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By HaleStewart May 13, 2014 11:41 am
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Why Austerity Does Not Work

         Over the last few posts, I’ve noted that in practical application the policy of austerity has been an abject failure.  Every country that has implemented these policies -- which involve large cuts in government spending during a slumping economy in the hopes they would lead to a decrease in government debt – have in fact had the exact opposite effect.  For most market watchers with a textbook knowledge of basic macroeconomics, this outcome was easily predictable.  But given the widespread belief that austerity would in fact work, it appears that a refresher course is necessary.

         First – why is it that austerity gained any traction at all in the intellectual debate?  The answer lies in the rise of the Reinhart and Rogoff paper “Growth in A Time of Debt” which was published in 2010.  This paper asserted that, “First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for public debt is similar in advanced and emerging economies.”  This paper became the intellectual backbone of the pro-austerity movement.  The conclusions reached in the paper were rightfully questioned by some economists from the time of their publishing.  However, it wasn’t until the discovery of a coding error which effectively rendered the conclusions moot that the concept was questioned within the public sphere.  
 

          Regrettably, simple macro level 101 econ concepts easily debunked the basic idea underlying this theory.  The place to start the analysis is the GDP equation: (consumption) C + (investment) I + (net exports) X + (government spending) G = GDP.  Each of these variables is influenced by certain factors.  For example, consumption is impacted by income, tax rates and confidence, while investment has an inverse relationship with interest rates tempered by expectations.  Exports rise and fall with the fortunes of trading partners.  However, all three of these variables were negatively impacted by the recession, leading to an economic contraction.  More importantly, severe economic contractions caused by the bursting of an asset bubble can lead to prolonged slumps, which explains the length of the Great Depression.  The reason is consumers are trying to repair their balance sheets, because the value of their assets has dropped sharply while the value of their liabilities hasn’t.  This greatly prolongs the period of recovery, which explains the slow nature of the current expansion.   (For more on this concept, read the Debt Deflation Theory of the Great Depression by Irving Fisher).
 

          Just as importantly, the underlying theory which supposedly proves the validity of austerity is an economic concept called Ricardian equivalence.  Under this theory, consumers lower their consumption in periods of higher governmental expenditures under the expectation they will eventually have to pay higher taxes to eventually pay for the government’s largesse.  When the government cuts spending, consumers actually spend more because they then calculate that they will in fact have more lifetime income.  The problem with this theory is it simply does not translate into reality.  For example, the US government ran very large budget deficits in the 1980s – an economic period defined by large amounts of personal consumption.  And throughout the period of EU austerity, we’ve seen incredibly weak consumer spending despite the decrease in government spending.  In short, rational expectations theory (another name for Ricardian equivalence) does not work.  Yet it has formed the basis for austerity thinking since its inception (for more on this, see this lecture by Mark Blyth).
 

    In conclusion, reality has demonstrated that austerity is a completely failed policy.  Cutting spending during recessions simply increases the negative effects of the recession.  From a simple math perspective, austerity lowers the value of the fourth variable in the GDP equation, leading to lower growth.  From a practical application theory, expansionary austerity does not lead to increased growth; in fact it leads to a more pronounced contraction.  

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer    

 

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