Alarming Report on European Crisis

One of the main flaws with Austrian economics is that it pays absolutely no attention to the actual working of an economy. From its founder, Carl Menger, and on leading Austrian theoreticians have worked hard to thoroughly isolate their theory from reality. As a result of this effort to keep the world at bay, they have become exceptionally useless as policy advisors; the Russian disaster decade, from the fall of the Soviet Union to the turn of the millennium, followed a strict implementation of Austrian theory as brought to the Russian leaders by two Swedish economists.

I recently reported on another example of how Austrian theory falls to the ground when confronted with reality. Phillip Bagus, professor of economics at the King Juan Carlos University in Madrid, Spain, claimed that a shrinking GDP is actually desirable. This notion that things get better in the long run when everyone is made poorer today (and tomorrow, and the next day) is widespread among Austrian theoreticians. Conveniently escaping the question “when” the “long run” comes about, they jump through economic hyperspace and make ridiculous arguments about how austerity is good and Europe needs more of  it.

Austrian theoreticians rely heavily on the so called Say’s Law. Put simply, this law dictates that any new investment in production capacity will automatically generate demand for whatever that capacity can produce. This is why they believe that austerity, which destroys economic activity today, will benefit everyone in the long run (though to get the full theoretical chain worked out one has to add their surreal theory of the interest rate).

The problem for the Austrians is that whenever their theory has been practiced, it has failed utterly. The aforementioned Russian decade of destruction is a great example – it took ten years before the Russian economy was producing on par with what the poorly managed, inefficient Soviet economy was able to crank out at the end of its life. Countries that did not take the destructive Austrian route from Communism to economic freedom did much better: East Germany, Czekoslovakia (later split into two nations) and Hungary are the best examples.

The Chinese economic success rests in part on the choice to actively and patiently transition from one system to another.

But it is not just in the realm of active destruction that Austrian theory can do harm. It has played a role in the definition and execution of austerity in several European countries over the past few years. Aforementioned economist Phillip Bagus from Spain raves about his country’s austerity.

When reality checks in, with tens of millions of people being hurled into poverty, misery, financial despair, hunger and hopelessness, the Austrianites are nowhere to be found. They have gone both scholarly and morally AWOL, which should be a wake-up call for anyone and everyone interested in economics and economic policy. An economist who is not willing to take moral responsibility for the effects of his policy advice should go look for another career.

As a contrast, I want to once again express my respect for Olivier Blanchard, chief economist at the IMF, for his courageous mea culpa after the IMF got it so wrong on the effects of austerity in Europe.

While the Austrian theoreticians vanish from reality, others step in and paint a picture of the waste and destruction that follows in the footsteps of austerity. The latest contribution is from Caritas, the charitable arm of the Catholic Church.  A new report from Caritas Europa conveys the image of an economic wasteland:

The prioritisation by the EU and its Member States of economic policies at the expense of social policies during the current crisis is having a devastating impact on people – especially in the five countries worst affected – according to a new study published today by Caritas Europa. The report finds that the failure of the EU and its Member States to provide concrete support on the scale required to assist those experiencing difficulties, to protect essential public services and create employment is likely to prolong the crisis.

What Caritas is saying here is precisely the same thing as I have been pointing to ever since I published my book Remaking America three years ago, namely that in times of crisis, governments that take to austerity will always default on promises to those who depend on government. This is really not very difficult to understand, but politicians from all over the industrialized world fail utterly to understand this.

Some are motivated by Austrian theory to turn a blind eye to the effects of austerity. Others do it because they are under the false impression that a balanced budget is more important than to keep government promises.

They all have one thing in common, though: they believe in short-term, immediate solutions to long-term, complex problems. More on that in a moment. Right now, let’s go back to Caritas:

The report “The Impact of the European Crisis“ is the first to provide an in-depth examination of the impact that current policies are having on people in the five EU countries worst affected by the economic crisis. It presents a picture of a Europe in which social risks are increasing, social systems are being tested and individuals and families are under stress. The report strongly challenges current official attempts to suggest that the worst of the economic crisis is over. It highlights the extremely negative impact of austerity policies on the lives of vulnerable people, and reveals that many others are being driven into poverty for the first time.

This is the truly troubling, two-pronged effect of austerity: first, it leaves the most vulnerable people out in the cold – the very citizens for whom the welfare state was constructed in the first place; then it devalues the standard of living of a large portion of middle-class working families. Unlike the poor, who are left to basically fend for themselves at the mercy of whoever passes their street corner, the middle class still has resources to prioritize from. They also pay taxes. When they see that they get less or nothing from government when they really needed it, and when they see that their taxes are as high as before – or even higher – they drastically change their economic behavior. They refrain from long-term spending commitments, such as a new house, a new car, appliances for their home, etc. Private spending is depressed, causing more job losses and solidifying the crisis.

The devaluation of the middle class is one of the most important features of Europe’s transformation from post-industrial prosperity to industrial poverty. It is refreshing to find well-done research on this in the Caritas report (get the full 68-page version here).

Caritas again:

The report’s conclusions are based on the unique grass-roots perspective of Caritas organisations working with people experiencing poverty. Its principal conclusion is that the policy of prioritising austerity is not working and that an alternative approach should be adopted. It points out that the authorities have choices that they can make in deciding what policy approaches to use, and how various measures are targeted. It calls for a fair solution to the debt crisis to be found.

This is where Caritas goes wrong. Their policy recommendations are essentially focused on reinforcing, not to say reinvigorating, the welfare state:

Economic and social policies must be integrated at EU level to a much greater extent
Stronger leadership is required at EU level for groups at risk of poverty, focusing on child poverty and youth unemployment
Social Monitoring should be put in place for countries in EU/IMF Programmes
EU Funds must play a bigger role in addressing poverty
The EU must increase the involvement of Civil Society Organisations in Governance

The answer to Europe’s crisis is not more government. It is less government. However, rolling back government is almost an art in itself. Done wrong – as in austerity – it causes more problems than it solves, without any prospect of any kind of recovery on the horizon. While an Austrian economist would tell the deteriorating European middle class that their private finances are going to improve “in the long run”, a Keynesian economist would insist that the Austrian present even a shred of evidence for his claim.

The cold, hard truth is that Austrian theory relies critically on the notion that a dollar less spent today is a dollar more spent tomorrow. The reallocation over time is governed, they say, by the natural interest rate. However, they have no method for defining the “natural” interest rate that will also allow them to prove that this intertemporal reallocation actually takes place.

In practical terms: the Austrian theorist who lends credibility to austerity policies has no way of explaining to a middle-class family, whose livelihood is in jeopardy due to that very same austerity policy, when and how they will be able to turn a corner. Granted, the free market is a spontaneous institution, but spontaneity is not the same as lack of evidence, foresight or structure.

Furthermore, history offers many credible examples of how an orderly transition from big government to economic freedom can actually work. The European section of the former Soviet sphere offers, again, plenty of examples of how that orderly transition can take place. It applies, obviously, to the transition from a Communist command-structure economy to a traditional European welfare state. But it also applies to the transition from that welfare state to full economic freedom: the key is always to provide a predictable pathway, where economic institutions change in a way that does not cause uncertainty but instead encourages private citizens to become consumers and entrepreneurs.

In my book Ending the Welfare State I explain what policy models can help us make this transition into economic freedom. I make a big point out of designing the transition so that the poor and needy:

a) do not suffer immediate financial hardship as government terminates its programs; and

b) are given a good chance to provide for themselves, on their own terms, in the new system.

The choice between reckless Austrian-based austerity and a sound, Keynesian path to economic freedom is not just one for Europe to make. The European crisis can tell us a lot about what we should and should not do here in America. Even though our economic outlook right now is notably better than it is in Europe, that does not mean our fiscal crisis is over. The federal budget deficit is still staring us in the eyes every morning, with irresponsible spending cuts and tax hikes on the horizon.

We need to make a different choice than Europe. We need to create a credible, sustainable path to limited government – and then stay the course.


  1. maxalexwell

    “This notion that things get better in the long run when everyone is made poorer today (and tomorrow, and the next day) is widespread among Austrian theoreticians” You are confusing not spending money for being poorer. The money doesn’t disappear if it isn’t spent, it is saved and used to increase production though investment. More and cheaper goods result.

    • S R Larson

      This is a common argument among Austrian economists. Here is one example of an Austrian economist who applauds shrinking GDP based on precisely the same argument as you are making:

      The problem is that the intertemporal price mechanism that Austrian theory relies on simply does not work. Even if we assume that we have a “natural” interest rate, you must still explain how, so to speak, a decision by Joe the Plumber to not expand his business today is also a decision to expand the same business at a specific date in the future.
      Keynes makes an excellent argument on this point in Chapter 16 of The General Theory. His conclusion is that when economic agents – he does NOT mention government – contract their activity today, it exacerbates uncertainty and pessimism in the economy and therefore weakens the case for a recovery “tomorrow”.
      You might also take seriously Keynes’s question about “when is the long run”. I know of at least one world-renowned economist who claims that the long run, as defined by Say’s Law, is one hundred years. Do you agree?