When Is Austerity Necessary At The Treasury?

I have made clear in the past that I believe that the time for austerity at the Treasury is the boom, not the slump.

However this is a very general and non-specific definition. I want to be a little clearer and more specific.

First, I think it is important to define austerity. Government is a two-way street. It sucks in money through taxation, and it pushes out money into incomes through spending. Net government spending is the net of these two figures. Austerity in a technical sense happens when the change in net government spending turns negative either through spending cuts, or through tax hikes, or a combination of the two.

Second, I think it is important to specify that this is not a debate about the ideal size of government. This is a debate about the short-term government spending and taxation trajectory, which is a very different subject to one’s ideal size of government. It is possible to favour very small government in principle, but at times oppose austerity. It is also possible to favour large and expansive government, and at times support austerity.

Now, to be very clear: the time for austerity at the treasury is the time when government activity is crowding out the private sector. When does this occur? Well, the clearest example that I can think of are World War I and World War II. It is easy to imagine how government can smother the private sector in times of war; resources are centrally controlled and directed to the war effort, labour and capital are directed away from productive activities and toward fighting, toward building bombs and weapons to destroy things. There is little slack in the economy, as in total war the state commandeers as much of society as it possibly can toward the war effort. Notably, austerity programs that massively reduced the size of government following the two world wars were successful, and did not have a long-term downward impact on growth.

In peacetime, it is also possible for the government to crowd the private sector out of the economy, in a similar way. By commandeering large quantities of resources, labour and capital, governments can leave little for the private sector to use to create, build and invent.

The two most important parameters to determine whether a government is crowding out the private sector are labour markets and capital markets. In the broadest sense, the specific parameters are interest rates and the unemployment level. When the private sector is being crowded out in labour markets, unemployment falls to a low level, as the government is utilising all the slack. When the private sector is being crowded out in capital markets, interest rates rise to a high level, as the government is utilising all the slack.

Today, both in Britain and the United States unemployment is elevated (meaning labour is freely and readily available) and interest rates are very low (meaning capital is freely and readily available). First, Britain:


Second, the United States:


What this means is that in a technical sense — and irrespective of one’s preconceived notions of the ideal size of government — government is not crowding out the private sector. There is plenty of slack in the economy in both labour and capital markets.

Yet in another sense — unrelated to spending — governments may be slowing private activity. By imposing high legal and regulatory barriers to entry, governments can slow business investment and prevent new businesses from forming, and the unemployed from becoming self-employed. Given the massive growth of legal and regulatory burdens in certain industries favouring only large and old competitors who can hire lots and lots of expensive lawyers, it is extremely likely the case that there are some negative effects. The OECD noted in 2006 that “administrative simplification and reducing administrative burdens are a very high priority for OECD member countries”, and red tape levels have grown in both sides of the Atlantic since then. I have repeatedly suggested that in the current economic environment governments ease the regulatory and legal burden for small and new businesses in particular to foster competition and lower unemployment.

However cutting back on red tape is a totally separate matter to fiscal austerity, which in the current environment by definition takes an economy with significant capital and labour slack, and creates even more slack.

The time for fiscal austerity at the treasury is a time of high or rising interest rates and low or falling unemployment, and especially when interest rates are higher than the unemployment rate. The reality is that most of the Western world has the opposite of that right now.