Austerity

According to Wikipedia, in the economic sense austerity is “a policy of deficit-cutting, lower spending, and a reduction in the amount of benefits and public services provided.” I can barely go five minutes without coming across another piece excoriating the folly of austerity. Austerity, it is argued, inevitably results in lower growth or recession, and therefore is to be avoided at all costs. I will argue that austerity is necessary and inevitable throughout the world as the post-WW II notion of perpetual government deficits to support social benefits, and other government spending, is shown to be unsustainable.

Austerity is being imposed upon most European economies as lenders refuse to fund endlessly expanding deficits. Greeks and Spaniards are rioting against austerity. The Irish are simply refusing to pay the new taxes. In a creative riff on “Lysistrata,” Italian pharmacists are withholding Viagra, presumably so that the political class shares their misery. Governments in these countries depend on borrowing to fund their expenditures. but cannot print money to service the debts. Defaults have begun and continued deficit spending is dependent on loans from the EU.

Government spending results in the consumption of real goods and services, which of course are produced somewhere by somebody. Therefore government spending dollars are included in GNP. If government spending is reduced, that implies that the goods and services consumed by government are no longer needed and therefore are not produced. The critics are right to say that if government deficits are reduced, then the economy will shrink. The critics then go on to conclude that because the economy shrinks, then austerity is a failure. This is where we part ways. The question is whether this shrinkage is a necessary and desirable outcome or not.

Here’s the rub. While aggregate demand is controlled (in part) by the rate of change of aggregate debt (Steve Keen’s credit impulse), we also have to take in to account the level of debt that has accumulated. Both the private sector and the government sector have over-leveraged themselves as the result of economic and fiscal mismanagement and the associated bubbles. The government sector continues to increase its debt – leverage – to offset the private sector’s involuntary deleveraging, driven primarily by the continuing collapse in property prices, both residential and commercial. Federal government debt in the U.S., for example, now exceeds 100% of GDP. Japan’s public debt is now over 200% of GDP.

Even at low interest rates, the cost of servicing this debt rapidly becomes prohibitive. Greece’s default was prompted by its inability to service its debt of around 110% of GDP. The math is simple. For example, the US takes in about 8% of GDP in taxes. Even if the interest on the debt is a mere 3%, nearly half of tax revenue is required just to pay interest, which obviously will lead to a debt spiral as further debt is assumed to pay interest. The likelihood of governments being able to run fiscal surpluses in the future to reduce these debt levels is remote. The obvious conclusion is that austerity is necessary in order to prevent future collapse from runaway debt. This outcome, it is true, is not as immediate as the short-term pain from austerity, but it is far more serious and every day spent increasing the debt makes the eventual problem that much bigger.

If these debts were not so huge, things would be different. But we are where we are, and the fiscal adjustment is necessary. Everyone’s standard of living will be affected by the withdrawal of the crack cocaine of additional debt. But crack cocaine will eventually kill you as larger and larger doses are needed to get “high.” So will debt. In both cases, there are withdrawal symptoms. In the case of cocaine, we understand that they must be endured in order to resume a normal life. Somehow, we fail to grasp that the same is true of debt.

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