Austere: adj; markedly simple or unadorned
The G-8 met this weekend at Camp David to address the failure of austerity in promoting economic growth, specifically in Europe where it has allegedly been practiced. Of course, austerity, as modernly defined by a certain segment of the economics profession, has nothing at all to do with the definition from Merriam-Webster cited above. Austerity is reckoned by those who oppose it to be an attempt to balance government budgets primarily through cruel spending cuts. Those who make this claim will find it hard to back up with facts in any European country outside Greece which had little choice in the matter given that no one will lend them the Euros to keep up their previous pace of spending. The reality is that efforts to balance budgets in Europe have depended much more on tax increases than spending cuts. The European experience proves nothing except that tax increases reduce growth.
Armed with this evidence and the election results in France, the economic luminaries of the G-8 decided that the answer to this conundrum of higher taxes producing less growth was to increase government spending. Oh, excuse me, “investments in education and in modern infrastructure, as appropriate” to be “financed using a range of mechanisms, including leveraging the private sector.” (Now I don’t know exactly what they mean by “leveraging the private sector” but I think it is safe to assume that no one at the meeting will ever be confused with Archimedes. Besides, I thought “leveraging the private sector” was the job of the central banks and a damn fine job they’ve done of it by the way.) Nowhere in the 500 word statement released at the end of the meeting is a mention of taxes. Well, not directly anyway. The statement does say that the members “commit to fiscal responsibility” and if their immediate response is more spending rest assured that the delayed response will be higher taxes to pay for it. In other words, the same austerity policies that have produced the current European malaise. One is reminded of Einstein’s definition of insanity.
The success of borrowing and spending even without the attendant tax increases doesn’t have a particularly appealing track record. Japan has run up the largest national debt as a % of GDP in the developed world pursuing this strategy repeatedly over the last 30 years. China’s recent and ongoing economic slowdown proves that while increased government spending – and massive increases in the money supply – can produce short term gains, it isn’t a long term growth strategy. France already spends over 50% of GDP through government and it seems fanciful to believe that more will solve their problems of high taxes and smothering regulations. In the US, our recent experience with stimulus spending and massive deficits hasn’t produced an enviable record with proponents left only with the argument that things would have been worse without it. Of course, that is impossible to prove and leaves a lot to be desired as a campaign slogan.
There are countries that have produced better recent economic results and maybe, just maybe, we should look to them for a model that actually works rather than doubling down on a strategy with a track record unmarred by success. Sweden, for instance, has a balanced budget, the highest growth rate in Europe last year and did not engage in stimulus spending. Instead, they introduced permanent tax cuts in 2007 for lower paid workers – along with a cut in welfare spending to pay for it. These types of reforms have been ongoing for two decades in Sweden after their own financial crisis in the early 90s. They didn’t do it all at once but spending is now under 45% of GDP for the first time in decades. Economic growth it would seem does not spring from more spending but less. And it should be noted that Sweden still spends more on government than the US but manages to produce higher growth. It isn’t just about how much is spent but how well.
Another example, although not a perfect one, is Chile whose economy is growing at nearly 6% despite a budget near balance. Chile’s approach to government budgeting takes account of the inevitable ups and downs of an economy still quite dependent on commodities. Chile ran surpluses as high as 8% of GDP in the years leading up to the crisis and the savings allowed them to run a deficit of 4.5% in 2010. Chile has also cut a variety of taxes over the last few years and did a better job of targeting their infrastructure spending.
There are many other examples around the world and the fact is that the countries with the lowest deficits are outperforming those with large ones. Of course, just because that is true doesn’t mean that the lower deficits are what produced the better growth. It could be that other factors caused the growth which allowed these countries to run smaller deficits, but if that is true the evidence is elusive. It is true though that a plethora of research shows that countries with higher debt levels grow slower than those with lighter debt loads. So even if government spending is effective at mitigating recession it would seem to have a greater chance of success when the spending isn’t accomplished with borrowed funds – as Chile seems to indicate. Unfortunately, because of past excesses, that isn’t an option available to Europe or the US. We need to find a better way.
All the economic research I’ve seen – over 20 different papers – shows that when “austerity” works, it is generally accomplished with more dedicated to spending cuts and less to tax increases. In fact, based on Sweden’s example, it seems the best approach may be to cut taxes and spending at the same time. The US had similar success with that approach in the early 1920s when Warren Harding cut both spending and taxes during the short depression of 1920-21. Just as an aside, this episode would also seem to refute Ben Bernanke’s fear of deflation as prices fell at double digit rates during that episode. Unlike the Great Depression, the deflation and the recession did not continue with employment and production recovering by early 1923. So, if we are looking for an economic strategy with demonstrated success, it would seem that tax and spending cuts are both in order.
Back to that definition of austere above which I believe is quite pertinent to our current economic condition. By that definition economic policy in Europe and the US is far from austere. There is nothing simple or unadorned about fiscal, regulatory or monetary policy and the complexity serves no one’s purpose except the politicians and lobbyists who make it so. The US tax code is over 70,000 pages long. It is within that considerable tome that our economy, and our society as well, has gone off the rails. The Dodd-Frank financial reform bill was over 2300 pages and that doesn’t include the writing of the actual rules which, not even half done, already adds up to 5300 pages. And even if fully implemented would have done nothing to prevent the recent JP Morgan derivatives debacle. Health care reform was nearly 2000 pages and there is no way to know the unintended – or intended – consequences of putting the entire thing in place even if it is Constitutional. Complex legislation – and the tax code and regulations it creates – is where corruption and crony capitalism hides from the light of day.
We do need government austerity, but it should not be confined to just taxes and spending. I do believe – and there is plenty of economic research to support it – that tax changes have a greater impact on the economy than spending changes. Raising taxes to close the budget gap will not work. Cutting spending alone would work eventually but the economic pain in the interim could be severe. One thing the G-8 got right is that we need stimulus and austerity. While cutting spending should be a priority, it must be coupled with stimulus in the form of lower tax rates and a simpler tax code. Reducing the complexity of the regulatory system would also provide a boost in the form of lower compliance costs and increased confidence in the efficacy of the rules. Paul Krugman says the confidence fairy doesn’t exist but how can the very real fear of another 2008 style meltdown not affect economic behavior? Simple rules that raise the quality and quantity of bank capital could do more in 5 pages than Dodd-Frank will ever accomplish in 5000.
Austerity is the only option in the current environment if confidence and growth are to be restored to their previous trends. It should be extended, based on the above definition, to all areas of government. Markedly simple and unadorned. Words for governments to live by.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773.
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