is quite high. Another reason is that the Eurozone has labor regulations that makes hiring new employees more expensive while still having higher minimum wage laws than, for instance, the United States. No surprise that the Eurozone has higher unemployment rates and long-term unemployment than the U.S. The “austerity plan” neither includes a reduction in the tax burden nor a significant labor regulation reform.

But here, context matters.

Without evaluating the merits of Europe’s Keynesian policies, it should be noted that Keynes’s recommendations were made within the context of small governments and low debt levels. States today are too big and hold too much debt. The fact that there is low inflation (or deflation) and unemployment is not enough to endorse Keynesian policies from Keynes’s point of view. The larger the state, the larger the burden over the private sector. The Eurozone has both a large stock of debt and a high tax burden with a chronic fiscal deficit. In the late 1990s, Argentines increased their government spending and the result was an economic crisis and the largest default in recorded history. The government was already too big and the debt was already too high.

There are two final comments I want to share.

The first one is a common asymmetry that I see in the pro-stimulus position. When government spending (or money supply) increase and the economy does not recover it is argued that the government is not doing enough. But it is rarely argued that austerity fails because the government has not shrunk enough. Why not consider that austerity fails because it is too small and too slow, but when government spending increases and money supply explodes without effect on GDP, it is not enough? Looking at the timid “austerity” in Europe the possibility that it has not been enough deserves a more serious consideration.

 

The second one is that an austerity plan, like any large economic policy, needs to be carefully designed. Just as pro-stimulus advocates defend smart spending in infrastructure. An austerity plan also requires a smart application. For instance, reduce the tax burden and deregulate the market. What fails, otherwise, it is not austerity itself, but a poorly designed and applied policy.