The ink has not even dried on the French election result before pundits pop out of the woodwork to comment on the new government’s fiscal policy. Since the coalition building is only in its infancy, there is no way of telling what the new government’s ideas will be for taxes and government spending.
In fairness, we can suspect that the big government that France already has will grow a bit bigger. However, we are far enough from the details of this that it would be prudent to refrain from bombastic conclusions and predictive punditry.
Dan Lacalle, a French economist and commentator, disagrees. On July 8th he opined on X:
He links to his own article from the Mises Institute in which he implies that any expansion of government spending in France will lead to acute fiscal problems.
So far, I agree. The point where Lacalle goes wrong is when he implies that France should resort to fiscal austerity to solve the problem. He reinforces this point with this rather startling claim:
France has never had austerity.
His proof is that government spends some 58% of the French GDP.
I read this and realized that France is in dire straits, for more reasons than the simple fact that the new government is probably going to be fiscally deadlocked for the better part of this parliamentary period. France is in dire straits because the only advice that their government will get from economists is either of the left-leaning ‘spend-til-the-end’ kind or from right-of-center economists who will tell them about the virtues of austerity.
Having lived through the austerity episode in Sweden in the 1990s, and having written extensively about the Greek fiscal disaster 10-15 years ago, I abhor any proposal that austerity is necessary, let alone good.
Unfortunately, the economics profession is divided into these two camps—more government or more austerity—as if those were the only remedies for a stagnant economy and endless budget deficits.
They are not. There is a third point to be added here, one that refutes both the virtues of government spending and the benefits of austerity. Bluntly speaking, it is a false notion that austerity is good; it was this very notion that in the wake of the Great Recession led to the macroeconomic disasters not only in Greece, but in Italy, Spain, Portugal, and to a lesser degree in other European countries. This notion brought serious economic and personal pain to millions of Swedes in the 1990s, to Denmark in the late 1980s, and so on.
Austerity is never good. If a government practices austerity for long enough, it destroys the livelihood of its own people. A decade ago, Greece lost one-quarter of its economy as a direct result of austerity.
With the European economy stuck in stagnation, I see a wave of austerity coming back to the continent. We as economists must speak up against it and propagate alternatives. To do so, we need to understand
- What austerity is,
- How it works,
- Its consequences, and
- The alternative.
Here in the first part, I will cover the first two items; stay tuned for Part II which will discuss consequences of and alternatives to austerity.
What is austerity?
In my book Industrial Poverty (Gower, 2014), I account for the battle over austerity policies in France right after François Hollande had defeated Nicholas Sarkozy in the 2012 presidential election (pp. 127-131). That very election, in fact, was dominated by political tensions over Sarkozy’s austerity policies and his desperate bid to maintain the AAA credit rating the French government had at the time.
A year earlier, in an account of Sarkozy’s austerity policies, The Economist branded him the “belt-tightener-in-chief“—a title he earned in no small part thanks to François Fillon, the French prime minister at the time.
Dan Lacalle is not alone in claiming that austerity has not really been practiced in Europe. Veronique de Rugy, an economist with the Mercatus Center at George Mason University, has made several attempts to suggest that European countries have not really tried austerity. Lacalle and de Rugy have in common the misdirected belief that austerity is only practiced when it leads to a reduction in government spending.
That is not what fiscal austerity is. It is not about reducing government spending. The term refers instead to a set of fiscal measures—changes in taxes and government spending—to reduce the deficit in a government’s budget.
It is easy to verify that this is what austerity policies are designed to do. All we need is to study the policy plans, and the intentions behind those plans, in countries where governments have used austerity measures. The European austerity experience 10-15 years ago is a case in point, especially when it comes to Greece, where international organizations—the IMF, the EU, and the ECB—explicitly and deliberately pressured the Greek government into budget-balancing austerity measures.
They did not pressure Greece to cut government spending. They pressured Greece into closing the hole in their consolidated government finances. Which is exactly what the Greeks did.
There is a simple yet fundamental reason why it is essential to understand what austerity is. Done wrong, fiscal policy can destroy people’s lives. As I explained last summer, the austerity policies in Greece went wrong; the fallout of them was so bad, in fact, that I have characterized the whole episode as a macroeconomic massacre.
Austerity policies are always wrong. There is no right way to do austerity. Here is why.
How does austerity work?
Suppose that in Year 1, a government earns €100 in tax revenue and spends €100. In Year 2, government decides to add another spending program, taking spending up to €110. Tax revenue is the same, and global investors in the sovereign debt market express concerns over the €10 budget deficit.
In response, in Year 3, the government decides to raise taxes by €10. This is an austerity-based policy measure: it is aimed at closing the budget deficit, and to do so with immediacy. The result is good, at least to begin with, when in Year 4, the new tax revenue starts flowing in.
However, due to the higher taxes, some businesses have had to close and others have reduced staff. Therefore, in Year 5, tax revenue falls again—while the cost of unemployment benefits goes up. Tax revenue is now down to €100 while government spending has gone up to €120.
Once again, government resorts to austerity. This time, though, it focuses entirely on cutting spending to close the budget gap. Therefore, going into Year 6, the government budget has been cut from €120 to €100.
The only problem with this cut is that a large number of unemployed workers have seen their benefits cut and low-income workers have lost some benefits as well. Their purchasing power is lower; together with reductions in other forms of government spending, these cuts reduce total demand in the economy. More people lose their jobs, tax revenue declines again, and demand for unemployment benefits goes up.
In Year 7, government gets only €90 in tax revenue, while spending has ticked up to €110.
This simple example illustrates the principle of how austerity works. It is aimed at closing the budget deficit, but because of the fiscal and macroeconomic dynamics of a modern welfare-state economy, it is impossible for a government to achieve that goal by means of austerity.
In other words, we learn two things from our example. First of all, it makes no qualitative difference if austerity is geared toward tax hikes or spending cuts. Some writers would contest this conclusion; using Sweden in the 1990s as an example, I have demonstrated that if austerity is focused on spending cuts, the consequences of austerity are less painful than if tax hikes are involved (Industrial Poverty, pp. 173-179). However, these are quantitative differences—what they show is that the declines in GDP and employment are less serious per dollar or euro or krona of austerity policy if that policy consists of spending cuts than if it consists of tax hikes.
There is less pain, frankly, from spending cuts than from tax hikes. But there is pain all the same. Austerity always causes economic pain. If I beat my dog for a week, and then stop beating it, my dog is going to feel better. Does it feel better because I beat it, or because I stopped beating it?
The second thing we learn from our little example is that there are macroeconomic mechanisms at work that prevent austerity from being effective. Those mechanisms are known as the multiplier and the accelerator—two transmission mechanisms of economic activity that work to magnify increases and decreases in economic activity. The multiplier magnifies an increase or decrease in consumer spending, while the accelerator spreads the positive (negative) effects of an increase (decrease) in business capital formation.
It is essential that we understand these mechanisms; to be frank, sometimes I suspect that those who think austerity can work either do not comprehend multipliers and accelerators or simply reject their existence. Either way, it is unwise to ignore them. Fiscal austerity affects consumer spending by taking money away from households, either in the form of higher taxes or cuts in cash and in-kind benefits. This results in reduced consumer spending.
When consumer spending declines, eventually, capital formation in the business sector is also affected. If businesses pay substantial taxes and receive government benefits (a.k.a., corporate welfare), then fiscal austerity will of course directly trigger a negative accelerator effect.
Now we know what austerity is and how it works. Part II will analyze the consequences of and alternatives to austerity.
