Austerity Is Not a Solutioon To Anything

Austerity is all the vogue among European central bankers and Republican Congressmen. The Republicans, and especially their tea party wing, have bought into the idea that the only way to cure the present recession/depression is to adopt the Paul Ryan austerity budget: cut spending, reduce entitlements, and work toward a balanced budget. This is perverse. Our economy has no problem that austerity will not make worse.

Austerity does not lead to growth, quite the opposite. The International Monetary Fund did a study which shows that an austerity policy that cuts the deficit by 1% of GDP reduces incomes by about 0.6% and increases unemployment by 0.5%. The US government had a deficit of $1.3 trillion in 2011. To cut that deficit by $150 billion (1% of the $15 trillion GDP), would cost $800 billion of real income and would increase unemployment by about 700,000 workers. Last year, the austerity program cost Greece 11% of GDP and Spain 3.1% of GDP.

Repeat, no theory says austerity is associated with growth. John Maynard Keynes, in his masterpiece The General Theory of Employment, Interest, and Money, finishes Chapter 3, The Principle of Effective Demand with his explanation of why some economists still hold to this perverse position: "The celebrated optimism of traditional economic theory… teach[es] that all is for the best in the best of all possible worlds provided that we will let well [enough] alone … It may well be that the classical theory represents the way in which we should like our Economy to behave. But to assume that it actually does so is to assume our difficulties away."

Through the last half of the 20th century, economists read their Keynes and agreed that in a less than full employment economy, the government should not let well enough alone. It could and should inject purchasing power into the economy through government spending. Cut taxes, increase spending, inject money and the economy will grow.

It is not hard to understand why. The average American with no economic training can look at unemployment and ask the obvious: why don't we put those people to work producing goods and services that people need? More specifically, with a GDP of $15 trillion, 5% additional recession-driven unemployment costs the economy $750 billion per year in lost output.

The use of a fiscal stimulus to put otherwise idle resources to work seems to be clearly common sense. Nevertheless, classical economics assumed that the economy was always at full employment, that laissez-faire was always appropriate.

Economic austerity, on the other hand, is a contractionary policy. It even has a multiplier making the effect greater than the initial amounts involved. State tax revenues are reduced forcing further cuts in services. Diminishing federal grants to states leads to the layoffs of first responders and teachers. Austerity cripples an economy. It is associated with decline, not growth. In a strangely honest moment, even Romney admitted that "as you cut spending you’ll slow down the economy.” His staff quickly tried to "walk him back" from that but it was too late. It was on the record. The Republicans in Congress remain the real austerity hawks.

Austerity is being imposed on southern Europe by the Germans and is being supported by the international banks, including the European Central Bank. It is a disaster. Most observers now recognize that austerity is pushing these countries deeper and deeper into recession. In Spain the unemployment rate is 25% and among those under 25 years of age it is 50%. We do not want to go there.

Europe has a problem but it is not overspending and austerity is not the solution. The deficits in Ireland, Spain, Portugal and to some extent Italy arose as a result of the financial crisis and the subsequent depression. The normal cure for this is for a country to print money, lower the value of its currency and thereby increase exports, decrease imports and stimulate growth. This is a tried-and-true solution but an option that is not available as these countries do not have their own currency. When they joined the euro, they gave up the right to you manage their economies using fiscal policy and they set up no coordinating mechanism.

Iceland and Britain, though they were in worse financial shape than Spain and Portugal, do not have a problem because they still have their own currency. The solution is simple but extremely difficult for the Europeans. They have to surrender their fiscal policy to a centralized authority. No one seems to have any hope that the Europeans are ready for a United States of Europe.

Similarly, the United States deficit and debt are not a problem because we have our own currency. We can and do print what we and the world need in the way of dollars. There is absolutely no chance of the United States ending up "like Greece."

In fact, President Obama would be most pleased if Mitt Romney and Paul Ryan continue to push their austerity budget.