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Austerity and growth: trying to make sense of a contradiction

Having read that the outcome of the Greek elections points to a continuation of the push for fiscal austerity in that country, my heart sunk. Then I see that our own Prime Minister has been quoted as telling…

In the aftermath of the Greek elections, there have been renewed calls to accompany austerity measures with pro-growth policies.

Having read that the outcome of the Greek elections points to a continuation of the push for fiscal austerity in that country, my heart sunk. Then I see that our own Prime Minister has been quoted as telling the G20 that austerity must be accompanied by a commitment to growth.

“Austerity must be accompanied by a commitment to growth”. Now this is not something that has been invented by our own Prime Minister. To use Paul Keating’s expression, everyone, including the pet shop galah, has been saying that austerity must go hand in hand with a commitment to growth.

What it is, however, is a contradiction in terms. As a piece of economics, it would not pass muster in a first-year undergraduate essay.

What such an expression does not clearly appreciate is that a policy of fiscal austerity reduces demand for goods and services arising out of public sector activity. If the level of production which producers undertake is determined by the demand for their goods and services, then austerity would tend to put downward pressure on that production and in turn the growth of output and employment.

In other words: in and of itself, a policy of austerity works counter to growth.

To not appreciate this and the contradiction in tying austerity to growth is to suppose that government expenditure, for example, has absolutely no effect on the level of demand for goods and services in the economy.

Now, I realise some people think this and that a dollar spent by government is somehow different from a dollar spent by you and I. There may be a sociological, anthropological, or even religious aspect to such reasoning that I’m unaware of. But for the life of me I can see no economic argument for such a view.

In the face of all the arm-waving of those pressing for austerity, this very simple point should be enough to stop the economic argument in favour of austerity in its tracks.

But no - the ideology of those pushing for austerity, I suspect, will not allow their argument to be sidetracked.

Instead the argument for austerity is then dressed up in some ill-fitting pseudo-economic clothes. In particular, austerity is supposed to instill confidence in the “markets” and in the private sector more generally and this would stimulate growth.

How this is supposed to work is one of the greatest pieces of hocus-pocus of recent times.

One argument is that austerity will assist in reducing public sector debts in the more troubled Eurozone economies and this will give confidence to the private sector.

It may provide some confidence to financial markets, though even this is questionable to the extent that those financial markets think for five minutes about the depressing effects of austerity measures on demand and production.

But even supposing that the austerity measures allow for some fall in interest rates payable on the sovereign Euro debt, this will be little assistance for the private sector or their confidence if no one is buying their goods.

And this setting the direction of policy to placate the financial markets is extremely irritating - as if these markets were part of the solution and not part of the problem.

Every second commentator on Europe also mentions fixing the euro policy architecture: but this must include moving away from an architecture which places supposedly sovereign governments at the mercy of those markets when funding their fiscal programs; in part to placate a European Central Bank and dominant Eurozone economies, whose economic thinking belongs in the dark ages.

Moreover, if austerity measures slow further the growth (or exacerbate negative growth) of certain economies in Euroland, this makes the job of reducing the public debt to GDP ratio even harder and requires even greater fiscal austerity. Before you know it, you may not have much of an economy left to worry about.

Nor will austerity mean just fiscal austerity. It will mean - as it always does when economic times are tough - “freeing” up markets.

Usually this is code for a race to the bottom in the labour market and on corporate tax rates. Though times don’t have to be tough for these pressures – witness the Australian discussion, for example.

The economic reasoning here is hard to fathom. To the extent that I can think of any, it would be that falling wages and prices across markets in economies such as Greece would stimulate demand for production and possible even help provide a real depreciation for Greeks and other troubled Eurozone economies relative to their Euro partners.

Again, to borrow a term from the famous economist Nicholas Kaldor, there are some economic howlers here. Not the least being that falling wages – engineered by high unemployment and a “freer” labour market - may well depress demand from households.

But also, although wage costs may be falling, if prices are also falling because of lack of demand, profits will not necessarily improve.

There is little impetus for confidence-inspired growth in this direction.

In sum, the linking of austerity and growth as if the former was indispensable to growth is a failure of the economic imagination.

It’s a sign that there is a problem requiring more than just a simple-minded conservative attitude to fiscal and monetary policies and to “market flexibility”, not to mention rolling over like the household dog until the financial markets feel like throwing troubled economies a bone.