Austerity is a bad word these days. Economists and politicians blame the austerity cocktail imposed on Europe’s periphery for the continent’s woes; the insistence on cutting government spending, they say, illustrates the wrong-headedness of the Washington Consensus and of Berlin who focus on deficits and debt when they should be focusing on economic growth. But austerity is not all bad - and the press for structural reform is precisely what Europe needs.
The case against austerity rests on a Keynesian argument. Effective demand is low during a recession, and the economy may equilibrate at an employment level below its full potential. Keynes argued that the process through which an economy bounces back – chiefly, wages falling to induce more workers to work – does not work very smoothly. An economy can get stuck as a result. A government can create demand through deficit spending; by putting money into people’s pockets, it can accelerate the recovery and help make smoother the business cycle.
The problem is that the Keynesian recipe of deficit spending is diagnostically neutral. It starts from an observation (low demand) but it does not investigate its root causes. Take an extreme example: assume that a country imposes a 50% tax on all goods and services. Consumption will plummet. A Keynesian might recommend that the state step in and buttress demand with deficit spending. Such spending will no doubt support the economy – the recession will be milder, and the economy may even grow. But in this (simplistic) scenario, the solution of more government spending is absurdly inefficient. Why not simply eliminate the tax? Keynesianism in a flawed economy is like heating a room with an open window: the heat will warm you but close the window first!
Whether an economy should apply a stimulus does not depend on whether such spending will create short-term demand and help the economy – it will. Instead, it depends on whether such recipe addresses the economy’s weaknesses. You cannot resolve microeconomic ailments through macroeconomics: Keynesians retort that growth is what matters – growth cures debt, for example, since countries tend grow out of their debt problems. So long as you can produce growth, you can cure many ills.
This is where the Keynesian argument loses steam. There is, of course, a question of whether government stimulus in fact generates long-term growth – although I have no intention to get into that debate. Instead, my view is that a recession is exactly the right time to make structural economic changes, especially when a country needs to reduce the footprint of the state and to revitalize the private sector through competition. Countries that managed to shrink the state did so after prolonged recessions or slumps: the United States, the United Kingdom, Ireland, Sweden, Finland, the Netherlands, Belgium and many others. Growth rarely favors reforms, especially in the form of a reduced state sector.
Keynesianism presumes that there are two courses: an austerity-driven recession or a deficit-driven expansion. But that’s a false dichotomy. Austerity can produce growth – in Greece’s case, the problem is that state spending is not falling quickly enough and, as a result, the state keeps raising taxes which, in turn, reduce consumption. It is not that austerity is causing the recession; rather, the issue is that austerity is not happening rapidly enough. More generally policymakers can either treat the symptom or the disease: for the most part, deficit spending is aimed at the symptoms. And like other policies that focus on symptoms – debt rescheduling or exit from the Eurozone – they miss the point and should be ignored.