One of the main conclusions of — on the one hand — Austrian economics, and on the other, Modern Monetary Theory is that it is bad and dangerous for government to take more out of the economy than it puts in, i.e. running a surplus. The two schools of thought take this idea to different conclusions; Austrian economics advocates for far less government in recessions, whereas MMT advocates for greater deficit spending in recessions.
Basing my conclusions on the disastrous austerity contractions of the Bruning Chancellery, as well as contemporary Ireland and Greece, I have already railed quite strongly against the concept of austerity during a recession. Readers have (understandably) been quite sceptical. The position I am taking puts me in line with Professor Krugman, and various other Keynesian characters. And I agree that every dollar spent by the government must be taken out of the economy in taxation. And, government spending is often (but not always) plagued with problems such as regulatory capture, mismanagement and malinvestment.
But the evidence is clear — heavily indebted nations that slash spending and (as in the case of Greece today) raise taxes to “pay down debt” actually tend to experience not just greater economic contraction, but also increased deficits as tax revenues dip.
This was the American experience during the Great Depression. A great deal of attention has been given to “monetary inflexibility” (i.e. keeping the gold standard) as a “cause” of the depression, but very little attention has been given to the fact that Hoover drastically raised taxes and cut spending in 1932, just as the depression really started to bite:
The onset of the Great Depression in 1929 led to a sharp decline in tax revenues, as the economy contracted. President Herbert Hoover’s response was to push for a major tax increase. The Revenue Act of 1932 raised tax rates across the board, with the top rate rising from 25 percent to 63 percent. That increase was justified on the grounds that the budget needed to be balanced to restore business confidence. Yet the $462 million deficit of 1931 jumped to $2.7 billion by 1932 despite the tax increase. Interestingly, the major cause of the deficit’s rise was a sharp decline in income tax revenue, which fell from $1.15 billion in 1930 to $834 million in 1931, $427 million in 1932, and just $353 million in 1933.
The bottom line here is that it cuts both ways: just as cutting spending in a recession can deepen the problems, so too can raising taxes. This is because both of these things can push the nation to a position where government is sucking in more than it is pushing out. When the economy is contracting, the last thing it needs is a bigger net drain.
So the problem here is residual debt. Governments have lots of it. When leaders like Cameron, Papandreou and Merkel propose austerity, what they are actually proposing is paying down debt, much of which is held off-shore. Very often their commitments to cut are attached to a promise to raise taxes. This means that governments are committing to suck in more (sometimes much, much more) than they are paying out, which is by definition contractionary. If governments were to default on their debt, this would be a different story — governments could then maintain any kind of regime, statist or non-statist, without the problem of sucking more money out of the economy than they are disbursing. But right now — even with Iceland’s positive example — default is considered to be politically unachievable, particularly in regard to the larger states such the U.S. and the U.K.
So it is very clear that governments embarking on austerity policies are making precisely the same mistakes as the Hoover administration 80 years ago. And, of course, as revenues drop due to the punishing austerity, the situation will only get worse.
Default will become increasingly attractive for the advanced economies.
Perhaps the most provocative paper comes from Jeffrey Rogers Hummel who reasons that default is virtually inevitable because a) federal tax revenue will never consistently rise much above 20% of GDP, b) politicians have little incentive to come up with the requisite expenditure cuts in time and c) monetary expansion and its accompanying inflation will no more be able to close the fiscal gap than would an excise tax on chewing gum. Most controversially, he argues that ”the long-term consequences (of default), both economic and political, could be beneficial, and the more complete the repudiation, the greater the benefits.”
Why does he take this view? Allowing for the Treasuries owned by the Fed, the trust funds and foreigners, total default could cost the US private sector about $4 trillion. In contrast, the fall in the stockmarket from 2007 to 2008 cost around $10 trillion. In compensation, however, the US taxpayer would no longer have to service the debt; their future liabilities would be lower.