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Thursday, May 23, 2013

The Not-So-Great Austerity Debate

The debate over the impact of “austerity” policies on economic well-being is raging once again, fueled in part by the discovery of errors in a much-cited study by Harvard economists Carmen Reinhart and Ken Rogoff of how national indebtedness impacts economic growth. As in previous rounds, however, basic economics has taken a back seat to high-powered statistical examinations of national income accounts. In the process, a crucial insight regarding the relationship between production and well-being has been overlooked. In short, GDP growth alone does not prosperity make.

Gross domestic product (GDP) functions in most analyses as the main indicator of economic well-being. So if it goes up, we’re all doing better, and if it doesn’t, we’re worse off. GDP is defined as the sum of private (consumption, investment, and net exports) and public (government) spending in an economy, typically during a year. It has become accepted practice to associate higher GDP with higher well-being for individuals, and it’s easy to see why: Before money is spent on something, that “something” must first have been produced. Thus, increased GDP means increased production. Given that people prefer more goods and services to fewer, increased production means people are better off. When pundits debate how austerity affects economic outcomes, they are usually talking about the impact of austerity policies on GDP.

Let’s ignore that not all austerity is created equal (both tax increases and spending cuts may count as austerity policies, but that is a different discussion) and tackle the general issue of whether austerity is good or bad for GDP. 

It turns out that the answer to this question may be completely beside the point. To see why, we need to examine further the conditions under which higher GDP increases well-being. Basic economics teaches that value—the ability of a good or service to satisfy a want—is subjective; people can and do value goods differently. Given subjective value, there is a powerful mechanism available for increasing self-perceived well-being: trade. 

Even when the stock of goods and services is fixed, trade improves well-being. If I have an apple, you have an orange, and we each want what the other has, we can both improve our well-being by exchanging goods. Nothing new has been produced, but in a very real sense, both of us are wealthier. The key assumption that makes this statement true is that the trade is voluntary. If neither party is coerced into the exchange, then each decides to engage in the trade because they expect to be better off afterward.

Trade creates GDP. I make my living as a graduate student lecturer, and I use my income to buy essentials and splurge on the occasional movie ticket. Spending on these activities eventually makes its way into the GDP numbers. Nobody forces me to buy these things and no one forces others to sell to me. Here again we see GDP creation coinciding with mutual increases in well-being. However, there is one organization in society that is able to engage in trades that are not voluntary: the government. 

Government can only acquire the resources to do what it does by taxing its citizens or printing money. Either way, the exchanges entered into by government involve an unwilling party. With taxation, this reality is obvious: “Give us $X or go to jail.” With printing money, it’s slightly more complicated, but the end result is the same: As the newly printed money makes its way throughout the economy, it puts upward pressure on all prices. This process causes inflation and represents the transferring of purchasing power from holders of a government’s currency to the government. Even when government engages in seemingly voluntary trades, as when it contracts the production of a good or service out to the private sector, somewhere there is an unwilling party to the exchange because government can only acquire revenue to pay for this transaction in the above ways. 

This point has an important implication for interpreting GDP: Production and trade in the private sector almost always results in increased well-being; production and trade in the public sector usually doesn’t. We know this because we know that we’d rather spend our own money than have others spend it for us. In fact, we need to be much more skeptical that a dollar of GDP generated by the public sector represents a true creation of wealth in the way a dollar of GDP generated by the private sector does. This insight follows from the nature of voluntary versus involuntary transactions and must be implicit, if not stated, in every discussion about how austerity impacts GDP. Countering drops in GDP with government spending, even if it does boost GDP, is not a good idea if those resources aren’t being used in a way that creates value.