Numerous governments across Europe have embarked on strict austerity programs. Europe is also sliding into a deep recession, with some countries already essentially in deep depression. Are the two phenomena related? Is the austerity exacerbating the economic downturn? Yes and no, and the yes should be no surprise.
For context, recall that the Obama Administration was greeted by a global financial contagion and the Great Global Recession. The budget deficit was already rising rapidly as tax receipts fell, thus creating a powerful countercyclical force, according to standard Keynesian theory. Obama concluded that more was better, and so was launched a giant spending surge of one massive binge and a series of lesser excesses.
The economic theory guiding this policy was traditional and straightforward: too little private demand. So, the theory goes, government had to create new demand for goods and services. The theory also completely failed, as all attempts at fiscal alchemy must. Government cannot create new demand in an economy; government can only move the existing demand around within the economy, with a little job loss due to the frictions of heightened inefficiency thrown in for good measure.
The money Obama spent was not plucked out of thin air. The federal government borrowed the money through the financial markets, thus reducing dollar-for-dollar the amount of lending that would otherwise have supported private demand.
The federal budget deficit went from 3.2 percent of the economy in 2008 to 10.1 percent in 2009. If the Keynesian theory had any validity whatsoever, under such a massive impulse the U.S. economy should have shot out of the recession like a rocket. It sputtered like a damp firecracker.
Now, under pressure from Germany, credit markets, and fear of an imploding euro, much of Europe is pursuing the Obama stimulus strategy but in reverse, slashing spending and raising taxes. As Europe’s recession unfolds, many are pointing to austerity as a prime cause.
In one respect this is completely incorrect, which is obvious enough when viewing Europe through the lens of the recent experience in the U.S. Obama’s spending surge created debt but not prosperity. Europe’s spending cuts are slowing the rise in debt but are not responsible for economic contraction. The spending cuts are necessary, and painful, but have no more to do with the recession than the upcoming Eurocup 2012 soccer championship.
The part of austerity that is exacerbating the recession is the tax hikes—no surprise—which in this case are more self-defeating than usual. Raising taxes on income, property, and final sales (the value added tax), all distort the economy, some more than others, often reducing or even wiping out the profitability of various business ventures.
In a strong economy with more opportunities to adapt, the immediate damage done by some of these tax hikes may be modest, and so government can expect some pickup in revenues along with the pickup in joblessness. In Europe’s economy today, workers and businesses can adapt only by going idle, and so there is little or no pickup in revenues to justify the increase in unemployment.
The only conceivable reason for Europe to even consider raising taxes is to reduce the amount of government spending that must be cut to hit their deficit targets. Understandable, perhaps, but self-defeating, as the tax hikes feed the recession, which whacks at tax revenues, thus sustaining the deficits.
Europe’s recession has many causes, too many to list here. But reducing the footprint of government spending is not one of them.