An ironic twist in fiscal policy

In an ironic twist in world politics, European leaders are calling for fiscal austerity while U.S. officials are preaching about more borrowing and spending.

In the wake of the Greek debt crisis, major European governments are recognizing the value of reining in the massive deficit spending that has not “stimulated” the world economy. By taking strong measures to contain their debts, governments will reassure investors and avoid spikes in interest rates on government bonds. Moreover, government spending cuts return resources back to the private sector, which needs them more than ever during a recession.

The European Central Bank has also embraced fiscal austerity. In its monthly June bulletin, the ECB went beyond mere theoretical arguments. It listed several historical cases of successful fiscal austerity programs.

The ECB documented several episodes when a government implemented aggressive policies to reduce its budget deficit, and the result was a stronger economy. Specifically, they reviewed the experiences of Belgium, Ireland, Spain, the Netherlands, and Finland in successfully reducing their budget deficits. Three of the countries—Ireland, the Netherlands, and Finland—saw immediate improvements in economic growth, but all benefited from tightening government finances.

Consider the case of Finland. From 1993-1997, its government budget deficit averaged -5.2 percent of GDP. But starting in 1998, the string of deficits turned into a string of surpluses, which averaged +3.8 percent of GDP from 1998-2002.

Finland embarked on this austerity program in the midst of high unemployment, which was 12.7 percent in 1997 (the last year of a budget deficit). In the first year of surplus, the unemployment rate had fallen to 11.4 percent, and it continued to fall in the subsequent years. It’s true, Finland’s unemployment had been falling steadily since its peak, at 16.6 percent, in 1994, but the crucial point is that the austerity program didn’t reverse the trend.

Turning from the labor market to total economic output, we find that in 1997, GDP growth was 2.0 percent, while in 1998 — the first year of a budget surplus — GDP growth rose to 3.4 percent. Also, average GDP growth was slightly higher in the first three years of budget surpluses, than in the preceding three years of budget deficits.

Now a Keynesian cynic might argue that Finland’s economy, for whatever reason, naturally recovered in 1998, and that this lightened the load on government social programs while bringing in more revenues. So perhaps the switch from massive budget deficits to sizable surpluses was a consequence, not a cause, of the improving economy.

It’s true that we can’t run a controlled experiment in macroeconomics. But in 1998, when the Finnish government went from a string of deficits to a string of surpluses, government expenditures fell sharply as a share of GDP — from 56.5 percent down to 52.9 percent in a single year. Yet the fall wasn’t merely relative: the Finnish government actually cut the absolute size of its budget by some 50 million euros. This cut was not large — less than 1 percent of the budget — but still impressive at a time when the unemployment rate had averaged almost 13 percent the prior year.

There is sound economic theory to justify a program of fiscal austerity. Whether the money is borrowed or taxed, government spending transfers resources away from private-sector entrepreneurs and into the hands of public-sector politicians. That’s why cutting the deficit through a tax hike is a cure worse than the disease. The empirical literature cited by the ECB supports this conclusion.

Despite the good sense of the Europeans, one of the most famous living economists — Nobel laureate Paul Krugman — has been heaping scorn on their push for austerity.

Krugman doesn’t deny that several countries have experienced economic turnarounds after their governments sharply cut spending. But Krugman’s arguments underscore the vacuity of the Keynesian position. He says that the previous examples aren’t relevant today because those success stories involved a country either slashing interest rates or expanding its exports. He says that short-term interest rates are already at rock-bottom levels and the world can’t increase its (net) exports, so he argues that the ECB’s case studies offer no guidance to today’s policymakers.

But what evidence do Krugman and the Keynesians have for their own policy recommendations? The two classic examples of massive deficit spending occurred during the 1930s and in our recent crisis — and these just so happen to be the two worst periods in modern economic history. In other words, the Keynesians’ “solutions” of bigger deficits went hand-in-hand with awful economic results.

Of course, Krugman and other Keynesians have a ready answer: things would have been even worse had FDR not run up the debt as high as he did, or had Obama not signed his “stimulus” into law. Yet, note the pattern: free-market economists can point to actual success stories, which the Keynesians must argue away. And then they have to explain years of stagnation after their policies are implemented.

Keynesian economics is based on the absurd premise that the way to fix a depressed economy is to let politicians borrow and spend unprecedented amounts of money. Not surprisingly, there are no clear-cut examples of this theory working in practice. Meanwhile, as the European Central Bank acknowledges, there are many examples of economic boosts coming from cuts in government spending.

President Obama and other policymakers should take the ECB’s analysis to heart. Economists from across the political spectrum acknowledge that the U.S. government needs to address its long-term debt problem. Yet both theory and history show that a well-designed austerity program can deliver immediate economic benefits as well.

Robert Murphy is a senior fellow in Business and Economic Studies at the Pacific Research Institute.