Freedomnomics

Article published Monday, July 16, 2012, at Real Clear Markets.

Austerity Works: It's Time to Give It a Try

By John R. Lott, Jr. and Sherwin Lott

Austerity or growth, is that the choice facing Americans and others around the world?

The debate never seems to abate. European Union finance ministers last week gave Spain permission to delay cutting some government spending and reducing its deficit, though many such as The Economist magazine fear that even the cuts that will be made go too far. A similar decision may soon have to be made for Greece. Even though the pro-bailout parties won the June Parliamentary election, they too are asking for a two-year delay in cutting spending and reducing their budget deficit.

The Obama administration has put increasing pressure on German Chancellor Angela Merkel to ease up on Germany's austerity prescription. President Obama continually touts more government spending as the cure, and derided Republican "let's cut more" spending strategy as the cause of Europe's economic problems.

Last month, German Finance Minister Wolfgang Schäuble was having none of it, telling Obama to fix the U.S. deficit before giving Europe advice: "Herr Obama should above all deal with the reduction of the American deficit. That is higher than that in the euro zone."

Paul Krugman has challenged Obama's critics: "We have actually had a massive unethical human experiment in austerity doctrine . . . there has been a very depressing effect on the economy. Where is the evidence that this other view [austerity] is at all right?"

So what is the evidence? Did the countries with the biggest stimulus programs weather the storm better than countries that reined in spending?

Using the latest Organization for Economic Co-operation and Development (OECD) data for all 32 countries that it is available for, there's a strikingly clear relationship. The countries with the largest stimulus programs suffered the most during the recessions. The more they increased spending or the more they increased their deficits, the worst they did.

Countries such as Ireland, Iceland, Estonia, Spain, and the UK dramatically increased per capita government spending, boosting it by 14.5 to 48 percent. Those nations also suffered the biggest drops in GDP, contracting on average by a total of 4.4 percent between 2007 and 2010. The share of their working age population that was employed fell by an average of 6.6 percent.

The most frugal countries, the Czech Republic, Hungary, Israel, Poland, Sweden, and Switzerland, let per capita government spending either shrink or grow much more slowly, ranging from -1.5 to 7 percent. The result? Per capita GDP actually grew by an average of 7 percent over the three-year period. These countries also saw the share of their working age populations with jobs grow. The results are not dependent on Ireland and Iceland being included, and also regressions show that increased government spending reduces the next year's GDP growth and employment.

In the U.S. we still aren't even close to having the same percentage of the working age population employed as we had in 2007. Our per capita GDP growth was abysmal during this time period, just a quarter of the growth for the six most frugal countries.

Larger deficits also failed to generate any increased growth. The countries that tried to borrow their way to prosperity suffered the worst economic contractions and slowest growth.

Governments weren't able to spend their way out of their problems. "If you look at the experiences of OECD countries over the past five years there's no evidence that countries that reduced government spending relative to GDP had slower economic growth," said Steve Bronars, an adjunct professor in economics at Georgetown University. "If anything, countries that showed greater fiscal restraint had faster growth in GDP and employment over the past few years."

The money that the government spends has to come from someplace whether it is borrowing or taxes. Whether the government receives the additional money from taxes or by borrowing it, the increased spending by the government, by necessity, implies others have less to spend. Politicians like to count those who received jobs by government spending but they don't subtract those who lost jobs when money was taken away from the private sector.

But the spending did more than simply move jobs; it temporarily reduces employment. People don't instantly move from one job to another. It can take months or a year or more for people to get a new job, and these massive increases in government spending have created a lot of chaos. The temporary reduction in employment also reduces GDP.

The Keynesian multiplier argument rests on the notion that government spends all of its money, but that private individuals don't. Yet, people essentially also spend all of their money. If you put your paycheck in the bank, either you spend it on the mortgage or car or food or the bank buys bonds or lends out the money. To believe the multiplier argument you would have to believe that saving is the equivalent of throwing money in a hole in the backyard.

"Austerity" may be a bad word to some politicians, but the countries that followed Keynesian policy have a trifecta of problems: poor GDP and job growth, plus they've left their citizens with massive debts to pay off. Government spending doesn't increase wealth, and it needs to be stopped before Europeans dig themselves an even deeper hole.

John Lott is an economist and co-author of the just released Debacle: Obama's War On Jobs and Growth and What We Can Do Now to Regain Our Future (John Wiley & Sons, March 2012). Sherwin Lott is an undergraduate at Johns Hopkins University.

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