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Wednesday, October 3, 2012

The False Choice between “Austerity” and Economic Growth

Keynesianism, with its emphasis on aggregate demand management to promote economic prosperity, has proven to be an abject failure since 2008 in the United States and elsewhere. President George W. Bush’s tax cuts in 2008 and the subsequent bailout of investment banks before President Barack Obama took office were in the Keynesian mold of promoting spending to sustain economic activity. President Obama’s various forms of stimulus expenditures were similarly motivated, and they have not produced the promised results. Ignoring the evidence, adherents of Lord Keynes’s view of how an economy works have changed their language from touting the virtues of economic stimulus to posing a false choice between austerity budgets and economic growth.

Such change of language apparently was influential in the last presidential election in France, when Nicolas Sarkozy lost to socialist Francois Hollande, who touted the virtue of growth promotion over austerity, or fiscal discipline. The same false choice was touted in the June Greek elections but without a decisive victory for the socialist growth promoters. The contrast between government budgetary discipline and economic growth promotion through increased government spending is sure to become pronounced in the U.S. election campaign. That is why the meaninglessness of the alleged alternatives needs to be exposed: Austerity budgets are the logical means of restoring economic growth; austerity and growth promotion are not alternatives. The failure of governments to promote robust economic recovery since the “Great Recession” will persist if a majority of the voting public is lured into thinking that voting against austerity is a vote for economic growth.

The key to understanding the falsehood of contrasting austerity budgets with promotion of economic growth is simple enough. First, whatever a government spends, it must first take from taxpayers and buyers of its bonds. Thus unless a government borrows from nonresidents or the country’s central bank, there is merely a one-to-one substitution in spending between the private sector and the government sector. Contrary to Keynesian mythology, therefore, increased government spending, whether financed by higher taxes or borrowing from domestic residents, does not change total spending, or so-called aggregate demand. By the same token, decreased government spending does not reduce total spending. Whatever the government does not take from the public to spend is retained to be spent by the taxpayers or the potential government bond purchasers.

Second, individuals are far better at managing their own funds or investments (out of savings) than government bureaucrats entrusted with spending tax dollars or funds collected from the sale of government bonds. Thus even though increased government spending does not change total spending when funded with tax dollars or domestically borrowed funds, it increases the share of total income or gross domestic product (GDP) entrusted to government bureaucrats and decreases the efficiency of the economy’s functioning and its growth. Austerity—that is, cutting government spending—particularly when revenue collection has decreased, is thus the rational path to reducing the inefficiency drag that most government spending has on an economy.

The Multiplier

Laid-off government workers may not find alternative employment quickly in a recession; their lot may improve, however, with the economy’s recovery. The same applies to laid-off workers in the private sector. Recovery will occur when private-sector economic activity picks up—with producers anticipating demand for goods and services and hiring workers to meet that anticipated demand.

But this is where Keynes’s adherents place the proverbial cart before the horse. By reasoning that employers must first anticipate demand before they hire workers, they think one must also accept that government’s appropriating funds to pay its workers (rather than laying them off) would promote private business activity—the Keynesian multiplier effect. But, as already pointed out, when government appropriates funds it merely displaces private-sector spending. The failure of the $787 billion stimulus from 2009, 2010’s Cash for Clunkers program, mortgage subsidies, the extension of unemployment benefits, and other doling out of funds by the Obama administration to stimulate aggregate demand and increase national income by a factor of 1.5 (according to the logic of Christina Romer and her colleagues on the Council of Economic Advisers)—all of these attest to the fundamental error of Keynesian thinking.

How To Grow an Economy

In a 1755 lecture Adam Smith explained that “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.” Smith’s “natural course of things” refers to the pursuit of economic activity in the private sector out of individuals’ self-love, or self-interest. Such pursuit, Smith also notes in The Wealth of Nations, is driven by “the desire of bettering our condition, a desire which, though generally calm and dispassionate, comes with us from the womb, and never leaves us till we go to the grave.” But thanks to the arrogance (or ignorance) of Keynes and his followers, the loudest among whom in the United States these days are Paul Krugman and Robert Reich, we now have people claiming that governments can promote economic growth directly through increased spending rather than merely creating a conducive environment for private enterprise to thrive. We’ve come so far in this version of what Smith described as “folly and presumption,” or “conceit,” that politicians talk about “growing” the economy as if they were farmers planting crops.

Were government budgetary allocations the best way to promote economic prosperity, the economies of the defunct Soviet Union and Maoist China would be the models for the world.

It is time the Keynesians recognized their failures and spared humanity the prolonged agony of economic malfunctioning—anemic growth or contractions and continued high unemployment. Budgetary austerity is not an alternative to economic growth promotion but the rational path to it.

Find a Portuguese translation of this article here.

  • James Ahiakpor is a Professor of Economics at California State University, East Bay. He received his Ph.D. in economics from the University of Toronto and he has taught at Saint Mary's University and the University of Ghana.

    He is a member of the FEE Faculty Network