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Voters in Greece and France on Sunday voted decisively against the austerity policies of their governments - and for good reason.
Voters in Greece and France on Sunday voted decisively against the austerity policies of their governments – and for good reason. European austerity has failed, producing higher unemployment while doing little to repair the fiscal imbalances it was supposed to fix.
Ever since the 1930s when classical economics allegedly could not explain sustained 20% plus unemployment and idle factories, we have been taught a government-centric view of the economy.
The problem with this government-centric view of the economy is that it treats the private sector as a mere appendage to government. From the vantage point of the individual worker or saver in the private sector, these same actions look quite different.
Of course, a sharp reduction inis likely to cause a short run dislocation in the economy. It takes time for employees who are laid off, or vendors who lose a key customer to find new work or new customers. But, this adjustment is no different from those that take place when companies have to downsize or adapt their operations to changes in consumer preferences.
An extreme example is provided by the U.S. experience after. Total federal spending was slashed 38% in 1946 and another 38% in 1947 or by a combined 29% of GDP. That is equivalent to reducing current federal expenditures by $4.4 trillion in two years. The went from a $54 billion deficit to a $3 billion surplus. Eight million men and women (12 % of the workforce) were released from the armed forces. did decline by 11% in 1946. But, the economy stabilized in 1947, and then grew by 4.4% in 1948.
The reason European austerity has failed is not because of the reductions in government spending, but because those spending cuts have been paired with tax increases. The Europeans are struggling to reduce government spending by less than 5% of GDP. But unlike the U.S., which paired extreme budget cuts with across-the-board reductions in personal income tax rates, the European austerity combines spending cuts with massive tax increases. The result is a toxic brew which shrinks both government and the private sector, producing recession, rising unemployment, and massive budget shortfalls.
A tax increase does far more than simply take money out of the private sector and give it to the government. Increases inalso reduce the opportunities for domestic economic activities in the same manner as increases in tariffs shrink the opportunities for international trade.
For example, a 2-percentage point increase in theraises the price of goods and services by 2%. Faced with higher prices, individuals demand less, both because prices are higher (the incentive effect), and because the same amount of euros can now purchase 2% fewer goods and services (the cash flow effect). Suppliers, faced with the fall-off in demand, may choose to absorb some of the tax by lowering the price they receive. However, the lower price received reduces both their desire (incentive effect) and ability (cash flow effect) to maintain the current level of supply.
As noted above, the cash flow effects are offset at least in part by government spending. But, here is what the government-centric view of the economy completely overlooks: The combination of higher prices-paid and lower prices-received shrinks the opportunity set for mutually beneficial exchanges, so fewer exchanges – and less economic activity – takes place, even if every dollar of tax revenue is spent. Imagine for example what would happen if a 20% tax were imposed on the proceeds of selling a stock. On a $20 stock, the bid-ask spread would widen from 25 cents to $4.25! In order for the seller to still receive $19.75, the buyer has to pay $24. We can only imagine how much the volume of trade would fall, and how many individuals associated with the securities business would lose their jobs.
The higher the marginal tax rate – whether it be a VAT or income tax or property tax – the greater the spread between the price paid and the price received, and the greater the obliteration of economic activity that otherwise would have taken place.
The final error of the government centric view is that the budget deficit is the key economic variable. Instead, chronic and exceptionally largeare a symptom of a government sector that has become over-sized relative to the private sector.
Austerity that combines the “shared sacrifice” of spending cuts and tax increases fails because it seeks to maintain this imbalance. However, the contraction in the private sector typically leads to increased government spending on unemployment and other relief payments, further increasing the size of government relative to the private sector.
The solution to Europe’s sovereign debt crisis is the policy mix that worked in the U.S. after World War II: monetary stability, reductions in government spending that shrink the size of government, and reductions in marginal tax rates which permit the private sector to expand. Reducing government-imposed rigidities in labor markets also would increase the opportunities for mutually beneficial exchanges, thereby leading to increased employment.
But, most of all, resolution of Europe’s debt crisis requires that, if not the governing elite themselves, then a majority of voters recognize the governing elite are not capable of managing the economy, and demand that those in power, with new found humility, admit the spontaneous order of the market, rather than government programs, is what will produce economic growth, rising living standards, and ultimately the revenues required to restore fiscal balance.
Private sector growth, not austerity or increased government spending, is the answer.
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