Across Europe, governments are announcing new austerity packages of spending cuts and higher taxes rather than Obama-style stimulus spending. In response, American economists such as Paul Krugman and Brad DeLong are warning that these policies will throw Europe back into a depression and should be avoided at all costs in the United States.
"The next time you hear serious-sounding people explaining the need for fiscal austerity," Krugman wrote in The New York Times in July, "try to parse their argument. Almost surely, you'll discover that what sounds like hardheaded realism actually rests on a foundation of fantasy, on the belief that invisible vigilantes will punish us if we're bad and the confidence fairy will reward us if we're good."
One crucial point Krugman leaves out is that most European Union member states have no alternative. Countries that rely heavily on foreign investors—such as Greece, France, Ireland, Italy, and Spain—must cut spending to avoid being shut off from the global capital markets.
Contrary to common belief, investors don't judge sovereign default risks based on public debt as a percentage of gross domestic product. Instead, bond professionals grade on a curve, assessing one country's fiscal behavior against another's. When investors lose confidence in a government's fiscal rectitude relative to its competitors, they withdraw, and the snubbed country suffers. Capital being a scarce good, the result is increased interest rates and a higher price for debt.
One of the key signaling devices for international investors is how a government behaves under financial duress—how it balances the demands of its debtors with those of its welfare recipients. Announcements of lower spending and higher taxes tell investors a country is willing to go to great lengths not to default on its debt obligations. If the government instead focuses on preserving its welfare state and public employee benefits, investors know default is more likely and will shy away from that country's bonds.Japan has the world's biggest debt as a percentage of GDP, at 227 percent, nearly four times the economist-recommended 60 percent ceiling. It has gotten away with its carelessness without risking default because the country relies more heavily than most on domestic investors to fund its follies. The United States, despite a dangerous debt burden relative to GDP (66 percent) and a structural deficit among the highest of developed countries (almost 4 percent), has so far also escaped investor censure, thanks to the perception that the dollar remains the safest currency in the world. European countries don't have that luxury.
But the benefits of austerity go far beyond signaling investors. Goldman Sachs economists Ben Broadbent and Kevin Daly, surveying the data of 44 large fiscal adjustments across the globe since 1975, concluded in a 2010 report that cutting annual spending by 1 percent triggers a net 0.6 percent in economic growth. As we will see below, this is a good deal compared to the $1.10 reduction in GDP we get for each $1 spent by the government to stimulate the economy. Lower spending reduces the fear of higher taxes, which leads to an increase in consumer and business demand and growth.
The notion that austerity is bad and stimulus is good rests on the Keynesian theory that if government spends a lot of money, that money will create more value in economic growth. This purported increase in gross domestic product is what economists call the "multiplier effect." It's a nice story, but like most fairy tales, it has scant basis in reality.
In a 2010 paper published by George Mason University's Mercatus Center (where I work), economists Robert Barro and Charles Redlick showed that in the best-case scenario, a dollar of government spending produces much less than a dollar in economic growth—between 40 and 70 cents. If that was the rate of return on our private-sector investments, America would soon cease to be a leading economic force.
Barro and Redlick also looked at the economic impact of raising taxes to pay for spending increases. They found that for every $1 in tax-financed spending, the economy actually shrinks by $1.10. In other words, greater spending financed by tax increases damages the economy. The stimulus isn't working, because the economic theory it is based on is fundamentally flawed.
The findings from my own quarterly reports on stimulus spending (mercatus.org/publication/stimulus-facts-data) further illustrate why these packages don't work. My analysis is based on the tens of thousands of reports from stimulus recipients published on recovery.gov each quarter, along with economic and political data from the Bureau of Labor Statistics, the Census Bureau, GovTrack.us, and other sources. My most recent analysis found that the total number of jobs the government attributed to stimulus spending as of April was 682,000. Factoring in stimulus dollars spent up to that point, the average cost of these jobs was $282,000.
That's a lot of money. Worse, four-fifths of these jobs were in the public sector. This outcome is far afield from the administration's original promise that the stimulus would create 3.5 million jobs over two years, 90 percent of them in the private sector.
A 2002 paper in the Economic Policy Journal, written by the French economists Yann Algan, Pierre Cahuc, and Andre Zylberberg, looked at the impact of public employment on overall labor market performance. Using data for a sample of OECD countries from 1960 to 2000, they found that, on average, the creation of 100 public jobs eliminated about 150 private-sector jobs, decreased by a slight margin overall labor market participation, and increased by about 33 the number of unemployed workers. Their explanation was that public employment crowds out private employment and increases overall unemployment by offering comparatively attractive working conditions. Basically, public jobs, especially ones that also exist in the private sector in fields such as transportation and education, offer higher wages and benefits, require low effort, and therefore crowd out many private jobs. When these new employees are paid with taxes it negatively impacts the economy.
The data released by the Bureau of Labor Statistics in June, then, were bad news. (See the chart.) They showed that since the passage of the stimulus bill, the private sector has lost 2.55 million jobs while the federal government gained 416,000.
The understandable temptation to take action in a time of recession should not lead lawmakers down unproductive paths. Stimulus by government spending doesn't work. European and American governments have tried it without success. Now is the time to tighten spending, no matter what some American economists might say.
Contributing Editor Veronique de Rugy (firstname.lastname@example.org) is a senior research fellow at the Mercatus Center at George Mason University.