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Austerity Bites - But It Isn't the Problem

The election results in Europe, we are told, are a vote against the austerity of "savage" spending cuts. Veronique de Rugy, in National Review Online, contested this claim, backing up her words with data. The Economist's Ryan Avent found her claims outrageous and presented data of his own to show that austerity was sooo there. Veronique has responded with more detail. Her case is essentially that in most countries, "austerity" has been implemented more in terms of tax rises than in spending cuts. The fact that the UK and France, both of which supposedly voted against austerity last week, have not actually implemented spending cuts, is best illustrated by this alarming chart.

It is important here to note that spending cuts are, in this debate, regularly portrayed as being harmful to GDP growth, as if shaving government expenditure results inexorably in a reduction in GDP. That is clearly not the case. The respected British economist Andrew Lilico, for instance, regularly points out that spending cuts in the Uk should lead to growth:

The key ways the government could raise the sustainable growth rate are as follows:

  • Cut government spending relative to GDP. The government is already committed to cutting spending below 40% of GDP.  If it succeeds, that could add 0.5% to annual GDP growth.
  • Raise the efficiency of government spending.  If public sector productivity grew as fast as private sector productivity, that could add 0.5% to annual GDP growth.  Matching private sector productivity growth should be a modest target, since there is considerable scope for catch-up, with public sector productivity growth having dropped one third behind over the decade to 2007. To achieve private sector levels of productivity growth, use private sector methods - surplus/profit motives; competition; private sector management methods and cultures, etc..  These things will be desperately unpopular, politically.  But they won't be as unpopular as having the banks go bust again and the economy collapsing into another massive recession.

Of course, as the graph above shows, Britain has not yet implemented these cuts, yet austerity is blamed for the current difficulties. The fact is that so much of Britain's economy now depends on its relationship with Europe, and the ongoing Eurozone crisis is affecting its economic performance. Andrew Lilico again explains why the fantasy currency called the Euro is at the heart of Europe's problems:

The problem isn't the austerity – that's inevitable and, if anything, helpful for growth (economies will be able to grow faster in the medium-term if they are dragging less of an anchor from high debt). The problems are as follows.

(a) In some cases the level of austerity won't be delivered. That is the case in Greece and Portugal. Greece has already defaulted, and is likely to do so again. Portugal will probably follow suit soon. That doesn't mean austerity would be bad if it could be done. It just can't.

(b) In some countries deficit reduction has tended, historically, to be associated with loose monetary policy – high money growth, inflation, and a depreciating currency. The key examples of this are Belgium, Ireland, Greece and Portugal (in the 1980s and 1990s Spain and Italy did not tend to have faster depreciation of their currencies when they were cutting deficits). But in the euro, these countries cannot devalue and the overall eurozone inflation outlook does not justify material monetary loosening.

(c) Some countries have significant competitiveness issues versus Germany. In particular this affects Greece, Portugal and Italy. Ireland and Spain are much closer to sustainable levels.

(d) Some countries have appalling banking sector problems, with governments likely to face unpleasant choices about whether to bankrupt themselves by bailing out their banks or surrendering sovereignty to France, Germany and the ECB by appealing for assistance recapitalising them. This is particularly so for Spain.

These are genuine problems. But they are problems created intrinsically by the euro and reflecting the banking crisis. Austerity alone is unlikely to be a sufficient answer. But it is a mistake to claim that austerity is the problem – no-austerity wouldn't be the answer, either.

To these factors I would add the structural problem of a highly regulated labor market controlled by the EU that allows deviation only in the sense of tighter regulation over the market. Indeed, regulation is a problem across Europe, one that sits hand in glove with the Euro, and prevents an appropriate supply side response to the crisis.

The Euro is an ill-suited currency for a collection of highly divergent economies and it, rather than so-called austerity and largely non-existing cuts, is what is responsible for the ongoing European crisis. Free marketeers need to make this case, or they will continue to be voted out of office. Of course, as I suggest at the American Spectator today, the results of the Greek elections might lead to the demise of the Euro in any event.