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Economics of austerity don’t add up

August 30th, 2012 · Gregory Clark · 9 Comments

Do Europe’s budget-cutting austerity-minded planners understand simple math? They say they have to embrace austerity policies to reduce excessive national debt. But those policies inevitably cut tax revenues more than they cut spending. National debt increases rather than decreases. Worse, recovery from the economic downturns they create then forces them to ease the original spending cuts. So the national debt situation gets even worse. Japan during its two decades of economic stagnation was the poster-child model for this economic folly in action.

Japan’s first experiment in austerity policies began under Prime Minister Ryutaro Hashimoto (1996-98). Severe spending cuts were seen as needed to rein in budget deficits caused by previous efforts to recover from the 1991 Bubble collapse. Recession followed quickly. Tax revenues collapsed. The national debt increased.

Under Prime Ministers Keizo Obuchi (1998-2000) and then Yoshiro Mori (2000-2001, Japan returned to fiscal expansion policies and the economy recovered rapidly, with the Nikkei Dow share index reaching almost 20,000. But with tax revenues still only in the recovery stage the deficit hawks were able to swoop in once again under Prime Minister Junichiro Koizumi (2001-2006). Austerity in the name of “structural reform” became the order of the day. The Nikkei Dow promptly collapsed to the 7,000 level, tax revenues fell again and the national debt increased by ¥200 trillion in just five years despite the boost to the economy from expanded exports to China and the United States.

Post-Koizumi, and as in Europe today, finally some began to realize that austerity policies were counter-productive. Prime Minister Shinzo Abe (2006-2007) reversed the Koizumi austerity slogans of “no economic growth without structural reform,” to say “no structural reform without economic growth.” But by this time it was too late (Europe please note). The dramatic stimulation policies now needed to revive the deflation-bound economy were blocked by the deficit hawks. Today under Prime Minister Yoshihiko Noda those hawks are back again, arguing that demand-reducing and politically unacceptable tax hikes will save the day.

The graph for Japan’s long-term economic history says it all. From 1980 through to 1990, Japan’s generally Keynesian policies saw a steady rise in government spending matched by a equally steady rise in tax revenue, while the national debt relative to GDP remained roughly at around the 50 percent level.

Since 1991, and despite various deficit hawk commitments to reduce government spending, that spending has continued to increase — from around ¥75 trillion annually to almost ¥90 trillion mainly because governments were forced to maintain or increase spending to counter the recessions they had created. Meanwhile tax revenues went into a steep decline — from ¥60 trillion down to ¥40 trillion per year. National debt relative to GDP jumped to well over 150 percent. Even allowing for global economic hiccups during the period, this increase in national debt can only be seen as a negation of austerity ideology.

End-of-the-world fanatics who cling to their beliefs long after the date they said the world would end look reasonable compared to these austerity fanatics.

True, austerity moves to stop wasteful government spending, nanny-state welfare, over-generous entitlements and bureaucratic boondoggling are welcome, provided they are replaced by compensating moves to expand productive government spending. Equally welcome are moves to encourage private spending and investment — privatizations and deregulations especially. But private investors will remain cautious when recessions and further falls in asset values continue. A government spending jolt to break the deadlock remains the only option.

Austerity hawks such as British Finance Minister George Osborne, tell us that the sight of planners determined to reduce deficits will reignite private investment confidence. Oh yes? No doubt that explains why those private investors are moving their funds into tax havens now said to hold a staggering 20-30 trillion dollars.

The other mantra for recovery is “create more jobs.” But you can only create jobs if you can create demand. Currently the planners are too busy killing demand. And there is the possibility raised in the book “Race Against the Machine” that innovation today cuts both jobs and demand.

Till now the planners have always assumed that as a last resort severe cuts in interest rates would force some kind of recovery. But today when interest rates in Japan, the U.S. and Germany are being cut to the bone we still see no recovery. Would-be spenders are spooked by the depth of the recessions created by austerity hawks.

In desperation the finance czars are now willing to try quantitative easing — the formerly much despised Keynesian solution of expanding the money supply. But they give the money to banks and companies who prefer simply to buy government bonds or pay down debt. Stimulatory effects are weak. A proper Keynesian approach would require the government to pump money directly into the economy, ideally in the form of infrastructure spending that provides immediate stimulation. Anti-Keynesians condemn these policies as digging holes and filling them in. But even that is better than leaving funds to stagnate in banks or tax havens. The U.S. only managed finally to recover from its Great Depression with the beginning of World War II. War spending is a lot more wasteful than digging and filling in holes.

Some see negative interest rates is another way to force surplus savings back into the economy. And then there is the solution being pushed here by rightwing Keynesians upset by the current harm to Japan’s economic prestige and military power, namely that the government take back from the central bank the right to issue money. But whatever you do, expand demand and stop worrying about deficits. They will cure themselves once you expand demand.

This article by Gregory Clark (website) first appeared in the Japan Times and has been republished on this site with the author’s kind permission. Gregory Clark is vice-president of Akita International University and a former member of the Bank of Japan, Expert Consultative Committee.

9 responses so far ↓

  • 1 BP // Sep 6, 2012 at 6:21 pm

    A courageous and thought-provoking article. Amid the loud clamour for austerity, it’s refreshing to read an argument of this high quality.

  • 2 Lachlan // Sep 6, 2012 at 9:32 pm

    No austerity for the established players. Coles putting in a fuel outlet, Woolworths a second food store and Melco/Mitre Ten (I forget or are they the same) moved to a bigger new location all in a regional centre nearby. Make hay while the recession shines. Actually a lot of commercial property has/is been taken up lately. I am not saying there are not otherwise signs of economic malaise but more correctly that may be the case for some and a different case for others. I shall name my observed phenomenon heterogeneomics. A group within which individuals display varying economic behaviour, that is. Well I guess I can join the leagues of useless economists now 😉

  • 3 BP // Sep 7, 2012 at 8:04 am

    “Woolworths a second food store and Melco/Mitre Ten (I forget or are they the same) moved to a bigger new location all in a regional centre nearby.”

    Same here. What I really can’t begin to fathom here is the new car phenomenon. It seems every man and his dog is driving a brand new $70K vehicle.

    If this is a recession, we sure ain’t going to hell in a handbasket, Lachlan… . 😀

  • 4 Greg Atkinson // Sep 7, 2012 at 8:43 am

    Well the ECB is going on an unlimited bond purchase adventure but only for nations who agree to certain austerity measures.

    Looks like austerity is very much in vogue in the Eurozone. But what is the alternative really? Borrow more and pass the problem onto the next few generations?

    In theory it sounds nice to throw money at a struggling economy but if it’s borrowed money and the interest rates are high then I am not sure it’s the right thing to be doing unless a lot of other measures are taken as well.

  • 5 Lachlan // Sep 7, 2012 at 5:20 pm

    “only for nations who agree to certain austerity measures.”
    That could be the critical point Greg, could be. Risk on, risk off continues.

  • 6 Stillgotshoeson // Sep 7, 2012 at 7:27 pm

    Lachlan // Sep 7, 2012 at 5:20 pm

    “only for nations who agree to certain austerity measures.”
    That could be the critical point Greg, could be. Risk on, risk off continues.

    Yeah, I picked up on this too Lachlan.

    Shoes Sydney.

  • 7 Lachlan // Sep 7, 2012 at 9:25 pm

    Oh well, guess they can sometimes buy reluctant leaders hey Shoes…print off a few more bills.

    BP this particular town is distant from any real mining spin off too, just an hour from surf beaches in fact. Another big slab is going down next to the new Melco also. You see the big players know the mass production of low cost solar cars is imminent. Yep that’s it, gotta be 😉
    Recessions and depressions are the wrong time to fall asleep on the job if you have capital.

  • 8 Lachlan // Sep 7, 2012 at 9:29 pm

    Silver is having a fun time again…all those solar drivers might need it. I’ll let em have it when i am finished with it for just $1000/oz 🙂

  • 9 Plornt // Sep 8, 2012 at 3:55 pm

    “Silver is having a fun time again…all those solar drivers might need it. I’ll let em have it when i am finished with it for just $1000/oz.”

    1000 an oz Lachlan lol. I hope you are right ! I know I am not selling it until I see a massive inflation spike that we all know is due re 110 bear cycles that I mentioned a few months ago. Just continue to trade around the investment.

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