The other side of the coin

Can austerity work?

European officials are backing away from tax increases and spending cuts – “austerity” – but cannot make clear to the public what they want to do, reports The New York Times.  “European Union officials insist that their economic policy has never been as dogmatic or narrowly focused on spending cuts as critics claim, and say they have long since moved beyond just austerity,” writes Andrew Higgins.  “But unable to speak plainly in any of the union’s 23 official languages, they have had trouble explaining their efforts in a manner that ordinary people can understand.”

Let’s try English.

Consider an economy with many jobless workers and closed factories.  The solution may be to spend more, raising the demand for what workers and plants produce.  If households won’t step up spending – perhaps fearing that they will need the money later – then the government can do so.  This may not cost the economy, because the workers and plants weren’t producing anything, anyway.  The government is not crowding out any production.

Now suppose that all workers and factories are producing.  Then additional spending won’t stimulate output, because the economy is already producing as much as it can.  Prices will rise, not output.  One solution is to accommodate the rise in demand by expanding the economy’s capacity, by building factories and educating workers.  This will require people to tighten their belts and to put more money in the banks, which will lend the savings to producers for construction and education.  (Firms acquire plants; workers acquire learning.)  In other words, people should save more and spend less. 

If the government now spends more, then it will crowd out some of this investment.  By borrowing more from banks, the government strips them of savings that otherwise would have been loaned to the producers.  Unless the government’s projects are more valuable than the private ones, economic growth will slow down, because the economy is adding capacity slowly.

A hole in the ace

The first problem – a lack of demand – affects the short run.  The second problem – a lack of supply – affects the long run.  The government can address both problems, each at the appropriate time.

Some policymakers argue that austerity can help the economy immediately by giving the government credibility.  Before people will invest, they want to be sure that the government will keep its word.  If it spends freely, racking up debts, then people may fear that it will tax them eventually, regardless of earlier promises, in order to settle its accounts.   But lowering the debt-to-GDP ratio is not the only way that the government can demonstrate its credibility.  (GDP is gross domestic product – the size of the economy.)  If it has a history of borrowing only in recession, or when it has a worthwhile project like building needed highways, then investors may conclude that the government can pay off its loans out of the tax revenues generated by the new economic activity, not by taxing them.

Much of Europe remains in recession, which may call for a short-run solution.  Kazakhstan faces a long-run problem.  Its economy has been growing 8% per year, on average, since 2000, and the unemployment rate now is only about 5%.  The economy needs more capacity, but the government’s history of reneging on tax deals with foreign investors is not likely to attract them.  Oil deposits will, but that’s the only ace that the government happens to be holding.--Leon Taylor, tayloralmaty@gmail.com

         

References

Andrew Higgins.  Europe facing more pressure to reconsider cuts as a cure.  The New York Times.  April 26, 2013.