A response to Steve Hanke’s defense of austerity

Since the outcome of the European elections, political leaders in the EU’s most stagnating countries have been calling for an end to austerity. While they seem unable to develop a realistic and politically palatable alternative, Europe remains in the doldrums, and pro-austerity views are having a comeback. One such example is Professor Steve Hanke’s defense of austerity (in “The EU’s Anti-Austerity Hypocrites” which aims at reasonable objectives with the wrong tools.

Austerity in Europe is about cutting public debt in high-debt countries. This is to be accomplished by spending no more than taxation brings in, so that countries can gradually “repay their debts.” Since most Europeans complain about high taxes, this also means public spending retrenchment. In other words, if you want less taxes and a balanced budget, you ought to cut your spending, too. So the plan is supposedly good for debt repayment and conducive to growth if governments accept the downsizing.

Hanke’s rebuke to European leaders who claim they “cannot impose further spending cuts … [because] their budgets have been cut to the bone” is quite reasonable. It is hard to question his pointing his finger at the abnormally high salaries of senior Italian government officials. In addition to this criticism, he could have added that such high salaries in Italy also contrast with the poor quality of the results: illegal trade, crime, and corruption eating up much of Italy’s shrinking economic pie, as Mario Draghi often warned when he was the governor of the Bank of Italy.

The argument for ending poor use of public spending, however, does not make a case for continuing austerity as defined above. Indeed, both Hanke and European leaders seem to fall into the trap of considering a balanced (and small) public budget as a necessary condition for growth, when instead it is, under current economic conditions, a sure recipe for continuing stagnation.

Hanke uses data about private credit contraction as evidence that the “EU’s problem is one of monetary, not fiscal, austerity.” Although he does not explain what he means by monetary austerity, one can guess that he advocates some kind of monetary measures that make banks lend again. But he seems to ignore that the volume of bank lending can hardly be maneuvered by public authorities and that bank lending is largely pro-cyclical and highly responsive to demand and profit expectations, as the Bank of England has acknowledged.

While it is generally believed that the problem of Europe’s low rate of investment and poor job creation has financial roots, it is not sufficiently recognized that governments’ attempts to balance their books are the major cause of such financial constraint on the private sector of producers and consumers. Macroeconomic evidence shows that job creation responds to demand conditions; that demand conditions depend on private decisions to spend what producers and consumers consider are excess savings according to their own personal judgment; and that savings are correlated with the size of the public budget deficit.

Austerity must end because fiscal repression is destabilizing Europe. There are many ways to do it. One is a 50-percent cut of value-added taxes throughout the region, to be funded by EU bonds. The question of high official salaries, or of organized crime, should be dealt with separately through true, genuine political cooperation among Eurozone member states.

As much as anyone would sympathize with a call for more austerity regarding senior officials’ salaries, this still leaves the issue of government spending as a political question, and one quite separate from that of how to revive demand, profit expectations, and bank lending in Europe. Austerity is a respectable policy approach when it is concerned with the quality of public spending. Austerity is harmful and unscrupulous when it is concerned with making all levels of government balance their books.