The Dangers of Putting All Your Eggs in the Basket of Austerity

If you visit the Bank of Greece in Athens today, you will be struck by the ironic message displayed at the bank’s entrance. There, banners promise a “fascinating journey through Greek’s modern economic and monetary history.” Inside the museum, you will be able to view lines of glass cases holding an array of Greek money, ranging from coins and old bank notes. The bank notes range from 5 drachma up to 100 million drachma, making the case for irony in that it is clear by this display that Greece has struggled with inflation throughout its history.

America too has had her struggles with inflation and the corresponding maladies of debt and deficit. The narrative out of the conservative camp is that austerity is the road to balanced budgets and economies unburdened by debt. So then, let us begin by examining this narrative to see if it makes any sense.

Our government has a significant debt challenge, with ever-increasing deficits and a lack of sufficient funding to support its ever-growing entitlement programs. Conservatives have taken the position that this situation demands dramatic reductions in funding through massive spending cuts. They also want to combine that strategy with subsequent cuts in tax rates, which according to them will benefit both individuals and businesses, thereby taking us down the road to future economic growth and stability.

Across the Atlantic, where much of our own economic challenges are blamed on the Europeans, Germany, France, Spain and Italy have all managed to reduce their structural budget deficits by enacting severe austerity measures. The International Monetary Fund (IMF) has projected that these countries should be able to reduce those deficits even further this year.

As we are beginning to see in Europe however, this may not necessarily be good news. The economic reality is that austerity can unnerve markets, not calm them. This is somewhat surprising because in theory, austerity and solvency should be functions of long-term growth, but markets seem to care more about the short-term. The response to cutting the deficit too rapidly is a negative impact on growth and the corresponding rise in the cost of debt service. That increase could result in higher, not lower, debt to GDP ratio which in the United States today is 110%.

In economics, the debt-to-GDP ratio is one of the indicators of the health of an economy. It is the amount of national debt a country has as a percentage of its Gross Domestic Product (GDP). A low debt-to-GDP ratio indicates an economy that produces a large number of goods and services and probably profits that are high enough to pay back debt. In comparison to the United States, Greece’s debt to GDP ratio in 2011 was 172% with Japan at 225%.

Conservatives point to the Europeans and maintain that America’s current economic crisis is driven by an ever growing sense of “uncertainty” which manifests itself through American business suffering from a fear of increased regulation and the potential for increased tax rates. Decreasing the size of government will result in decreasing the role of regulation in the market and will ultimately calm business leaders’ fears of future increased taxation.

To decide if austerity is a tool that can be used to control debt and deficit means we have to understand the economic rationale for austerity at this time and what its effect would be on short-term economic growth.

A growing number of economists and international economic organizations argue that austerity actually hurts in the short-term. This argument should be easy to believe as austerity measures dampen expenditure and by consequence, economic growth. One of the arguments that have turned the water muddy is the conservative notion that the current recession is normal and that austerity measures are necessary after the extravagances of the first half of the past decade.

Oh if only the U.S. economy was simnply faced with just one economic challenge—ballooning debt—then the choice of austerity would make sense. Unfortunately, debt is not the only economic problem America is faced with today. The urgent and critical problems that need to be resolved immediately are ones of aggregate demand, depressed investment and high unemployment. All of these issues are connected to the fallout from the financial crisis that exploded in the last days of the Bush administration and left us with substantial household debt overhang, which continues to increase as asset prices continue to fall. This of course is one reason why so many Americans are underwater with regards to the value of their homes.

The conservative narrative does nothing to resolve the primary causes of our current economic malaise. Continuing to cut government spending will lead to higher unemployment while having an adverse impact on demand. Reducing tax rates on the rich means reducing government revenues which only serves to further amplify the supposed logic of cuts to government spending, which further increases cuts in government jobs.

The U.S. government cannot address its long-term debt crisis without first addressing the challenges of short-term economic growth. Further depressing economic growth through austerity measures will only cause the current economic troubles to worsen and would extend the amount of time required for our economy to fully rebound. Prolonged economic slowdowns will cause the government to suffer lower revenues and can only work to increase deficits and debts, not correct them.

The conservative narrative also argues, with its myopic focus on austerity, that our primary concern should not be the current economic plight we are in, but rather on the futures of our grandchildren and great-grandchildren. In normal economic times, this argument might be rational. However, unless we address and more importantly, resolve the conditions that stunt economic growth and sustain high levels of joblessness, then there will be no economy to manage 10 or 20 years from now.

I am not arguing for haphazard government borrowing and spending. In the near term, government spending can have a positive effect on economic growth. Interest rates on government bonds are at historic lows, which the government should take advantage of, and increase its investment over the next few years in infrastructure, energy, education, science, and technology research. These are areas that will continue to decline in a prolonged economic slump, and, with regard to infrastructure, will only be more costly to correct later.

To wit, we should not take government debt lightly. The issues of entitlement reform and austerity should be engaged, with plans to address the dramatic projected future increases. However, we cannot succeed in this process by depressing current economic growth. Now is the time to grow in economic strength in order to weather the hardships of austerity in the future.