Only Keynes Can Save Europe

Recently I have reported on the changing tone among Europe’s political leaders when it comes to austerity. The change came after the French government basically declared that it would not be able to unite around the same kind of job-destroying policies that the EU so viciously had forced upon France’s southern neighbors. But rather than admitting that their austerity policies have been a disaster for Europe, the Eurocrats simply shifted foot, declaring plainly that austerity had done its job.

Given the death of jobs and destruction of prosperity from the Aegean Sea to the Iberian peninsula, this is more than a little arrogant. It is political elitism coupled with a disdain for the lives of regular citizens.

It is, in one word, Eurotarianism.

If the EU Commission really cared about the citizens whose taxes are paying for their lavish lifestyle, they would pay a lot more attention to mundane things like, oh, the GDP growth rate of the euro zone. As technical and yawn-inspiring as that figure might be, it is still one of the best indicators of whether or not austerity is working. (Let’s not forget that Greece, Italy, Spain and Portugal are still enforcing austerity policies, despite the new words hot-airing out of the mouth of some Eurocrats.)

A good place for them to start learning about reality would be a recent article in Euractiv about the sluggish – to say the least – European economy:

The eurozone economy shows little sign of recovering before the year-end despite an easing of financial market conditions, European Central Bank Mario Draghi said … after interest rates were left at a record low. The ECB held its main rate at 0.75%, deferring any cut in borrowing costs … .

The common belief among parishioners of the Austrian school of economics is that so long as a government balances its budget a so called natural interest rate will emerge that will encourage entrepreneurs to invest and expand their production capacity. Regardless of the budgets of EU’s member states, if it was true that a low interest rate encourages investments, then a rate of 0.75 percent should have entrepreneurs all over Europe flocking to the banks.

Do you see that happening?

Neither does Euractiv, which reports that the ECB is also ready to keep interest rates down through its bond buying program:

The central bank has said it is ready to buy bonds of debt-strained governments such as Spain and Italy once they sign up to a European bailout programme with strict conditions, under a programme dubbed Outright Monetary Transactions (OMTs). So far no request has been made, but the announcement alone has calmed markets.

And is thereby keeping interest rates down. How surprising. The ECB has explicitly said that “we will use our money printers to churn out whatever trillions of euros it takes to buy every single treasury bond from Spain, Italy, Greece and Whateveristan, from now until Sweden freezes over”. When owners of even the junkiest of euro-denominated treasury bonds know that they can always get their money back, no matter how bad things get, then of course they will rest easier.

The problem is of course that at some point they will have had to print so much euros that owners of bonds outside the euro zone will want to secure the exchange rate of the currency. That becomes increasingly difficult if the ECB is going to flood the world with euros just to save its member states from the financial junk yard.

No one can say for sure when that point will come. Doomsday preachers have cast a spell on the U.S. dollar for years, yet it still stands relatively strong. That does not mean the doomsdayers are wrong – all it means is that we simply do not have enough examples of collapsing currencies to predict where either the Federal Reserve or the ECB will have printed too much money for their own good.

But long before we find that out, we will find out that the low interest rates the come with excessive money supply are not going to get the wheels turning in the economy. There is a very simple reason for that, which we will get to in a second. First, back to Euractiv:

Gloomy data this week indicated the eurozone economy will shrink in the fourth quarter, which the ECB could eventually respond to by cutting rates. Recent survey evidence gave no sign of improvement towards the end of the year and the risks surrounding the euro area remain on the downside, Draghi said. He signalled the ECB would downgrade its GDP forecasts next month, describing “a picture of weaker economies”, and said inflation would remain above the ECB’s target for the rest of the year, before falling below two percent during in 2013.

It is interesting that inflation is above two percent in an economy – the euro zone – that is at a complete standstill when it comes to GDP. While we will have to wait for the micro data behind the inflation number to know exactly where it comes from, my bet is that it is caused by tax increases and terminated government subsidies in austerity-ridden countries. The private sector is always quick to pass on such explicit and implicit tax hikes, even in tough economic times.

Pricing in modern economies is typically done on a mark-up basis where producers and seller review prices about two times per year. (If your microeconomics professor told you anything else, then I’m sorry for the rude awakening…) This means that if we have austerity measures being put into place this spring with a direct effect on consumer prices, we will see repercussions in inflation data for the rest of the year.

That said, inflation above two percent and interest rates at rock-bottom levels is actually – according to standard economic theory – a good recipe for investments. You see consumer prices on a slow upbound trajectory, which tells you that if you lock in your costs today you have good reasons to expect profit margins in the future. At the same time, with very low interest rates you have good reasons to believe that you will lock in those low costs.

So why aren’t they investing?? Patience, my young padawan. Uncle Keynes will give you the answer in just a moment.

Euractiv again:

Before making any decision to cut rates further, the ECB will focus on making sure that its looser policy reaches companies and households across the eurozone, a mechanism that has been broken by the bloc’s debt crisis. The new bond purchase plan is the ECB’s designated tool but it can only be activated once a eurozone government requests help from the bloc’s rescue fund and accepts policy conditions and strict international supervision.

Which is technospeak for “more austerity”. Despite the hot air from Barroso, nothing has changed in the conditions that the ECB attaches to its bail-out program for debt-mired member states. Governments in already-suffering countries know that if they try to push more tax hikes and spending cuts on their citizens they will have an armed revolution on their hands – or be booted out of office in the next election and replaced by Nazis or “Bolivarian” communists. They obviously don’t want this to happen.

The problem for the ECB is that their bond-buying pledge has now calmed the markets, but the member states have not accepted the terms of the program. This means that in effect, the program is worthless. In order to avoid losing credibility the ECB is going to have to relax the conditions attached to the program, not now but in a year or two. The reason is that the countries in Europe’s dungeon of debt will not recover from their current crisis.

Why won’t they recover? Because their fiscal policies are still geared entirely toward balancing the budget in the midst of zero or negative growth and very high unemployment. With too few taxpayers and too many entitlement consumers indebted governments continue to run deficits – and therefore continue to try to close those gaps with the same policies that brought about the depression in the first place.

In order for those economies to start growing again the hopelessly indebted governments must give the private sector room to spend money. So long as consumers are pushed to the end of their finances by high taxes and unemployment they won’t spend. If they don’t spend there won’t be any demand for consumer products, services, houses, cars, food, clothes, haircuts, vacation travel services, books, plumbers, painters, carpenters, restaurants, recreational services like spas and gyms…

Which brings us back to why entrepreneurs are not taking advantage of virtually free money. They have no reason to believe that they will get their money back in the form of sales revenue.

People have cut their spending today, which according to the pastors of the Church of Mises and Menger means that they will increase spending by the exact same amount at 1:20PM on Monday. Keynes, however, had a more sober analysis. Here is how he opened Chapter 16 of his General Theory of Employment, Interest and Money:

An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand,— it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.

Only Keynes can save Europe. It would take an enormous load of work, though, to allow his theory of effective demand to actually go to work in the European economy. While economically possible, I seriously doubt that there is enough political will power to allow that to happen. It would mean that those who have gained enormous political power both in the Eurocracy in general and among the austerity merchants, will have to take more than a few steps back.

I frankly don’t think this is politically possible. I am fairly certain that Europe has gone so far down the path of austerity and big government that it won’t ever come back again. But this message from Uncle Keynes could serve as an excellent reminder for American lawmakers to get their own house in order – the right way.

The Keynesian way.

Austrian Theory vs. Economic Freedom

My apologies for a long article, but this is a very important topic.

When someone titles his article “The Bankruptcy of Governments” it attracts interest from every friend of economic freedom. If the piece is well-written, it makes a valuable contribution to the intellectual battle over the future of Western Civilization. We need more of intellectually sharp contributions and less of ill-founded demagoguery. Our followers on the political side of the arena are inspired by us, bring our arguments and our analysis to the legislative hallways and try to get laws and budgets passed that will change economic policy and the role of government in the better direction.

If we get it right, all the way from good analysis to good policy decisions, we win – and more importantly: everyone else wins when we all benefit from more economic freedom. The wealthy can invest and improve businesses under more liberty; the poor and needy get more opportunities to improve their lives; creative, entrepreneurial people get more opportunities to build new businesses.

However, if we get our analysis wrong our cause is badly hurt. In theory, it does not matter where the mistake is made in the chain from analysis to legislation, but the closer the error is to the analytical starting point, the more serious the mistake is. Policies that are built on flawed legislative work will have repercussions that are limited to the legislative process; analysts and policy advocates can still do their work without having put their future credibility in jeopardy.

When the error is in the analytical foundation, the entire chain unravels. Bad analysis contaminates analysts, policy advocates, grassroots and activists, as well as elected officials. We who create the analytical foundation therefore have to hold ourselves to the standard that we can’t miss once.

In fact, as I explain in my book Ending the Welfare State, with the big welfare state we have today we will in reality only get one chance to restore economic freedom. If we stumble on the reforms or execute them in such a way that it causes a lot of hardship for many people, we will lose the battle for at least a generation. By that time there won’t be much of a prosperous, industrialized world to save.

For precisely this reason it is crucial that we freedom scholars and analysts do not waste our time – and other people’s time – on analytical constructs that lead to pain, suffering and a certain death for the cause of freedom. This is also why I engage other scholars and analysis whose ambition it is to promote economic freedom, but whose analysis I disagree with.

In the field of economics there is one school that meets all the criteria of purportedly supporting freedom but in reality doing a lot of harm to the cause. That school is, hardly surprisingly, Carl Menger’s Austrian tradition of economics. I have already on a few occasions written about the flaws in Austrian economics and I will continue to do so until its role in the freedom movement has been marginalized to the point of no influence.

This side of Marxism, Austrian economics is the most ill-conceived theory currently at use in the public policy arena. When it was put to work in Russia after the collapse of the Soviet Union, the result was a decade of economic waste, deprivation, abject poverty and collapse of almost every social institution except the Orthodox Church. The demise of a bankrupt government did not automatically, through some spontaneous order, give rise to a well-ordered society with a minimal government. When big government disappeared chaos, anarchy and mob rule took over.

With this experience in mind we have to know exactly what we are doing when we lay out a path to limited government. The article mentioned earlier, “The Bankruptcy of Governments”, has a promising title but unfortunately turns out to be yet another example of flawed Austrian thinking. It is an important example to discuss, though, precisely because it so well illustrates the fine line between good and bad analysis.

The author, Alasdair Macleod with the British think tank The Cobden Centre, starts off well:

For a long time governments have been redistributing peoples’ income and wealth in the name of fairness. They provide for the unemployed, the sick, and the elderly. The state provides. You can depend on the state. The result is nearly everyone in all advanced countries now depends on the state. Unfortunately citizens are running out of accessible wealth. Having run out of our money, Governments are now themselves insolvent. They started printing money in a misguided attempt to manage our affairs for us and now have to print it just to survive.

That is not entirely true. The excessive money printing did not start until the Great Recession broke out in 2009. Up until that point EU governments in particular were very good at maxing out taxes on their citizens. But Mr. Macleod’s point about governments printing money just to survive financially is a good one, and falls well in line with my analysis.

However, this statement…

The final and inevitable outcome will be all major paper currencies will become worthless.

…is a bit on the excessive side, to say the least. Austrians have been crying about American monetary inflation for years, yet it has not happened. The reason is that their analysis does not recognize the existence of transmission mechanisms between the monetary and the real sectors of the economy. In order for newly printed money to drive up prices in the real sector there has to be some movement of activity in the real sector to motivate price setters to mark up their prices at hyper-inflation rates. In a recession like the current one those transmission mechanisms are weak – consumer credit demand is weak and it is tough for small businesses to get bank loans for investments. As a result, the newly printed money stays in the monetary sector of the economy, where it has no contact with prices.

This does not mean that a modern economy in a recession cannot succumb to high inflation pressure. We know numerous examples from Latin America where government has used its own spending to push newly printed money out in the economy. This is in part how Venezuela under Hugo Chavez got stuck with 30 percent inflation. So far this has not happened in the United States, but that is no guarantee it won’t happen. While the simplistic Austrian prediction is wrong, the facts on the ground are not sufficient to completely dismiss their argument. More evidence is needed, especially on the nature of the transmission mechanisms.

Alasdair Macleod disagrees. True to the Austrian school he dismisses the use of empirical evidence and quantitative reasoning in economics:

Modern economists retreat into two comfort zones: empirical evidence and mathematics. They claim that because something has happened before, it will happen again. The weakness in this approach is to substitute precedence for the vagaries of human nature. We can never be sure of cause and effect. Human action is after all subjective and therefore inherently unpredictable.

Does this mean that Macleod never drives? After all, he apparently cannot be sure that his fellow Brits will drive on the left side of the street tomorrow just as they did today.

Macleod’s statement about the “inherently unpredictable” nature of human action is of course rather silly. It is, however, typical for the Austrian school. One of its key tenets is the denial of empirical analysis, which of course begs the question why they even bother with economics. But by taking the attitude that human action is inherently unpredictable they also suggest that we as humans are not rational. Rationality means, among other things, repeating successful behavior in order to assure your own survival. In terms of economics this means repeating successful trade and other exchange relations with other rational individuals.

I should not have to explain this to someone who is in the game to change public policy. But Alasdair Macleod appears to be one of those activists/analysts who have been seduced by the supposedly refined nature of Austrian theory without seeing its public-policy consequences. If he did he would realize that a theory that starts out with suggesting that human action is inherently unpredictable will have a hard time convincing legislators that they can trust people to make the right decisions on their own. Quite the contrary, in fact: if we all behave unpredictably there is no chance for a society with a minimal government to survive, let alone thrive; the only way to create a stable, predictable society would be to have government organize and regulate it.

Macleod is of course wrong on the fundamental nature of human action. So is the Austrian theory. May I recommend some reading on the role of uncertainty in economic analysis. Austrian theorists might also want to disseminate Armen Alchian’s classic but very dense essay on uncertainty, evolution and economic theory.

Because of their disdain for empirical evidence and quantitative reasoning, Austrians have a hard time constructing workable analytical arguments on their own. Instead they often spend their time producing pure rhetoric, often directed at competing theories. Mcleod is no exception, going after the man Austrian theorists dislike almost as much as Karl Marx:

Keynes was strongly socialistic. In the concluding remarks to his General Theory, Keynes looks forward to the euthanasia of the rentier (or saver) and that the State will eventually supply the resources for capital investment.

This statement is not only false, but also very telling of the difference between Austrian theory and Keynesianism. Austrians prefer the armchair as the foundation of their analysis, while Keynesians work inductively to constantly evolve and enhance the proficiency of their theory and their ability to interact with the public policy arena. The statements by Keynes that Macleod has cherry-picked are from chapter 24 of the General Theory, where Keynes has left his theoretical work and is speculating about what role economic policy could play, and how government would fit in to that role.

It is important to note that in the preceding 23 chapters of his General Theory Keynes barely even touches upon government, even as a subject of conversation. Already for this reason, Macleod’s statement about Keynes being a socialist is false. But there is also a deeper and from a policy viewpoint more important reason. When Keynes got to the end of his book he had examined the “mechanics” of a modern industrialized economy – he had in effect laid the groundwork for what we now know as macroeconomics. With this pioneer work Keynes challenged a great many prejudices held by Classical economists, but he also opened for the potential of an entirely new era of economic policy.

First and foremost, Keynes’s work allowed for a new understanding of what brings about recessions – and, even more importantly, depressions. Never before had anyone systematically proven that when you try to starve an economy out of a recession, you make matters worse. But to produce and explain this proof, Keynes had to spend almost the entire volume we know as his General Theory; as he was finishing it, he only had time for brief, speculative thoughts about what role government could play in defending or restoring full employment.

This is what Austrians do not get. Keynes’s analysis was systematic. He built a macroeconomic theory, induced from evidence, that allowed him and anyone else who takes it seriously to do an open-ended analysis of what role government might play. Unlike closed systems like Marxism or Austrian theory, the Keynesian analysis is open in that its conclusions are not deductively produced – or, to be blunt, dictated – by the theory.

Herein lies the problem with Austrian theory. Because it refuses to recognize the role of evidence, it refuses to open itself to the probable – as opposed to uncertain – nature of human action. Because there is no room for probability, there is no open end to the analysis an Austrian produces. His conclusions are dictated beforehand.

This leads to major problems when theory is brought in to the public policy arena. More on that in a moment. First, let me wrap up Macleod’s point about Keynes being a “socialist”. In chapter 24 of the General Theory Keynes suggests a death tax as one possible policy measure to help build economic policy in favor of full employment. The tax would be used to fund investment activity when private-sector activity is unable to reach full employment. Keynes speculates on the possibility of having government be a permanent agent in this way, which he suggests would mean that the economy would be operating at or very close to the point of full employment.

Keynes’s theory of investment equates full employment to a point where the so called marginal efficiency of capital is virtually zero. The practical meaning of this is that there is no more profit opportunity left in expanding the economy’s capital stock – it is operating at its economically viable maximum. This is accomplished, Keynes suggests (but does not firmly conclude), when private-sector investment is supplemented by government investment, funded by a death tax

Obviously, a death tax, even at 100 percent, would never lead to government replacing private investment funding. Yet Macleod makes the critical mistake of thinking that the point where the marginal efficiency of capital is zero is also the point where private credit is eliminated. He misreads Keynes’s idea about “euthanising the rentier” as the elimination of privately funded investment. In reality, this statement means that funding for investment is so abundantly available that it ceases to be scarce. Thereby no one can make money on credit in response to systemic uncertainty. Individual risk factors still remain, though, as Keynes makes clear in his elaboration of his theory of investment and the concept of the marginal efficiency of capital.

In short: government eliminates systemic uncertainty while the private sector handles uncertainty and risk at the market level.

I disagree with Keynes’s speculation about the death tax. But I do agree with him that the free market is unable to incorporate and manage systemic uncertainty. How that is best done is a matter for further scholarly work; my own doctoral dissertation was devoted entirely to finding the demarcation line between the roles of government and the private sector in managing uncertainty. What I learned from Keynes is that there is indeed a role for government to play there; the exact nature of that role is still an open question, especially because the attempts made thus far at organizing government to eliminate systemic uncertainty have had a lot of side effects.

I apologize for the wordiness of this article, but it is important to understand the depth of the problem with Austrian theory. One good way to do that is to contrast it toward its arch enemy, Keynesianism.

Speaking of which, it is almost amusing to witness the obsession that many Austrian theorists have with Keynes. As Alasdair Macleod demonstrates, this obsession sometimes gets so bad that they throw out the only analytical tool they themselves cherish, namely logic, just to get another chance to go after Keynes:

The misconceptions of Keynesianism are so many that the great Austrian economist von Mises said that the only true statement to come out of the neo-British Cambridge school was “in the long run we are all dead”.

Let’s put this in its proper Austrian context. In December last year one of the Cobden Centre’s academic advisors, Phillip Bagus, applauded the shrinking GDP that some European countries were experiencing. Bagus was jumping up and down with joy over the fact that Greece had lost a quarter of its GDP and suggested merrily that this elimination of economic activity would free up resources that would create new investments and new jobs. He suggested that it was a home run for the economy that people were laid off from jobs right and left and forced to scavenge for food because an austere government was not providing the poverty relief people had been promised.

Bagus is a prime example of what Austrians do when they enter the public policy arena. They are completely locked in to their theory, without a single open window to the outside world and its empirical evidence that when they are confronted with the worst economic crisis since the Great Depression they suggest that the world needs more of the same. To them there is no such thing as hesitation and caution among private entrepreneurs and consumers. Their static and rigid theory says that consumers and entrepreneurs fail to produce full employment for the economy because government takes away resources from them. There is a great deal of truth in this part, but what the Austrians forget is that there is a second leg to this analysis: they conclude that all you need to do is fire government bureaucrats and  they will all get jobs in the private sector. All you need to do is shut down a government agency and someone else will take over their office.

The problem is, as we witnessed in Russia during the 1990s, the private sector may hesitate to step in and absorb idle resources formerly employed by government. The one tiny detail that Austrians forget is that an entrepreneur will not make an investment unless he has reasons to believe that he will be able to pay off the loan he funded the investment with. Furthermore, the banks won’t lend him money toward the investment unless he can make a good case for the profitability of that investment.

Keynes knew of this problem very well. That is why he speculated that government should supplement private investment in times of uncertainty, in order to eliminate systemic risk factors. While I disagree with Keynes’s particular suggestion, I am wholeheartedly with him on the nature of the problem. Individuals can be held back by uncertainty and thereby, in the aggregate, hold back the entire economy.

Austrians do not believe in uncertainty. They recognize its existence but they do not incorporate it into their analysis. Instead, they assume that all that needs to happen for the economy to be perpetually in full employment is that the so called “natural” rate of interest can prevail. They assume the existence of this “natural” interest rate without ever providing proof of its existence. This assumption, again entirely theoretical, allows them to create a perfect intertemporal allocation of resources – in other words, to eliminate uncertainty.

When you ask an Austrian theorist when this natural interest rate will come about, he will give you an answer that resembles something like “in the long run”. In other words, in the long run the economy will always be in a perfect state of equilibrium and full employment.

Keynes always criticized Classical economists for relying on the long run to fix all sorts of problems. When Austrian theorists take the same view on the long run as Keynes did, they jeopardize the very foundation – flawed as it is – of their own theory. Either they have to resort to illogical reasoning or they have to make up their mind: do they agree or disagree with Keynes on the role of uncertainty in the economy?

Alasdair Macleod, needless to say, does not see this lack of logic in Austrian theory. He marches on like nothing happened. The rest of his analysis is unfortunately as simplistic as the Austrian theory he relies on. He echoes a commonly held belief among Austrians that there have never been economic crises before big government:

The misallocation of economic resources which is the result of decades of increasing government intervention cannot go on indefinitely. Businesses have stopped investing, which is why big business’s cash reserves are so high. Money is no longer being invested in production; it is going into asset bubbles. Dot-coms, residential property, and now on the back of zero interest rates government bonds and equities. These booms have hidden the underlying malaise.

Although I disagree with John Kenneth Galbraith on virtually everything under the sun, I have to give Galbraith credit for his book A Short History of Financial Euphoria. There, Galbraith takes the reader on a journey through speculative bubbles that have occurred throughout history – the ones we know of – and done so at times when there was no big government.

I have discussed the nature of today’s crisis at length in other articles. Very briefly, I do agree with Macleod that government has played a bad role in exacerbating this crisis – my conclusion is that our banking system would have absorbed the shock from the real estate crisis were it not for the fact that those same banks had also invested heavily in government bonds. During 2011 and 2012 more and more of those bonds turned into bad assets, effectively destroying an otherwise sound balance on banks’ balance sheets.

The implication of a sound analysis of today’s crisis is that we need to get government out of the economy, but that we need to do it in a structurally sound way and by showing great respect for two groups of citizens:

  • Those who already live on the dole because they have lost their jobs and been let down by government;
  • Those who still work but have become dependent on government to make ends meet.

The true challenge for freedom-minded public policy scholars is to design a path for our economy out of the welfare state without causing undue hardship for either of these two groups. It can be done. The problem is that we are not getting much help from Austrian theorists here: all they suggest is the destruction of the welfare state so that Phoenix may rise from the ruins.

Macleod is no exception. He makes a good observation about the role of government…

Take France. Government is 57% of GDP. The population is 66m, of which the employed working population is about 25m, 17m in the productive private sector. The taxes collected on 17m pay for the welfare of 66m. The taxes on 17m pay all government’s finances. The private sector is simply over-burdened and is being strangled.

But then, instead of helping pull the economy out of this entitlement quagmire, Macleod resorts to the favorite Austrian pastime, namely to bash the printing of money:

The progressive replacement of sound money by fiat currency has destroyed economic calculation, and has destroyed private sector wealth. These policies were deliberate. We have now run out of accessible wealth to transfer from private individuals to governments. That is our true condition. Governments will still seek to save themselves at the continuing expense of their citizens, and in the process destroy what wealth is left.

He never gets to the usual advocacy for a gold standard, but he comes pretty darn close. However, as a brief look at Galbraith’s book will show, we have had crises even during the heydays of the gold standard.

The problem is not big money. The problem is big entitlement. It would be nice if Austrians could put down their Scriptures and help us get rid of the welfare state in a sound, stable way that encourages people to be optimistic about the future. If they are not interested in that, may I suggest they withdraw to their academic chat rooms and stop pretending to be concerned.

Another Failed Austerity Defense

Discussing austerity policies with an Austrian economist is a little bit like discussing free-market capitalism vs. socialism with a leftist. Both compare an abstract ideal of their favorite theory to a poorly managed, diluted and distorted example of their opponent’s theory. There is a reason for this common character trait: both Austrian economics and socialism are exclusively theories with only inferential contact with the real world.

Unfortunately, a Keynesian economist cannot afford himself that privilege. He has to stand with both feet on the ground and begin his reasoning right there. The same goes for the free-market capitalist who is trying to propose policies that will let private citizens – be they consumers, investors or entrepreneurs – go about their business unfettered by government.

Some would object right there and say that there are no more fervent advocates for free-market capitalism than Austrian economists. Rhetorically, that may be true, but as soon as we get down to the policies that Austrians suggest, a divide opens up between them and the free-market capitalist whose cause they claim to be advancing.

This gap between Austrian theory and the real life is particularly obvious in today’s Europe, where Austrian economists have had lauded the current destruction of GDP and have had only one complaint: it’s not enough. The former point is made by economics professor Phillip Bagus and the latter comes from think-tank economist Veronique de Rugy.

As I have explained at length, both Bagus and de Rugy are wrong, morally as well as analytically. And perhaps the Austrian community is beginning to realize that they have ended up on the wrong side of the European crisis. Today a good friend sent a link to the latest issue of The Free Market, a monthly publication of the Mises Institute. There, Mark Thornton makes a case for what he calls “real” austerity, joining his fellow Austrians Bagus and de Rugy in a passionate plea for tough budget cuts all across Europe.

However, unlike his two comrades Bagus and de Rugy, Thornton actually takes time to try to elaborate his case. Therefore, it is my pleasure to counter his analysis with free-market Keynesianism.

First, a quick reminder of where I stand with reference to big government: the welfare state must go, permanently and forever – but it must do so in a way that does not cause undue harm to the most vulnerable of our fellow citizens.

With that in mind, let’s give microphone and spotlight to Mark Thornton:

Austerity has been hotly debated as either an elixir or a poison for tough economic times. But what is austerity? Real austerity means that the government and its employees have less money at their disposal. For the economists at the International Monetary Fund, “austerity” may mean spending cuts, but it also means increasing taxes on the beleaguered public in order to, at all costs, repay the government’s corrupt creditors. Keynesian economists reject all forms of austerity. They promote the “borrow and spend” approach that is supposedly scientific and is gentle on the people: paycheck insurance for the unemployed, bailouts for failing businesses, and stimulus packages for everyone else.

Three points.

1. “Real austerity means that the government and its employees have less money at their disposal.” Well, that is exactly what has happened in Greece, and is currently happening in Spain and, to a lesser degree, in Italy. Thornton better provide a more concise definition of Austrian-based austerity, or else we will have to assume that Phillip “Less GDP is good” Bagus has the final say on that matter.

2. The austerity policies that are currently being forced upon crisis-ridden countries in Europe has nothing to do with repaying “the government’s corrupt creditors”. I would not consider the regular middle-class family corrupt because it buys treasury bonds. Nor would I consider retirement funds, investing the same middle-class family’s long-term savings, to be corrupt because it buys treasury bonds.

The real reason why Greece, Spain, Portugal and Italy are raising taxes and cutting spending is that they are trying to close a budget gap. This budget gap, in turn, is the work of an overloaded, over-bloated welfare state.

3. Bailouts for failing businesses has nothing to do with Keynesianism. I challenge Thornton to provide one logically consistent example from the vast academic Keynesian literature that prescribes corporate welfare. This is a good example of how Austrian theorists bastardize Keynesianism to lower the analytical bar for themselves.

Austrian School economists reject both the Keynesian stimulus approach and the IMF-style high-tax, pro-bankster “Austerian” approach. Although “Austrians” are often lumped in with “Austerians,” Austrian School economists support real austerity. This involves cutting government budgets, salaries, employee benefits, retirement benefits, and taxes. It also involves selling government assets and even repudiating government debt. Despite all the hoopla in countries like Greece, there is no real austerity except in the countries of eastern Europe.

Mark  Thornton might want to talk to his fellow Austrian economist Phillip Bagus about this. In December, Bagus said:

One would think that a person is austere when she saves, i.e., if she spends less than she earns. Well, there exists not one country in the eurozone that is austere. They all spend more than they receive in revenues. In fact, government deficits are extremely high

Bagus then goes on to argue that so long as there is a deficit, governments are by definition not austere. When governments close their deficits, they are austere, he concludes. This definition is quite different from the one Thornton is putting forward, which couples tax cuts with spending cuts. The question, then, is: what role does the deficit play in Thornton’s definition of austerity?

I realize that any theory, be it Austrian, Keynesian, Rational Expectations or Marxism, is full of internal disagreements. Being only one of two libertarian Keynesians in the world (there is another one in Australia…) I know very well what it is like to clash with people who share your overall theoretical viewpoint. That said, the disagreement between Bagus and Thornton has nothing to do with fundamental theory or methodological principles. It is entirely on the application side, where things are conditioned by solid theory and methodology. Therefore, the question is: how deeply does this disagreement cut into Austrian theory?

Back to Thornton:

For example, Latvia is Europe’s most austere country and also has its fastest growing economy. Estonia implemented an austerity policy that depended largely on cuts in government salaries. There simply is no austerity in most of western Europe or the U.S. … The Keynesians’ magical multipliers have once again failed to materialize. Given that most of these economies have not achieved growth from stimulus, they should give the idea of true austerity a fresh look.

Let’s start with Thornton’s claim about Latvia. Here are the latest numbers from Eurostat on real GDP growth in Latvia:

2006 2007 2008 2009 2010 2011 2012 2013 2014
Latvia 11.2% 9.6% -3.3% -17.7% -0.9% 5.5% 4.3% 3.6% 3.9%

Needless to say, the numbers for 2013 and 2014 are forecasts, and as we know from the past few years any GDP growth forecast in Europe should be taken with a big grain of salt. Therefore, the only numbers worth looking at are the ones from 2006 to 2011; the 2012 figure is still an estimate, as it takes about one quarter of a year to process all data for last year’s GDP. But let’s be generous to Thornton and assume that the 4.3-percent growth number is accurate.

If you started out with $100 in 2006, and that money grew on par with GDP, you’d have $105.70 in 2012. That is less than one percent growth per year.

The same experiment on the U.S. economy, using the same database from Eurostat, allows the $100 to grow to $107.52. By Thornton’s own reasoning, this means that the U.S. policies of out-of-control debt spending, bank bailouts and completely irresponsible and wasteful stimulus packages is in fact a better strategy than what he defines as “real austerity”.

As for Estonia, here is my exchange with Michael Tanner where I refute the idea that Estonia has implemented some sort of “real” austerity.

There is one point, though, where I will give Thornton a thumbs up. He is absolutely correct about the multiplier and its failure to work in Europe. There are two reasons why it has failed (and neither is that the multiplier does not exist, which it does). First, there is a confidence component embedded in the multiplier, which econometricians – who do forecasting on suggested fiscal policy measures – consistently fail to recognize. A consumer will respond to an income increase with more spending if, and only if, he is confident that: a) the income increase is of a lasting nature, or: b) he won’t need the money in the bank for contingency purposes.

If a consumer is uncertain about the future, he will refrain from spending a dollar extra he has earned so that he can have money in the bank in case tomorrow turns out to be worse than today. The same goes for entrepreneurs, whose responses to certainty exhibit themselves in their investment and hiring decisions. A temporary increase in orders will not make a construction contractor hire more people on permanent payroll. A temporary rise in the demand for a certain car model will not be enough to motivate the manufacturer to invest in a new assembly plant.

Confidence, or its flip side which we know as uncertainty, is hard to quantify. The consumption functions that form the base for traditional multipliers do not come with specific confidence components. Mainstream economics still resists the very notion of distinguishing between risk and uncertainty, but in some heterodox circles, primarily Post Keynesian economics, there is a reasonably good body of literature on this. My own doctoral thesis is one of them.

There are ways to quantify the confidence component and embed it in the multiplier. However, those applications have not been absorbed by the mainstream economics literature, and are therefore – understandably yet regrettably – still not used in econometrics.

The second reason why the multiplier has failed in Europe has to do with a recently recognized asymmetry in the multiplier. The traditional view is that the multiplier mechanically works the same way for expansions and contractions in economic activity. This is still true under regular business-cycle circumstances, and when it comes to private-sector economic activity. When these two conditions do not apply, however, the multiplier starts acting up, throwing economists out of their comfort zone.

The IMF recognized this in a good, highly recommendable paper by Olivier Blanchard and Daniel Leigh. Concerned over the consistent errors that the IMF made in forecasting the effects of austerity policies in Europe, they set out to find the bug in their models. It turned out that the multiplier is stronger for contractions in economic activity than for expansions. While not explicitly spelled out by Blanchard and Leigh, their results indicate that the stronger reaction to a contraction has to do with the fact that the contraction is caused by government spending. The explanation could be that the reductions in spending hit low-income families more than others, whose economic margins are small or non-existent. As a result, they contract their spending more than higher-income families would.

Uncertainty and asymmetric response together explain why the multiplier has not kicked the European economy into higher gear. There is, however, a third one. Thornton seems to believe that just because there are persistent deficits in Europe, no spending cuts have taken place. This is a regrettable exercise of armchair theorizing; there is plenty of evidence to the contrary. Thornton might want to start with this piece.

Then, finally, we get to some specifics as to what Thornton himself wants to do about a nation in economic crisis:

Austerity applied … simply means that the government has to live within its means. If government were to adopt a thoroughgoing “Libertarian Monk” lifestyle, then government would be cut back to only national defense (withoutstanding armies and nuclear weapons), with Mayberry’s Andy and Barney protecting the peace.

A philosophical view I definitely share – I am strong supporter of Robert Nozick’s minimal state. But pointing to a star in the sky is one thing. Building the space ship that will get us there is an entirely different matter, one that Austrian theorists do their best to avoid discussing. They touch upon it in the passing, like Thornton:

The national debt would be wholly repudiated. This would involve certain short-run hardships, although much greater long-run prosperity.

Thornton is more than welcome to explain exactly what he means by “repudiating” the national debt. I was under the impression that Austrians considered contractual enforcement a cornerstone of a functioning, civilized economy.

As for the reference to “long-run prosperity”, I am curious: how long is that run? The only concerted effort at estimating that long run, based on Say’s law, that I can remember ever seeing actually places the end of the long run at 100 years. The proof offered (by Swedish economist Assar Lindbeck) is that there is no trend in unemployment  over that period of time. This would echo Keynes’s famous comeback that “in the long run we’re all dead”.

Another question is what the “short-term hardships” actually involve. Does Thornton recommend immediate turn-off of the welfare faucet? An immediate shut-down of tax-funded, government-run hospitals?

I like the challenge that Austrian theory presents, partly because it is often of high analytical quality. But so long as its advocates won’t even waste a single breath on specific policy recommendations, their theory amounts to little more than fiscal sophistry. Unfortunately, Mark Thornton confirms this impression.

But more than that, the steady stream of calls for even more spending cuts, even harder reductions in entitlement spending, and a faster execution of them, puts Austrians in rather ugly moral company. They come across as little more than sophisticated Ayn Randians, their policy ambitions darkened by the shadow of overt egoism and disrespect of the poor and weak.

Mark Thornton and his Austrian fellows should also keep in mind that their dismissive attitude toward the suffering that tens of millions of European families are now enduring does – in some people’s eyes (not mine) – qualify him for even more ominous friendships.

In contrast to Austrian armchair theorizing, I offer a facts-based, empirically workable, Keynesian route to limited government. It is built on reality, solid analysis, recognition of human nature and a steadfast moral commitment to not let the poorest and weakest among us pay the price for the damage that big government has done to our economy.

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.

Austrian Economist Applauds Shrinking GDP

Despite the terrifying consequences of austerity policies across Europe, there are still those who claim that austerity is in fact good and something desirable. My response to Veronique de Rugy’s irresponsible claim that there is not enough austerity in Europe caused quite a stir, and motivated some people to organize an entire conference about European austerity at the Cato Institute.

Today another Austrian theorist joins the austerity appreciation choir. Phillip Bagus, professor of economics at King Juan Carlos University in Madrid, Spain, bizarrly tries to argue that the current crisis, especially the decline in GDP, is actually good for Europe:

Many politicians and commentators such as Paul Krugman claim that Europe’s problem is austerity, i.e., there is insufficient government spending. The common argument goes like this: Due to a reduction of government spending, there is insufficient demand in the economy leading to unemployment. The unemployment makes things even worse as aggregate demand falls even more, causing a fall in government revenues and an increase in government deficits. European governments … reduce government spending even further, lowering demand by laying off public employees and cutting back on government transfers.

The problem is not insufficient government spending. The problem is insufficient spending. It is correct that we who analyze the crisis from a regular macroeconomic perspective identify reductions in government spending as an aggravating circumstance. It is also true that reductions in government spending have caused the Greek recession to escalate into a depression. But it is a non-sequitur that the remedy would be to increase government spending. It would be better for the economy on all accounts that private sector demand increased.

That said, it is an indisputable fact that if you remove $100 worth of government spending and those $100 are not replaced with private spending, the economy suffers a net loss of $100 worth of spending. It follows that government spending cuts are not always good for short-term macroeconomic activity.

Back to Bagus:

What can be done to break out of the spiral? The answer given by commentators is simply to end austerity, boost government spending and aggregate demand. Paul Krugman even argues in favor for a preparation against an alien invasion, which would induce government to spend more. So the story goes. But is it true?

The good professor needs to look beyond Paul Krugman. Just because one economist is overly simplistic and sometimes outright stupid, it does not mean that another can do the same and retain his credibility. But instead of recognizing this Bagus goes on an eclectic flea-killing hike through the landscape of semantics:

First of all, is there really austerity in the eurozone? One would think that a person is austere when she saves, i.e., if she spends less than she earns. Well, there exists not one country in the eurozone that is austere. They all spend more than they receive in revenues. In fact, government deficits are extremely high … . A good picture of “austerity” is also to compare government expenditures and revenues (relation of public expenditures and revenues in percentage). Imagine that a person you know spends 12 percent more in 2008 than her income, spends 31 percent more than her income the next year, spends 25 percent more than her income in 2010, and 26 percent more than her income in 2011. Would you regard this person as austere?

In addition to dressing up the term “austerity” in an erstwhile French definition with no connection to modern economics, Bagus also makes the classic mistake of comparing an individual to a government. I am intrigued by the frequency with which Austrian economists do this. It is as though they purposely want to deny that governments have entirely different lines of credit than private citizens, and that those credit lines fundamentally change the case for government deficit spending.

Then Bagus makes an analytical somersault worthy of a circus acrobat:

This is what the Spanish government has done. It shows itself incapable of changing this course. Perversely, this “austerity” is then made responsible for a shrinking Spanish economy and high unemployment. Unfortunately, austerity is the necessary condition for recovery in Spain, the eurozone, and elsewhere.

In effect, Bagus says that Spain would have been better off if government had spent less or taxes had been higher. His analysis is entirely static, completely void of recognition that economic activity takes place in time. He also treats austerity as if it was an accounting balance, not a policy strategy.

His somersault continues:

The reduction of government spending makes real resources available for the private sector that formerly had been absorbed by the state. Reducing government spending makes profitable new private investment projects and saves old ones from bankruptcy.

Given the context, this is one of the most uninformed statements I have ever heard from an economist. The only way to mitigate its severity is to implicitly assume that Professor Bagus is injecting an implicit axiom into his argument. If so, he would be in good company. There are allegedly 126 implicit axioms in Spinoza’s Principia Ethica. However, implicit axioms do not solidify economic analysis. They blow holes in it.

The mere notion that a cut in government spending leaves more resources available to the private sector sets the good professor up for a lengthy lecture on public finance. In order to spend a dollar, government has to either tax a dollar or borrow a dollar. That is where government takes resources away from the private sector. If government takes a dollar in taxes or in the form of a loan, and then spends it, then it actually returns the money to circulation in the economy. It is less efficient – often a lot less efficient – than if the private sector could make the decision on how to use that dollar, but it is nevertheless returned.

If on the other hand government takes that dollar from the private sector but then refuses to spend it, how does that put the dollar back in the hands of the private sector?

If Professor Bagus bothered to look, he’d see that in every crisis-ridden country in Europe, spending cuts are coupled with tax increases. When government cuts its spending by one dollar, it still takes that dollar from the private sector – plus another dollar. The private sector is left with less, not more as Professor Bagus tries to tell us.

Here is how he tries to deny these basic facts:

Take the following example. Tom wants to open a restaurant. He makes the following calculations. He estimates the restaurant’s revenues at $10,000 per month. The expected costs are the following: $4,000 for rent; $1,000 for utilities; $2,000 for food; and $4,000 for wages. With expected revenues of $10,000 and costs of $11,000 Tom will not start his business. Let’s now assume that the government is more austere, i.e., it reduces government spending. Let’s assume that the government closes a consumer-protection agency and sells the agency’s building on the market. As a consequence, there is a tendency for housing prices and rents to fall. The same is true for wages. The laid-off bureaucrats search for new jobs, exerting downward pressure on wage rates.

This is economic sophistry. The rent for a restaurant is not going to go down because government sells an office building. Likewise, government bureaucrats are not the first in line to apply for waiter jobs at a restaurant. But if Professor Bagus has a lot of examples of that to show us, he’s more than welcome.

It gets better:

As the government has reduced spending it can even reduce tax rates, which may increase Tom’s after-tax profits. Thanks to austerity the government could also reduce its deficit.

All of a sudden Professor Bagus has magically made the unemployed government bureaucrats disappear. Their lost income, which led to reduced private consumption and thus less demand for restaurant dinners, has conveniently not become a problem for the good professor. The increased cost for unemployment benefits when the bureaucrats are laid off is also gone with the wind.

The world looks simple and two-dimensional if you close one eye.

It looks even simpler if you disregard the fact that there are people out there who have been lured into dependency on government for their livelihood, who would suffer tremendously if we did what Austrian economists like Professor Bagus suggest, namely to simply and quickly terminate entitlement programs:

In the end, the question amounts to the following: Who shall determine what is produced and how? The government that uses resources for its own purposes (such as a “consumer-protection” agency, welfare programs, or wars), or entrepreneurs in a competitive process and as agents of consumers, trying to satisfy consumer wants with ever better and cheaper products (like Tom, who uses part of the resources formerly used in the government agency for his restaurant).

Notice how he slips “welfare programs” into his argument, as if they were nothing more than expenses for utilities for a government office building.

The fundamental problem with government is not that it sucks up resources that could be better used by the private sector. That happens, and it has to stop at some point, but that is only an ancillary problem. Far more serious is the problem we have with people who have lost, or given up, all other options in life than government dependency. These are the people in Spain who live off welfare and still have to resort to food scavenging to survive. These are laid-off workers in Greece whose unemployment benefits have been so drastically cut they can barely even feed themselves on a daily basis.

We are talking about retired people who believed government all their working years, when government promised to provide health care and a pension when they retired. Now government is cutting down on both and they have no money to go anywhere else. But even those who have some cash in the bank find it next to impossible to go anywhere else: government has monopolized such large segments of the welfare sector that private alternatives barely even exist anymore.

When Professor Bagus cuts or eliminates welfare, these are the people he will leave out in the street to fend for themselves. The good professor chooses to rely on the free market forces to reduce the cost of living for small businesses so they will hire all those thrown out of welfare programs. But unless the professor can prove otherwise, I will compare the deflation effect from spending cuts to the distance a mouse can move a rock by pushing on it with its nose.

It is necessary for the future that we eliminate government-provided welfare programs, but it must be done in an orderly fashion. Those who depend on government must be given a road out of their dependency without suffering immediate financial hardship in the bargain. It can be done, but unlike the uninformed, irresponsibly simplistic approach of Professor Bagus, the real solution takes hard work and ingenuity.

Overall, Professor Bagus gives the impression of being out to simply score a few quick points on a rather serious subject. But I cannot escape the feeling that he might actually believe what he says. This feeling is reinforced by his amazing reasoning regarding GDP:

But does austerity not at least temporarily reduce GDP and lead to a downward spiral of economic activity? Unfortunately, GDP is a quite misleading figure. GDP is defined as the market value of all final goods and services produced in a country in a given period.

What is so misleading about that? Has Professor Bagus developed a national accounts system that works better than the one that gives us GDP?

Hold on to your hat now:

There are two minor reasons why a lower GDP may not always be a bad sign. The first reason relates to the treatment of government expenditures. Let us imagine a government bureaucrat who licenses businesses. When he denies a license for an investment project that never comes into being, how much wealth is destroyed? Is it the expected revenues of the project or its expected profits? What if the bureaucrat has unknowingly prevented an innovation that could save the economy billions of dollars per year? It is hard to say how much wealth destruction is caused by the bureaucrat. We could just arbitrarily take his salary of $50,000 per year and subtract it from private production. GDP would be lower. Now hold your breath. In practice, the opposite is done. Government expenditures count positively in GDP. The wealth destroying activity of the bureaucrat raises GDP by $50,000. This implies that if the government licensing agency is closed and the bureaucrat is laid off, then the immediate effect of this austerity is a fall in GDP by $50,000. Yet, this fall in GDP is a good sign for private production and the satisfaction of consumer wants.

This reasoning makes me wonder if Professor Bagus is even vaguely familiar with the national accounts system. He tries to make the case that wealth somehow belongs in our annual sum total of our economic activity (what is commonly known as GDP). But GDP does not measure wealth, nor is it designed to do so.

Here is an analogy that the good professor hopefully understands. GDP measures the amount of water that flows from your shower. Wealth, on the other hand, is the amount of water standing in your bath tub. One if a flow, the other is a stock. Or consider the difference between your monthly income and the money sitting in your savings account. One is a flow, the other is a stock.

Even more ludicrous is the idea that you compare the hypothetical value of an economic transaction that never took place with the value of actual transactions that have taken place. This comparison violates the very foundations of economics as a science; it is as though a demographer would compare today’s American population to what it would have been if all my unborn brothers would have been born.

I certainly hope the good professor is making this comparison only to score a careless rhetorical point.

And now for the final Austrian punch – the notion of “artificial” economic activity:

Second, if the structure of production is distorted after an artificial boom…

Definition, please. An analytically useful one.

…the restructuring also entails a temporary fall in GDP. Indeed, one could only maintain GDP if production remained unchanged.

Still no definition of “artificial” economic activity. Professor Bagus offers a hint, though:

If Spain or the United States had continued to use their boom structure of production, they would have continued to build the amount of housing they did in 2007. The restructuring requires a shrinking of the housing sector, i.e., a reduced use of factors of production in this sector. Factors of production must be transferred to those sectors where they are most urgently demanded by consumers. The restructuring is not instantaneous but organized by entrepreneurs in a competitive process that is burdensome and takes time.

As I have explained, the Spanish economy did indeed see a housing boom that was helped along by government regulations (similar to those that caused problems on the U.S. housing market). However, if this is what Professor Bagus defines as an “artificial” boom in the economy – the artificial component being regulations governing the mortgage loan market – then any action taken by any government by definition causes artificial economic activity. If we spend money on the U.S. Supreme Court and the Court hires law clerks for the justices, then the money that those clerks spend is an artificial stimulus of the Washington, DC local economy.

The “Austrian” response to this would be that:

  • All government economic activity is artificial because it hampers private economic activity, and
  • In a perfect world it is so small it won’t cause any booms and busts.

The first point is false. Spending on law and order and on the enforcement of contracts is good for the economy. It creates a stable economic infrastructure for private entrepreneurs to work and operate within. In its absence the economy would actually perform worse.

Empirically, it is possible to show that government spending on infrastructure can have positive effects on the economy. Would Austrians define such spending as “natural” or “artificial”? My guess is the latter, as Austrians habitually reject empirical evidence.

The second point is meaningless unless our Austrian friends can come up with an empirically workable definition of “artificial” economic activity.

It would be interesting to see how Professor Bagus would explain his final punch to the people in Greece who are now in their fifth year with a contracting GDP:

In this transition period, when jobs are destroyed in the overblown sectors, GDP tends to fall. This fall in GDP is just a sign that the necessary restructuring is underway. The alternative would be to produce the amount of housing of 2007. If GDP did not fall sharply, it would mean that the wealth-destroying boom was continuing as it did in the years 2005–2007.

There is absolutely nothing that says GDP has to fall for these reasons. Professor Bagus argues as though there is no restructuring going on during regular economic times. But the fact of the matter is that there was a significant migration of jobs and capital between sectors of the American economy during the long, 20-year expansion period during the Reagan and Clinton presidencies. From 1980 to 2000 the number of private-sector employees in the American economy increased by 50 percent, but the number of employees in manufacturing remained unchanged. Yet this significant shift in favor of a service-based economy took place while unemployment trended down from double digits to four percent.

I am sure Professor Bagus is a good guy, but his economic analysis leaves a lot to wish for. Sadly, many friends of limited government believe Austrian theory as gospel. The consequences can be just as disastrous as the ones that come out of bastard Keynesian policies that relentlessly grow government.

Which, ironically, puts Professor Bagus in the good company of the esteemed economic airhead, Dr. Paul Krugman.