Opinion     

Austerity or stimulus? What we really need is growth

Shanghai Daily, March 29, 2012

• Austerity isn't working in Europe. Greece is collapsing, Italy and Spain's output is declining, and even Germany and the UK are slowing down. In addition to their direct economic costs, these "austerity" measures aren't even swiftly closing budget gaps. As incomes decline, tax revenue drops, and it becomes harder to cut spending. A downward spiral looms.

  Europe's experience is a warning that austerity - a program of sharp budget cuts and (even) higher tax rates, but largely putting off "structural reforms" for a sunnier day - is a dangerous path.

  Why is austerity causing such economic difficulty? What else should we do?

  Lack of "stimulus" is the problem, say the Keynesians, epitomized by the New York Times and its columnist Paul Krugman, who has been crusading on this point. They claim that falling output in Europe is a direct consequence of declining government spending. Yes, 50 percent of GDP spent by the government is simply not enough to keep their economies going. They - and the US - just need to spend more. A lot more.

  Where will the money come from? Greece, Spain and Italy simply cannot borrow any more. So, say the Keynesians, Germany should pay. But even Germany has limits. The US can still borrow at remarkably low rates. But remember that Greece was able to borrow at low rates right up to the moment that it couldn't borrow at all. There is nobody to bail out the US when our time comes. What should we do then?

  Monetary stimulus

  The traditional Keynesian answer was: Move on to monetary stimulus. Deliberately inflate and devalue. Break up the euro so the southern European countries can inflate and devalue even more.

  Lately, Keynesians have been pushing an even more audacious idea: Deficits pay for themselves. In a March 17 column, Krugman wrote: "there's a plausible case that spending more now actually improves the long-run fiscal picture."

  US federal revenue is less than 20 percent of GDP. For deficit spending to pay for itself, then, US$1 of spending must create more than US$5 of output. Economists have been arguing about whether this "multiplier" is more or less than one; five is beyond any reported estimate. Keynesians made fun of "supply siders" in the 1980s, who made similar claims for tax cuts. At least those cuts had incentives on their side, which stimulus doesn't.

  Is there another explanation, and a more plausible way forward?

  The stimulus explanation is curious for what it omits. Think of Greece.

  Is it irrelevant that Greece is 100th on the World Bank's "ease of doing business" list; 135th on "starting a business" and 155th on "protecting investors?" Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can't fire people? Does it not matter at all that, as the International Monetary Fund delicately put it in its latest report on Greece, the "structural reform program" aimed at "deeply ingrained structural rigidities in labor, product, and service markets" got nowhere?

  Greek taxes

  Doesn't it matter that Greece has a high combination of individual, corporate, wealth and social taxes? True, Greeks famously don't pay taxes, but businesses that must operate illegally to avoid taxes are much less efficient.

  Money is fleeing Greece, Italy and Spain. Does talk of exiting the euro, followed quickly by devaluation, inflation and capital controls, have nothing to do with lack of investment?

  Keynesians urge devaluation to gain competitiveness. Greek wages have in fact declined about 10 percent to 12 percent, according to the IMF. Yet investment and production aren't turning around. Greek "demand" needn't matter - the whole point of the euro area is that Greece can sell to Germany, so long as Greece stays in the euro area. But it isn't happening. Is that a mystery? Would lower wages compel you to invest money in Greece; surmount a thicket of regulation; and expose yourself to the threats of wealth, property and business taxation, currency expropriation and capital controls, or even nationalization?

  In sum, isn't it plausible that a good part of Europe's austerity doldrums are linked to "supply," not "demand;" "microeconomics," not "macroeconomics;" weeds in the economic garden, not a want of fertilizer? Isn't it plausible that factors beyond simple declines in government spending matter in a debt crisis?

  That insight suggests a different strategy: Let's call it "Growth Now." Forget about "stimulating." Spend only on what is really needed. We could easily stop subsidies for agriculture, electric cars or building roads and bridges to nowhere right now, without fearing a recession.

  Rather than raise taxes further on the "rich," driving them underground, abroad, or away from business formation, fix the tax code, as every commission has recommended. Lower marginal rates but eliminate the maze of deductions. In Europe, eliminate the fears of wealth confiscation, euro breakup and currency devaluation that are driving savings and investment out of the south. Most of all, remove the profusion of regulation and (increasingly) direct government management of the economy.

  John H. Cochrane is a contributor to the Business Class column at Bloomberg News. Shanghai Daily condensed the article.

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