August 6, 2013 · by Elliot Brice   From: http://donotgogentleblog.com

Economics is often said to be more of an art than a science. This is because, unlike in the sciences, it is very hard to draw solid conclusions from empirical data. This might be the case; nonetheless you’d be stupid not to try and draw some conclusions from the experiences of others. And when we look at the experiences of various national economies right now there are definitely some lessons to be drawn.

The biggest lesson is: ‘don’t be Europe’. Europe is bad and going backwards. Don’t do what they did. The failure of European economic policies have clear implications for economic theory and the economic policies of Australia and the rest of the world.

So what is the nature of the mess Europe finds itself in? Even answering that question is controversial; everyone agrees Europe is in a mess, but it’s not even clear what exactly the mess is. Is the mess a debt crisis fueled by dangerously high sovereign debt? Or is it an employment crisis fueled by low and negative growth? The governments of the Euro zone have clearly identified the crisis as a debt crisis because their solution has been austerity – slash government spending to cut back their respective deficits. However a good 3 years of austerity has failed to solve the crisis.

In the UK, government debt as a percentage of GDP only continues to rise and is now above 90 percent. French debt to GDP is also up around the dreaded 90 percent mark and rising. Spain lives in the mid 80s and is on an upwards trajectory, as is the debt to GDP ratio of Portugal, Ireland and most other European countries. Greek debt to GDP has fallen slightly but years of austerity have barely made a dent; their ratio still lies above 150 percent. See here and here.

So what’s going on here, why has government spending failed to stop the crisis? Perhaps because the crisis is not really a debt crisis. Sure debt is part of the problem, but the debt crisis and the growth crisis are two sides of the same coin. And by ignoring the other side of the coin, European governments have offered misdirected solutions that have only made the crisis worse. They have sacked public servants, slashed government welfare, increased the cost of things like university education, and put an end to many government services and programs that people depended upon in the process destroying countless lives and creating a lost generation who will never enjoy the opportunities their parents had.

They must be doing something wrong. We might get a clue at what they are doing wrong by having another think about that ratio that austerity nuts are obsessed with – debt to GDP. One way to reduce it is obviously by reducing debt; but that only works if GDP stays the same. The problem with that is that slashing billions of dollars of services, firing people and generally withdrawing cash from the economy almost inevitably results in a reduction in GDP. This explains why the debt to GDP of most European countries is not going down, despite harsh austerity. They are cutting spending, but that is resulting in lower growth. In fact it is resulting in negative growth. And that negative growth is sending companies out of business and driving people out of work.

Greece, Italy, Spain, Belgium, France and the Euro-zone as a whole remain in recession. The UK has experienced some slight economic growth in recent times but they are not exactly a success story having very nearly gone through three recessions over the period of time since the global financial crisis hit.

So I contend that trying to address debt to GDP through austerity is not a great idea.

If you are really concerned about debt to GDP then have a look at the other side of the ratio. You can reduce debt to GDP by increasing GDP. Even if you spend more and increase debt, the ratio of debt to GDP will still go down as long as GDP goes up by an even greater amount. And that is fairly likely to happen given the multiplier effect of spending: if the government spends 50,000 dollars employing someone, then that individual might spend 20,000 of that on a new car. Then the owner of the car shop might spend her new 20,000 dollars on a holiday to another city in the same country. Then the tourism operators in that city will spend their new 20,000 dollars on food, clothes etc. And the food and clothes sellers in the area will collectively have 20,000 new dollars to spend on something. This will go on and on; clearly the 50,000 the government has spent has resulted in more than 50,000 dollars worth of economic stimulus.

The above example has already resulted in over 80,000 dollars worth of stuff being bought. You might respond that in an economic downturn the government employee is likely to save their income rather than buy a new car. It is true that well off people will save in a downturn but less well off people tend to spend their money; which is why it is much more efficient to stimulate the economy through welfare for the poor rather than tax cuts for the rich. Furthermore, obviously (if the government has established a decent tax collecting structure – something Greece and Italy never did) then all of this new economic spending will result in more tax revenues, which will – guess what! – reduce the debt.

Slash and burn austerity hawks commonly used a 2010 study by Carmen Reinhart and Kenneth Rogoff to justify their policies. It argued that if a country has 90 percent debt to GDP or above, then economic growth will slow significantly. Of course a second study by Thomas Herndon, Michael Ash and Robert Pollin claimed to discredit the 2010 study, saying it was based on faulty calculations. Yet I would argue that even if the math wasn’t wrong, there is more explaining to do. After all, correlation doesn’t equal causation. And just because on average countries with 90 percent debt to GDP levels had much lower economic growth rates, that doesn’t mean high debt to GDP causes low economic growth. In fact based on what I was arguing above, it would seem to me that, if anything, low economic growth causes high debt to GDP. So what is more important than cutting debt? Stimulating growth!

The European economic crisis is not a debt crisis at all, it is a growth crisis and an unemployment crisis. Debt is the symptom but not the cause. And even if it was the cause, austerity is not the solution.

Karl Marx argued that capitalism lurches from crisis to crisis. You don’t have to be a communist to realise that this is a powerful insight. We have booms (that are often bubble’s waiting to burst) and we have busts; no one can deny it. Marx argued that it lurches from crisis to crisis because when there is an economic boom and demand for labour is high, workers will, according to the law of supply and demand, only work for high wages. This will result in high inflation (which is bad for business) and obviously will also directly dent the profits of businesses. As a result businesses will need to downsize and an economic crisis will ensue. This is the problem that the Hawke/Keating government’s Accord sought to address by asking unions to temper their demands for high wage growth.

On the flip side (which is the relevant side at the moment), when there is excess supply of labour (high unemployment), businesses can get away with paying low wages (as the law of supply and demand shows). This might seem like it would be good for business (and right wingers often argue that low wages would lead to full employment) but if wages are low for most people then savings will be low; once workers have spent their money on the essentials they won’t have much left over to buy any non-essential products. And so the businesses selling non-essential items, like TVs and antique furniture and tickets to rock concerts, will be in trouble. Businesses will start to close and an economic crisis ensues. So, Marx argues, we can’t win either way; capitalism is doomed to fail.

Businesses might try to get around this latter scenario by searching for new markets, especially in developing countries, finding new people to buy their stuff. This worked for a while; even though workers in Detroit couldn’t afford to buy the cars they were making, Chrysler found some rich people in China and Africa to buy their stuff. Eventually though the crisis came; once the banks stopped lending to people, and credit cards were maxed out, incomes weren’t high enough to keep buying things -and the great recession hit. I don’t think the solution to this problem is to do away with the system, because there is no credible alternative. Yet what we do need to do is to smooth the business cycle – it is in no one’s interest to lurch from crisis to crisis, bubbles and busts.

What I get from Marxian economics (as opposed to Marxist economics) is that the extremes of capitalism – bubbles and busts – cause severe crises; and an extreme response to an economic crisis will only create another crisis. A crisis results from either a bubble – excessive growth – or a bust.

Austerity is an example of an extreme response; it takes money away from those that need it, causes higher unemployment, lower wages and hence sends us hurtling towards another crisis. And that is how Europe finds itself now, lurching from serious crisis to serious crisis.

Marx also reminds us that extreme inequality, which austerity fosters, is bad for economic growth. Extreme inequality leads to the situation above, where most wealth is concentrated in the hands of the few while most workers have little money to spend on luxury goods, leading to a slump in business activity and an economic crisis.

The solution to Europe’s crisis then must involve a path forward that reduces wealth inequality, does not lead to significantly lower wages or higher unemployment; nor should it involve unsustainable wage growth built upon a bubble. The solution is to have prudent economic management that aims for sustainable wage growth, sensible government intervention in the economy to boost spending when necessary, a progressive taxation system that reduces inequality and a strong safety net that helps people get back on their feet and prevents an excess supply of labour. This Keynesian approach might not eliminate all booms and busts – they may indeed be an inevitable feature of capitalism as Marx said. Yet it can reduce the extreme volatility of capitalism and make crises less likely. This is the approach Australian Labor governments have largely followed. It is also the approach Obama has tried to follow (though he has had to negotiate with ideologically blinded austerity obsessed Congress). And the results in Australia and even the US are far more promising than Europe.

Any attempt by a potential future Abbott government in Australia to change from this path more towards an austerity path should be a cause for concern. It would be a triumph of small government ideology over doing what works. Europe has shown that the game is up for austerity hawks. Economic theory now needs to shift to the left, in line with what works.

Elliot Brice has studied economics at the University of Melbourne and is currently studying to be a high school teacher at the same institution. He also has an Honours degree in philosophy.