Three decades ago, U.K. Prime Minister Margaret Thatcher was confronted with a nation bordering on irrelevance, a stagnant economy and a set of entrenched beliefs about the relationship between government and the people.
Thatcher faced down striking coal miners and forced through a series of free-market reforms that unshackled Britain’s economy and made it vibrant once again. To the chorus of accusations that she was killing the economy, she replied: “There is no alternative.”
She was right. Short-term pain ― in that case, a recession and a sharp spike in unemployment ― for long-term gain is generally a winning strategy.
We could use a dose of Lady Thatcher today. Instead, German Chancellor Angela Merkel has been cast in the Iron Lady role, charged with fending off policy prescriptions that run counter to her preferred fiscal discipline for the euro zone. In the last week alone, Harvard’s Lawrence Summers, Princeton’s Paul Krugman, Columbia’s Joseph Stiglitz and Berkeley’s Christina Romer wrote op-eds claiming that austerity isn’t working. Instead, the focus should be on growth.
That’s a false dichotomy. Who wouldn’t choose growth over austerity?
Europe’s real choice isn’t unlike the one faced by the U.S., according to Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. The choice is cyclical versus structural.
“It’s all about recession,” Glassman says. “The thinking is, when the economy comes back, everything will be fine. There’s a resistance to looking at fundamental structural problems,” which in Europe include an aging population, overly generous pensions, a rigid labor market and a large, unsustainable social safety net. “The more you push back on austerity, the less focus there is on structural problems,” he says.
And that’s only part of the problem. Economists can’t agree whether government spending creates growth, creates the illusion of growth (government spending is a component of gross domestic product) or hampers growth because the private sector, anticipating a higher tax bill in the future, reacts adversely.
China’s fiscal stimulus following the 2008 financial crisis was touted as successful, though who can really tell with China? Japan, on the other hand, has little to show for decades of public spending except oodles of debt: a debt-to-GDP ratio in excess of 230 percent, the highest among industrialized nations. Japan is fortunate that its biggest creditor is the Japanese public.
“It’s not at all clear that government spending is expansionary,” says Robert Barro, a professor of economics at Harvard University. “Moving toward fiscal discipline will have a positive short-run effect.”
Krugman pooh-poohs the idea that the private sector will step up to the plate if government puts its house in order. He derisively compares this notion to a belief in the “confidence fairy.”
What should we call his premise that government spending is the route to salvation? A confidence game? Why would taking money from one individual via borrowing or taxation and giving it to another have anything more than a transitory effect on the economy? Even the government calls such finagling “transfer payments.”
Answer: Because economists believe that a dollar of government spending creates more than a dollar of GDP growth. It does because they say it does.
There are other econometric models, such as Barro’s, that find a multiplier of less than one. French political economist Frederic Bastiat explained how that could be 162 years ago in his parable about the broken window. We can see the dollar spent by the government; what’s unseen is how the money would have been spent had the government not commandeered those resources.
And if this isn’t enough to make you question the anti- austerity advice, consider that countries such as Spain, whose credit rating was just downgraded two levels to ‘BBB+’ by Standard & Poor’s, might not be able to borrow the amounts necessary to crank up growth (assuming you’re in Krugman’s camp). Last month, the yield on Spain’s 10-year bonds surpassed 6 percent for the first time this year.
Even if Spain could borrow enough at increasingly higher interest rates, what happens if growth fails to materialize? Another year older and deeper in debt.
If the eurozone is determined to spend money, its first target should be the banking system. Europe’s banks are undercapitalized and need to raise their capital-adequacy ratios to 9 percent by the end of June, according to Carl Weinberg, chief economist at High Frequency Economics in Valhalla, New York.
“Save the banks, save the economy: Funding TARP was less bad than letting the U.S. banking system fail,” Weinberg says, referring to the U.S.’s Troubled Asset Relief Program.
These are the same European banks that, courtesy of cheap three-year loans from the European Central Bank, have been the biggest buyers of sovereign debt, preventing yields from rising even further.
Europeans, excluding Germans, have started to bridle at austerity, which is a surprise since most austerity measures are only on paper. Last month, Socialist Francois Hollande edged out President Nicolas Sarkozy in the first round of France’s general election. One day later, the Dutch government, aligned with Germany on the issue of austerity, collapsed over budgetary cuts.
With eurozone unemployment tying a record high of 10.9 percent in March, the voices urging budget discipline will probably be drowned out by those who want to spend more now and ignore the long-term, growth-retardant effect of accumulated government debt.
Will Merkel capitulate? My bet is she stays in character and responds with something that would make Lady Thatcher proud: “This Frau’s not for turning.”
By Caroline Baum
Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own. ― Ed.