In Europe, time for true austerity

Talks to form a coalition government in Greece collapsed again this week as a result of the country’s belt-tightening backlash. The country now faces an unpleasant dilemma: agreed-upon austerity measures in exchange for bailout funds, or a messy default and exit from the Eurozone. Greece’s deteriorating situation raises many questions about whether austerity is the right path for other struggling European nations trying to avoid this same fate.

For several years now, European governments have tried versions of austerity — usually understood as an attempt to reduce the ratio of government debt to gross domestic product — in hopes of reviving the continent’s flailing economies. But not only have their efforts failed, we’re now told, they have actually made things far worse.

According to one naysayer, former Obama administration chief economic advisor Larry Summers, austerity efforts are “counterproductive” to growth. In a recent Bloomberg TV interview, Nobel laureate and economist Paul Krugman said, “I wish I’d been wrong for the sake of the world” about his prediction that “Austerians” pushing for fiscal retrenchment would destroy Europe. This sentiment is echoed in countries such as the Netherlands, among others, which have announced they will start spending again. And newly elected French President Francois Hollande’s victory was pegged to his absolute rejection of austerity measures.

There are two basic problems with this growing anti-austerity backlash. First, where spending was actually reduced, the cuts have been relatively small compared to the size of the problem and meaningful structural reforms were seldom implemented. Second, to the extent declining Europe countries pursued austerity, it has mainly been through large tax increases. If the economies of Spain, France, Britain and other European nations are suffering, it’s not because of “savage” spending cuts. It’s because small spending cuts are overwhelmed by tax increases.

Consider Britain, where supposed austerity measures represent a “stunning failure of policy,” according to Krugman in his New York Times column. In 2009, British Prime Minister Gordon Brown promised he would reform social programs and dramatically cut spending and taxes. Instead, he increased the top marginal income tax rate shortly before he left office. When David Cameron replaced him in 2010, he promised to pursue the same austerity measures. However, in 2011-12, spending increased from $1.15 trillion to $1.2 trillion, and public pensions have yet to be reformed. Instead, the government increased the capital gains tax, national insurance tax and value-added tax along with other fees and duties.

In Spain, the conservative party raised the retirement age from 65 to 67 in January 2011, but it has failed to implement comprehensive structural reforms. It was, however, successful in pushing through higher personal income and property tax rates in an attempt to balance its books. This year, the government has proposed reducing the deficit by $35.2 billion through a combination of tax increases ($16 billion) and spending cuts ($19.2 billion). But the spending reductions, even if implemented, won’t be enough to compensate for an overly optimistic growth rate. Although the increase of the corporate income tax will be real, so will the increase in public pension and unemployment benefits.

Then there are the French, who elected a Socialist president for the first time since the 1980s. Hollande wants to replace what he calls austerity with “pro-growth” policies. But there is nothing austere about France’s spending, which rose by $33.4 billion between 2009 and 2010 and an additional $29.5 billion in 2011. French public spending already equals 56% of GDP. Hollande’s own wishful projections show total tax receipts rising from 45% of the economy to 47% in five years thanks to his plan to impose a 75% top marginal income tax rate for those earning more than $1.3 million and an increase in the corporate income tax. If this is pro-growth, then garlic breath is pro-romance.

If the critics of austerity can’t find contemporary examples of where it’s been successfully implemented, they can look at history. Research consistently shows that successful attempts to reduce government debt ratios follow a single-minded devotion to actually cutting spending rather than just talking about it.

In a 2009 paper, Harvard economists Alberto Alesina and Silvia Ardagna looked at 107 examples in developed countries over 30 years and found that successful austerity packages — defined by a reduction in debt to GDP greater than 4.5% after three years — resulted from making spending cuts without tax increases. They also found that this form of austerity accompanied by the “right policies” (easy monetary policy, liberalization of goods and labor markets, and other structural reforms) is more likely associated with economic expansions rather than with recessions. This makes intuitive sense: Austerity based on spending cuts signals that a country is serious about getting its fiscal house in order in a way that taxing and spending certainly does not.

On the other hand, they found that the so-called balanced approach — typically a mix of spending cuts and tax increases — is a recipe for failure. It fails to stabilize the debt, and it is more likely to cause recessionary economic contractions. And when it comes to plans such as Hollande’s that would explicitly increase spending and taxes, they find little chance of either economic expansion or debt reduction.

As Britain slips back into recession, the Cameron government might want to remember that lesson. That’s what Italy is doing. After years of failing to cut spending, Italian Prime Minister Mario Monti has taken steps to reform the pension system, and he recently pledged to make $5.5 billion in spending cuts over the next six months to avoid a hike of the national sales tax from 21% to 23% in October. That decision came after Italy’s ministers tied the country’s deepening recession to the mainly revenue-driven $38.4-billion debt package adopted in December.

If the Italians actually want to revive their economy, they — and other Europeans — should hurry past the talking stage and abandon the so-called balanced approach to their situations. They must start actually cutting spending and reforming their bloated governments. They have nothing to lose but their debt.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.