Austerity & Taxation

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.

From the Economist:

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.

After all, it has worked well so far for Iceland

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23 thoughts on “Austerity & Taxation

  1. Hey

    Been listening to the audio book of Frédéric Bastiat’s “The Law”. I figure you might have already read/listened to it, but if not you may consider his thinking worthy of your opinion and consideration. He speaks, like you, not so much about particular people or companies or even policies in as much as he speaks about “systemic” problems to do with ideas, etc. I would be most fascinated to hear your take on this book in any case.

    A quote from the book I like:

    “They (those who ruled in ancient times) did not understand that knowledge appears and grows with the passage of time, and that in proportion to this growth of knowledge, might takes the side of right”

    • Bastiat was a genius. I need to incorporate more opportunity cost analysis into my work, because it is a very important concept that has gone missing from modern economic literacy. The only time I have quoted Bastiat in this blog is when Krugman started talking up the “fake alien invasion for aggregate demand” scenario. I am not worth of the comparison.

  2. What about 1920-1921 recession.. in was over in less than a year.
    I know what your answer will be – but in 1920 usa was a creditor and there was not that much debt.
    My answer would be debt won’t count for 1-2 years, because anyway the interest set by the Fed is 0% , and the Fed most probably wont need to print that much money anyway.
    The foreigner would have been very willing to buy Ty’s because if there were no spending, there is no need for big devaluation of the currency.

    So cutting spending w/o increasing taxes would work if the transition period is short, which it will be, because whoever didn’t pay attention will be bankrupt.
    Again my proposition would be for government increase in spending to be only to help the really poorer and workers who have to transition, that is it.
    With clear mandate of when the booze stop.
    All the other bailouts,spending, should be abandoned and most of the current spending cut to at minimum pre-crisis levels.
    If big companies have to be saved, there is bankruptcy for that … split those companies and sell them. Not that there is no people with enough money that will step to by the parts on the cheap.
    Mind you those will be the ppl who correctly predicted what will happen and they wont be expecting ‘booze’ from the gov.
    Of course there will be carnage, but it would have been shorlived and deep.
    What we got now or in general what your proposition for the gov to step hard on spending… we get prolong exhausting crunch.

    It is like having a tooth pain and curing it by getting drunk, instead of going to the dentist to fix the reason (which is painful for a while but solves the problem).

    The other benefit on short vs. long crisis is that some ppl can protect themselves if they have some savings to weather short period, not so for protracted one.

    • I know what your answer will be – but in 1920 usa was a creditor and there was not that much debt.

      Not bad. That is my answer. I’d hasten to add there is another factor: rates of dependency. In the early 20s, the dependency was not there like it was today. Simply, there wasn’t much to cut. Today, it’s messier, because there are hordes and hordes of people — some of whom can’t just find a job, e.g. the retired or the disabled — who will feel cuts the instantly, spending will fall and thus so will revenues.

      All the other bailouts,spending, should be abandoned and most of the current spending cut to at minimum pre-crisis levels.

      Yeah, I mostly agree with this. Of course, the money saved is disbursed back to the taxpayer. The difference with the austerity nations in Europe is that the money is not disbursed back into the real economy, but instead transferred to creditors, any of whom are overseas.

      What we got now or in general what your proposition for the gov to step hard on spending… we get prolong exhausting crunch.

      I’m not actually suggesting government increase spending. I’m not Paul Krugman. I just don’t want to see any more countries adopt the European austerity regime, because it is clearly the worst of all worlds. I’m for the Icelandic model; default, as soon as possible, and as much as possible. As far as I’m concerned that is the shortest-term solution. Reducing the debt overhang solves the whole problem. It will be difficult to get creditor agreement on this, but I think as the benefits of such a solution become more apparent, creditors will, I think, open up to the possibility, as ultimately if the entire economy benefits, they will benefit too.

      • Ok, then we almost agree then … ;)
        I think the medicine should be austerity with a little mix of spending…
        You think it should be abit more on the spending side rather than outright austerity……
        Krugman believes it should be outright spending.

  3. Iceland is not Greece. The Culture is different and the people are different too. Remember this that the Asians – S. Koreans, Indonesians, and the Thais were all went through austerity measure during the 1997 Asian financial crisis and they all came out better. But the Greeks won’t do what the Pacific Asians did that is re-start over again: pay cut and work a lot harder to pay off debts and grow again.

    Or is it because that fact that even if they can and will they couldn’t because they in the Euro Zone?

  4. S. Koreans, Indonesians, and the Thais were all went through austerity measure during the 1997 Asian financial crisis and they all came out better.

    That’s very debatable. Again, there were dropoffs in tax revenue due to lowered spending. But the key here is actually that S.E. Asian nations had very high domestic savings rates. And savings rates dipped during austerity, as people needed to spend more to get by. The nations now prescribed austerity are debt-ridden, at every level, public and private. And — as Stiglitz pointed out at the time — the bubbles actually came about in S.E. Asia because of inflows from global credit markets, not because of domestic bubbles or malinvestment. It was very much a case of punishing Asians for the misdeeds of Wall Street. The same thing is true of most of the bubbles in the Eurozone periphery; burst real estate bubbles that were stoked by foreigners and bankers.

    Or is it because that fact that even if they can and will they couldn’t because they in the Euro Zone?

    Yeah. Europe is nothing like an optimal currency zone. And i think a lot of the fallout is assymmetric, to the extent of being unfair: Greeks are already working almost the longest hours in Europe:

  5. The more I think about there is no way out other than default. Debt is fragile and will keep breaking the system until it is expunged.

  6. I like the idea of default after all this is supposed to be part of the risk when loaning out money. However the default by governments would result in what exactly? Major banks and institutions would lose their money and the chain of debt default would look like what? Who would be affected?

    • There are three or four kinds of default.

      A traditional default would destroy the international financial system via default cascade, leading to a global credit freeze, and would force the world to work out a new financial order. This is extremely risky (could lea to war, etc) but inevitable if we fail to get a handle on the problem.

      A negotiated default could potentially sustain the current system, if creditors and sovereign debtors could really get together and reach workable compromises in the interests of financial stability. This is extremely politically unlikely.

      Transforming debt into equity is another possibility. Simply, all of those owed money would get a claim on sovereign assets (say, a certain amount of upvalued gold, or a certain amount of land). While I do not think creditors necessarily deserve this “pound of flesh”, it would transform the financial system into something much more sustainable.

      Finally, there is hyperinflation, which is very much like a traditional default, but possibly even messier still.

  7. What about the cost of default? For creditors more than for bankers I guess. And I’m not sure if devaluation will really benefit Greece given their low productivity, at least for the past 15 years.
    What if Germany bails them out, or if the EU allows them a 5-10 years structural reform?

    I have a question too, I’m not that experienced. How does the currency get replaced?

  8. What about the cost of default?

    A paper from Jeffrey Rogers Hummel shows that — in the longterm, compared to other options — default appears to be relatively cheap:

    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.

    Now, as I outlined above, there are a variety of different kinds of “default”, some of which appear messier than others. Certainly, if the U.S. announced tomorrow that it was just going to stop paying back its debt, this would be a disaster.

    How does the currency get replaced?

    You mean in the context of Greece?

    From the BBC:

    If Greece were to act unilaterally and just do it, the so-called “nuclear option” involves introducing a new currency – the new drachma – and letting supply and demand do what it does.

    In this case, probably more supply than demand.

    “The new currency would fall through the floor and inflation would go through the roof,” says Peter Dixon, an economist at Commerzbank.

    It would be a legal minefield, as basic financial transactions such as mortgages would have to be redenominated. But that would not be the end of it.

    “Living standards would be hit hard. It might seem like an attractive option, but the short-term costs are massive.”

    Wouldn’t banks – who have already agreed to take a “haircut” of 50% – just accept the devalued new drachma-denominated debt?

    “Well, no, because it may well halve in value again,” Mr Dixon says.

    The assets of banks inside Greece and those outside holding Greek debt would be devalued. And of course, they would not be able to borrow commercially.

    Greece would probably have to impose capital controls to prevent all the money leaving, much as Malaysia did in 1998 after the Asian financial crisis.

    So in the best-case scenario, Greece would have no buying power, everything would be extremely expensive and it would also be broke.

    So it would be very painful. But as the drachma falls, we would finally reach an equilibrium where tourism and investment start flowing back into Greece. Simply, the cheapness of the currency would stimulate demand for Greek goods and services and assets. Slowly, things would recover.

    • Wouldn’t a German bail-out be less expensive? Given structural reform imposed by Germany and EU?
      I mean Greece was not really productive for the past decade or so, and social costs of the default might cause uncertainty that would still keep investors and tourists away?

      • To fully bail out Greece would cost far more than Germany would be able to agree to. They’ve had enough problems and discontent with the first two bailouts.

        And now Juncker says we may need a third. And these bailouts are just to keep things ticking over, so they do not default in March. What abut next year? And then what about Spain, Italy and Portugal who are facing many of the same problems? Bailing out Europe — as Zero Hedge have noted many times — is far too costly.

        What uncertainty is there about a default? Greece defaults, reintroduces the drachma, and that’s it. That causes a lot of problems, but it is a resolution to the uncertainty. It is better to default now than to default in five years time when Greece and Europe may be much weaker. The “uncertainty” comes from Greece staying in the Euro, and needing continual bailouts that always come with forced austerity that actually makes the problem worse.

        And I’m not even sure Greece can be fairly called “unproductive”. Look at the chart I posted above. They’re working the second most hours in the whole of Europe .

  9. Pingback: Nassim Taleb’s Big Idea: Transforming Debt Into Equity « azizonomics

  10. Here is a solution. Reduce Taxes, balance the deficit by reducing admin workers in the government. These workers then have to apply for jobs, and perhaps could use their savings (They are Government workers, they must have savings) to reeducate themselves and find gainful employment. Because business has a new pool of literate skilled workers, they can opbtain financing (Debt or equity) and pursue new market opportunities.

    The amount of taxes, regulation/red tape is suffocating small business. The business that starts in a garage and grows into a multinational organisation (Apple, Microsoft etc)

    Reducing the government will never work because of the Government Sector Unions, holding government (left and right) to ransom.

    I am starting to think Africa might be the “New World”. Vast mineral wealth, plenty of cheap labour, and after speaking to many African Engineers, Geologists etc, they are keen to learn and work. If we can find a country uncorrupted by Socialist ideals, I think Capital will move to Africa.

  11. What about the cases when “austerity” and “fixing the economy” cannot be separated (i.e. let’s just wait for the recession to pass)? What if (as in Greece) a whole chunk of the economy is unsustainable and built around structures and propensities that are deeply intertwined with the state apparatus?

      • “while maintaining spending levels”

        Uh, but we’re now getting into a whole different discussion: spending. I thought we were merely talking about whether to cut or not cut. If we get to spending, a whole array of other issues will spring up, but the main one would be: what if you’re spending on keeping a bubble inflated and a whole unsustainable structure of the economy in place? What if the US debt increase in the last 5 years is merely the bill came due for a decade of bubbles and unsustainable economic enterprises?

        • Yes, but the whole discussion on austerity is about spending. My objection is that falling spending levels in a recession (i.e. austerity) will generally lead to falling tax revenues, which will often lead to bigger deficits.

          I don’t know if you ever read my post on how I can be opposed to Euro austerity but support Ron Paul, but I think that’s a fairly clear example. Cut the unproductive and wasteful crap (foreign military bases, etc) but make sure that money still goes into the real economy, and not just to foreign creditors in paying down debt; build roads, trains, improvement internet, give tax rebates, tax cuts, etc.

        • OK, but then I understand that you’re not so Krugman-like, and you’re actually pro-austerity. Krugman (Summers, most Keynesians I think) would not want to cut anything; Krugman would only want to spend, spend, spend, and hope for the economy to magically recover. The only difference between your version of austerity and the Euro-austerity seems to be (to me) the fact that the Euro-austerity is badly managed and also doesn’t take into account the human factors (what is doable given the constraints on the ground).

          Of course, there are other issues with what you’re saying above like: are we suggesting the existence of an omniscient being that will know exactly the things to spend on, and what IS the real economy? Aren’t we getting to the Chinese model where the leaders decide what’s productive and unproductive (the model that supposedly reached its limits and should become more free-market-oriented)? Also, could this plan even be put into practice? What if the real economy is intertwined with the wasteful one? Is it possible that this omniscient being will need to be all-powerful so as to be able to reconstruct the economy from a billion scattered lego pieces into an economy that is “productive” and “sustainable”? I’m not saying these issues render your ideas incorrect, and certainly, some EU leaders begin to lean towards what you’re saying (a Marshall plan for Greece etc.) – though the alternative to these would be the “creative destruction” (a concept I understand you support). A “creative destruction” in this case would be a depression. Why fear it so much? Could it be that the Keynesian policies of trying to smooth the slightest recessions lead ultimately to such intractable situations where we have to choose between full-blown depressions and masterfully designed Marshall plans?

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