In the wake of the Great Recession of 2007, with near default of the Greek government and the financial difficulties of Spain, Portugal, Ireland and other countries in the EU, the European Central Bank and the IMF insisted on strict austerity measures that were imposed in the exchange for financial aid. Prior to this, interest rates on government bonds of these countries had risen to double digits, and the fear was that lenders would be unwilling to continue to support the governments unless strong steps were taken to cut budgets and reduce budget deficits.

The expectations were that as a result of the austerity measures, government debt would be brought down to manageable levels. In addition, the increase in confidence that austerity measures would have was supposed to increase investment and bring down unemployment.

Unfortunately, this did not happen. None of the governments that imposed austerity measures managed to reach the objectives of reducing debt, increasing growth, or brining down unemployment. In all cases, debt as a percentage of GDP actually increased substantially, unemployment skyrocketed, economic output fell, and the entire EU was thrown into a deflationary spiral.

In Spain and Greece, one out of three people are unemployed, and two out of three people under 25 years old are without work. The average unemployment in the EU stands at over 10%, and unemployment under 25 stands at a record breaking 24%. Economic growth in the countries where austerity was imposed have been negative, whereas countries who did not impose austerity have managed at least some moderate growth.

 

If we look at the change in government debt, the interesting thing is that in those countries that did not impose austerity, the debt grew very little, but in those countries where austerity was imposed, debt grew faster that before the austerity!

What on earth went wrong? How can spending less increase your debt?

Why austerity does not work

When a household gets into debt, cutting its expenses does not decrease its income. Austerity is therefore a good policy for an individual household. When it comes to governments, the situation is different. Government spending in the EU is in average about 40% of National Income, and any meaningful reduction of spending will have a direct effect on the economy.

Suppose that the government cuts salaries, reduces pensions, retrenches people, and stops the building of roads. The people who have their salaries cut or are made redundant will have to cut down on their expenses, and this will affect retails stores and other businesses. It people buy less, the businesses may have to fire staff, and this will put even more unemployed people on the streets that can no longer afford to buy goods. They may not be able to pay their rents, and so the landlords gets affected. The landlords may owe money to the banks, and if they get no more rent, they cannot make payments on their loans.

The road contractor that no longer have job from the government may also have to lay off people, and could in the worst case go bankrupt.

In this way a downward spiral is created, that drags down the economy. As the economy shrinks, government revenue from taxes also shrinks. Therefore, it can very well be that a government cut in spending will cause an even greater loss in tax revenue, and thus increase the government’s need to borrow money.

Britain’s recovery

Proponents of austerity point to UK as a success story that austerity really works. Indeed, the country’s economy has grown in the two last years, and unemployment is down. However, this argument is somewhat disingenuous, as UK’s brief stint of austerity ended two years ago. The original schedule of steady reduction in the budget deficit was halted, and stimulus spending resumed. Therefore, UK’s way to recovery is rather a proof that austerity does not work. The economy was doing very badly, and as soon as the austerity program was stopped, the economy improved.

In the words of economist Paul Krugman, “If I keep hitting myself in the head with a baseball bat, and then I stop, I will start to feel better; this doesn’t mean that hitting yourself in the head with a baseball bat is a good thing!”

What do economists say?

There are many different economists with very different views as to how the economy works, but not a single school of economics recommend that the government introduce austerity measures at the inception of a major recession. Keynesian economists would recommend the opposite: Let the government spend more money in a recession to stimulate growth. Even Monetarists, who in theory might support austerity if it was matched by a large increase in the growth of the money supply, are reluctant to recommend such a policy because of the great amount of uncertainty surrounding the impact of a cut in government expenditure in the short run. In the present implementation in Europe, the austerities were imposed without any increase in the money supply, so the policy as implemented was definitely at odds with Monetarist theory. Traditional Marxist economists would consider the crisis an invariable result of the capitalists system, and imposing austerities would to them be to ask the common people to bail out the rich capitalists.

So the austerity measures imposed in Europe lacked support from all economists, regardless of the economic school they represented. The terrible suffering imposed on people in the EU were predictable and inevitable. The fact that in spite of this austerity was imposed in so many countries was irresponsible and stupid.

Poor governments – Rich nations

If reducing costs is not possible, the only other option is to increase income. Since the 1970s, under the influence of Reaganomics and Thatcherite policies, there has been a trend towards transferring wealth from the poor to the rich. This was done by lowering the taxes on the wealthy, and freezing salaries of normal people. In the United States in the 1960’s, a man working an eight to five job could support a middle class family. These days, to maintain the same living standard, both husband and wife have to work, and much longer hours. The trend is similar in other countries. At the same time, due to the lower tax revenues, governments had to borrow money to meet their obligations. The end result was an increase in government debt and an increase in inequality.

Today, many governments have debts that equal the entire income of the country for one year. That is, it would take every penny all people earned in the entire nation during one year to pay back the national debt! At the same time, government assets have dwindled so they also roughly equal one year of national income. The end result is that most government has a zero net worth: what they own equals what they owe!

This does not mean that Western nations are poor. On the contrary. They net assets of the private sector equals five to six times of national income. So, while the governments are poor, the private sector has grown rich.

Most of these assets belong to a very small group of rich individuals. The richest one percent own about 35% of the national wealth; the next nine percent own another 35%; and the poorest half of the population owns only 5% of national wealth.

Austerity hits hardest on the bottom half that owns almost nothing, while the rich even manages to increase their wealth during hard times. A far better proposal to resolving the debt crisis would be to impose a progressive wealth tax that would hit the rich instead of the poor. If a onetime tax on assets would be imposed that taxed the richest one percent with 35% of their wealth; the next nine percent with 20% of their wealth; and the next twenty five percent with 2.5%, we could completely wipe out the national debt and in the process transfer speculative hoarded assets, that does not benefit the economy, into productive assets that will increase welfare for everyone.