Not All Austerity Is Equal

Prominent economists, politicians, and pundits throw around the term “austerity” as if policies by that name always take the same form. They usually use the term to criticize the concept and its effects by pointing to Europe’s stagnation at the hands of “savage” cuts in government spending. But this mindset ignores the question: Austerity for whom? The answer is especially important if the United States, which has continued to follow in Western Europe’s footsteps with this month’s fiscal-cliff deal, is to learn from the Old World’s mistakes.

Raising taxes on the private sector while government continues to gorge itself on tax-and-spend policies does not bring prosperity. Businesses undergo austerity by way of the recession-induced reduction in demand for their goods and services, yet the public sector doesn’t feel the need to tighten its own belt commensurately. Increasing the public burden upon the private sector only compounds what is already a harsh business environment.  This is what most European nations have tried as their “austerity” programs, and they continue to suffer because of it.

On the other hand, the proper form of austerity closes a fiscal gap by reducing the burden of the state upon the already struggling private sector and cutting spending; this does bring prosperity.

Unfortunately, most European austerity programs fall into the first category, but they are commonly and mistakenly associated with the second.

To illustrate, let’s compare the United Kingdom’s austerity program, a frequent punching bag for the anti-austerity crowd, with that of Estonia, a lesser-known but highly successful model of austerity. Unsurprisingly, anti-austerity politicians and activists never mention the case of Estonia when they clamor for more Keynesian stimulus spending.

Source: Eurostat; Government revenue, expenditure, and main aggregates

Source: Eurostat; Government revenue, expenditure, and main aggregates

The British government’s austerity policy has entailed increasing taxes from the pre-austerity level, while continuing to increase government spending, too. Meanwhile, Estonia has tried to close its budget gap by defining austerity as cutting government largesse. U.K. politicians seem to believe that austerity applies only to the private sector, while their Estonian counterparts believe it applies to both firms and state.

After enduring one year of painful but necessary cutbacks by government and business in order to regain competitiveness, Estonia is now outperforming the U.K. on every major economic indicator. The U.K., on the other hand, has allowed austerity for the private sector to take place for nearly three years without any commensurate cuts in government. Our tea-drinking Atlantic neighbors have suffered accordingly. In December, chancellor of the exchequer George Osborne announced that austerity will now last through 2018.

Source: IMF

 Source: Eurostat; Industry Production Index

Source: IMF

Source: IMF

Austerity, it turns out, does work. But its costs have to be borne by businessman and bureaucrat alike. Governments must let recessions take their course in order to liquidate bad assets and free resources to more productive uses. They must not prolong them by squeezing out more tax revenue from already hemorrhaging firms and propping up inefficient economic activity with more public spending.

In the United States, this is a principle that Washington should heed as it deals with its own economic malaise. Unfortunately, both the fiscal-cliff deal and President Obama’s budget take a page right out of the U.K.’s failed handbook, by actually asking government to bear almost none of the burden, and placing it all on the private sector:

Source: Congressional Budget Office (August 2012, January 2013)

Source: White House

This is the wrong sort of austerity. President Obama talks much of the need for shared sacrifice between rich and poor, but refuses to allow government to share in the austerity that American businesses have faced since 2008.