Tuesday, April 10, 2012

Europe needs spending cuts, not tax increases

With Spanish and Italian yields surging, and with Spanish equities yesterday hitting a new post-March 2009 low, the Eurozone crisis appears to be entering yet another panic phase.

The basic problem is that while the ECB's recent efforts to provide sufficient liquidity to the banking system have improved conditions dramatically, the underlying problem facing the Eurozone has not yet been addressed: How exactly are the PIIGS countries going to implement the severe austerity measures that investors are begging for; how are they going to address their huge deficit spending problem? 

As I mentioned in a post last week, the problem with austerity is not so much the proposed cuts to government spending, but the proposed increases in taxes: 

It's tax austerity that is creating the problem: Spain's desire to raise taxes in order to help reduce its fiscal deficit—at a time when the economy is struggling and unemployment over 20%—is likely to harm the economy and aggravate the deficit, rather than reduce it. Raising taxes is the problem because that is basically an attempt to validate a level of spending that is already way too high; furthermore, it asks the weakened private sector to carry an additional burden and spares the bloated public sector from needed adjustment.

With a HT to Greg Mankiw, there is serious academic research by Alessina and Giovacci to back up my claim:

The accumulated evidence from over 40 years of fiscal adjustments across the OECD speaks loud and clear:
First, adjustments achieved through spending cuts are less recessionary than those achieved through tax increases.
Second, spending-based consolidations accompanied by the right polices tend to be less recessionary or even have a positive impact on growth.
These accompanying policies include easy money policy, liberalisation of goods and labour markets, and other structural reforms.
There remains a lot of work to be done on identifying the appropriate accompanying policies and understanding the channels through which they help spending-based stabilisations, but the fact is there, as shown for instance in a recent paper by Roberto Perotti (2011).
Third, only spending-based adjustments have eventually led to a permanent consolidation of the budget, as measured by the stabilisation – if not the reduction – of debt-to-GDP ratios.

And here's the key point: "... we should stop focusing fiscal policy discussions on the size of austerity programmes. A relatively small tax-based adjustment could be more recessionary than a larger one based upon spending cuts. Likewise, a small spending-based adjustment could be more effective at stabilising debt-to-GDP ratios than a larger tax-based adjustment."

If the economists and politicians of Europe are not brain-dead or totally ignorant of the facts behind successful fiscal adjustments, they will do the right thing and focus their efforts on spending cuts rather than tax increases. Doing the right thing is always the sensible thing, and in this case, the only thing that has a chance of working. Doing the wrong thing at this point is almost unthinkable.

How hard can this be? I refuse to believe that there will be massive Eurozone defaults and subsequent financial and economic chaos spreading throughout the world. The solution to today's problem is far easier and less painful than the consequences of failing to find a solution.

And by the way, the U.S. needs exactly the same kind of solution.


Anonymous said...

Europe needs to ditch the Euro. That is the fundamental problem.

Right now, Germany needs a stronger currency because it has a relatively strong economy (with rising inflation and wage pressures), while the PIIGS need a lower currency to fend off threatening deflation and to make their wages more competitive. But since they all have the same currency, this desired outcome is going to be extremely difficult to achieve.

The only silver lining is that wages in Germany might rise high enough to push work out to the peripheral nations ... but by the time that happens it might be too late. If the Euro had never been adopted, these things would already be sorting themselves out.

Rob said...

"How hard can this be? " ... Empires rise and empires fall ... they fall because they find adjustment to a new reality "too hard" ... in the modern world we hope to use collaboration and co-operation to mitigate the worst effects of empires crashing ... but it does seem that the European mentality is too deeply entrenched in the belief that "the world owes us a living".

Hope I'm wrong. But remember, my dear Californian Optimist, sometimes the real optimists are the pessimists, because they are prepared for the worst.

Anonymous said...

Unfortunately we see tax increases all over Europe. Yesterday the government of Czech Republic decided to increase income taxes and VAT to new highs. ( VAT rate to 21%; Income tax will be increased from 15% to 16% with an additional contribution for high earners ).

McKibbinUSA said...

Defining austerity is always postponed until after austerity is approved as a strategy, which is why austerity rarely works -- spending cuts are essential, but tax increases are too easy for governments to pass -- what we see happening in Europe is coming to California in the near-term -- all eyes should be on the debate in California today over tax increases versus spending cuts -- Gov Brown is devoting his governorship to raising taxes versus spending cuts, and the judiciary is giving him plenty of help -- what happens in California will define America in the coming decade...

Hans said...

This malfeasance requires a political solution...

Socialists, have repeatedly demonstrated their utter contempt for free enterprise and economic literacy...

The solutions are painfully simple; economic theorists can stay in the lab..

The great pretender, The Euro, a bane to capital and capitols alike..

Gloeschi said...

The "stimulus" packages were great for the stock market. But now "reverse stimulus" is still a reason to be bullish, right?
Regarding the "easy and simple" solution (austerity), why don't you talk to Krugman - he thinks the opposite (austerity is the cause of the current economic problems).
"Tax austerity" = bad, "Spending austerity" = good? From the viewpoint of the deficit, a dollar not spent is the same as a dollar additional taxes. The difference being that spending cuts hurt the poor, while tax increases hurt the rich.

"I refuse to believe that there will be massive Eurozone defaults". Better start believing now.

Frozen in the North said...

Sorry but I completely disagree, the solution preached here (and I use the word preached advisedly) is the same old pablum being preached by the American Republican for every kind of illness.

Cutting spending is certainly a good idea, but when unemployment is around 25% and the government spending accounts for more than 50% of the economy cutting fast and furiously is not always the solution...

For many European countries the first problem is competitiveness -- internal devaluation is rarely successful (despite what the right believes) it usually ends with non-democratic solution (look at Italy today).

Cutting government expenditure, reducing red tape are all worthwhile ideas, but to work they have to be part of a greater solution. In otherwords society as a whole has to particiate in the pain of change.

This is too often forgotten -- as it is here! where cutting expenses is the end all and be all of the solution to Europe's problems

Benjamin Cole said...

I agree with Unknown.

In addition to federal government limited to some percent of GDP--say 20 percent---Europe needs to go back to national central banks.

Greece, for example, needs to balance its budget and print a lot of drachmas.

But with its economy ailing, with feeble tax collection and state workers getting pensions at age 50, Greece can neither balance its budget nor print money.

Kiss Greece goodbye for a generation. Under "austerity" programs their national debt to GDP ratio has gone from 100 to 165 percent.

The USA still has a central bank, so we are better off. We spend much more than Europe on defense-homeland security-VA, about 7 percent of our GDP.

We have some federal workers, in uniform, who can retire at age 38 into lifelong pensions and taxpayer-paid medical care. Greek railway workers would blush at such a plan

No one on the right calls for cutting our corprolitic defense-homeland security-VA complex, and no one of the left wants to cut entitlements. Even the ballyhooed Ryan budget has no cuts at all for the $1 trillion a year we spend on defense,home and security-VA. That's more than $13,000 a year for a typical family of four. Every year.

The Fed will not do much to boost growth--monetizing debt (as Milton Friedman advised for Japan) would boost the economy and help us deleverage.

The DJIA is waffling again, back still at 1999 levels.

Good luck investors.

Benjamin Cole said...

Below is list of largest federal agencies financed by income taxes. Where should we cut?

Defense 3,200,000
Veterans Affairs 240,000 

Homeland Security 200,000
Treasury 162,119 

Justice 124,870 

USDA 100,000 

DOT 100,000
Health and Human Services 62,999 

Interior 57,232 

Commerce 41,711 

NASA 19,198 

EPA 18,879
State 18,000 

Labor 16,818 

Energy 14,000 

GSA 14,000

Squire said...

Don't cut a dime from defense until there is a rational energy policy in place.

Bill said...

How did the world survive when yields were 18% back in the late '70s and early '80s?

Benjamin Cole said...


You can't carry oil in aircraft carriers.

The defense budget is largely waste, patronage, coprolite and pensions.

Remember, you have had decades and decades of an organization growing, but without any market competition. No creative destructionism.

The Defense Dep't spends $80 billion a year just on R&D, and they say they have nowhere to cut, even in a national fiscal crisis. Really--we can't halt R&D for a few years? Really? As the terrorists are becoming so much more powerful and sophisticated? They are flying stealth bombers now?

Defense is running about 40 percent higher, adjusted for inflation, than when Reagan was spending like crazy to beat the Russians--an enemy that actually had serious military ability.

Like any federal agency, Defense, Homeland Security and the VA are now largely wasteful. No different from Labor, HUD or Commerce, USDA.

We need a ground-up re-do. Ask some think tanks to devise defense budgets at 1 percent of GDP and see what they come up with. It can be done, and must be done.

Squire said...

I want to see liquid fuels given priority. You can convert coal to liquids for all I care. A good thing would be compressed natural gas.

Chaos theory rules the current government. They don’t want to fix the energy problem. Having things go bad allows them to claim they the populous needs them to save them.

Fix the energy problem and you fix the defense budget.

My very small super high tech manufacturer client does work for the military. I also believe high tech should be the way to go for the military. It is expensive, but less so than bulk munitions. High tech can reduce the budget a lot.

McKibbinUSA said...

@Squire, we need 90% cuts in defense spending and entitlements -- defense spending and entitlement spending are both lard that needs to be cut -- the US needs more freedom and 90% less government -- neither defense spending nor entitlements get a pass this time around...