Why the United States and Europe can't cut their way to economic prosperity.

Commentary about business and finance.
June 14 2010 12:06 PM

Austerity Now!

Can the United States and Europe cut their way to economic prosperity? Probably not.

Can we avoid Greece's fate by pinching pennies?
Can we avoid Greece's fate by pinching pennies?

If British voters thought they had replaced the dour visage of Labour Prime Minister Gordon Brown with an optimistic one in fresh-faced Tory David Cameron, they were sadly mistaken. On June 7, the new PM Cameron brought down the hammer, telling the British public that the most urgent issue ahead "is our massive deficit and our growing debt. How we deal with these things will affect our economy and our society, indeed our whole way of life." With a deficit set to top 11 percent of gross domestic product this year, and a debt of $1.12 trillion and rising, Cameron prescribed a harsh regimen of spending cuts and possible tax increases. Tony Blair's motto was "Cool Britannia." Cameron's is likely to be "Austerity Now!"

At first, most developed economies responded to the global financial crisis in 2008 and '09 with stimulus: They increased government spending and cut taxes. John Maynard Keynes provided the playbook: In slack times, the government needs to fill in for diminished private demand. But 2010 is shaping up to be a year of parsimony. To win support for an international bailout, Greece enacted a tough package of budget cuts and tax increases. Spain's left-wing government at the end of May slashed civil-servant pay by 5 percent and froze pensions—even though one in five Spaniards is out of work. Recently, German Chancellor Angela Merkel unveiled a $144 billion package that would raise taxes on airline flights and cut defense spending and public works—and Germany's deficit is a manageable 5 percent of GDP. "We can't have everything we want if we are to shape the future," Merkel said.

We're not hearing that kind of rhetoric in the United States yet, but the new austerity has crossed the pond. Even though unemployment remains at 9.7 percent, the House of Representatives in May scaled back a proposed jobs bill out of concern for the deficit. President Obama recently called for federal agencies to identify cuts of up to 5 percent in 2012. States and cities are slashing budgets and raising taxes. Around the world, what economist and New York Times columnist Paul Krugman has called "the pain caucus" is in the ascendancy.

Different countries are joining the caucus for different reasons. Many, especially slow-growing, highly indebted countries in southern Europe (Spain, Italy, Portugal), see austerity as a way to avoid the fate of Greece. Others are reacting to fears of stimulus-induced inflation. In fact, signs of inflation are scarce. "To say that we need policies now to fight a global outbreak of inflation is like arguing that we need policies now to guard against the imminent alarming spread of the North Polar ice cap," says University of California–Berkeley economist Brad DeLong. Yet some important economies remain hypersensitive to the merest trace of inflation. Germany is taking tough steps on deficit reduction in part because it wants to set an example for the European monetary union, but also because it remains paralyzed by the ghost of the 1920s' hyperinflation, which destroyed the Weimar Republic and paved the way for Hitler's rise.

There's also a strong political element to the newfound frugality. For incumbents, calling for wage cuts and tax increases can be poison. But for those who have just taken office, like Cameron, embracing austerity highlights the tough steps he's taking to clean up the mess left by his predecessor. In the Netherlands, on June 9, in the first national elections since the Greek crisis, the center-right VVD party, which called for 3 percent budget cuts and a balanced budget, triumphed.

In the United States, a different set of factors is driving the trend. With unemployment high and long-term interest rates near record lows, inflation under control, and Democrats poised to suffer losses in the midterm elections, further stimulus would seem to be a no-brainer. But the same internal debate that roiled the Clinton White House in 1993—when advisers Robert Rubin and Robert Reich tangled over the relative merits of deficit and reduction and stimulus—is being replayed today. In 1993 the Rubinites won the day, arguing that Democrats needed to demonstrate a commitment to deficit reduction to avoid being tarred as tax-and-spenders. Seventeen years later, the Obama administration has made a different calculation: Higher short-term deficits are a greater political risk than slower growth and higher unemployment. But the debate fails to recognize the anti-stimulus provided by states and cities, which are prohibited from running deficits. The Center on Budget and Policy Priorities calculated that 33 states made tax changes in 2008 or '09 that would increase annual revenues by $31.7 billion. Meanwhile, state and local governments slashed 22,000 jobs in May. "The actions that states are taking because of the recession and their balanced-budget requirements are slowing the economy," said Nicholas Johnson, director of the state fiscal project at CBPP.

It's difficult to contract your way to growth. The world's large economies need to run higher deficits in the short term to promote growth and close the gaps later. St. Augustine famously pleaded: "Grant me chastity and continence, but not yet." Policymakers might stop looking to Milton Friedman and John Maynard Keynes and rethink Augustine. Give us austerity and deficit reduction—but not yet.

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