Message to Europe: Government Spending IS Austerity

"General Lucius Clay, postwar Governor of the U.S. military zone in Germany, remarked to Finance Minister Erhard, ‘My advisors tell me that you should not try to balance the budget, but should engage in deficit spending.' To this Erhard replied, ‘My advisors tell me the same thing, but we are not going to do it. We intend to balance our budget, not to incur any indebtedness, to avoid inflation and keep the mark stable and sound." - Howard E. Kershner, Dividing the Wealth, p. 135.

A Wall Street Journal headline from last month, "Europe, in Slump, Rethinks Austerity", captures well the binary view of economic growth at the moment: spend or recess. With seven Eurozone nations technically in recession, it's widely assumed within the mainstream economic commentariat that absent heavy government spending, recession will be the rule.

What's ironic about this broad supposition is how divorced from reality it actually is. For one, it's fair to say that austerity of the spending cut variety hasn't even been tried yet.

Indeed, as economist Richard Rahn recently wrote, "government spending has risen as a share of gross domestic product (GDP) in all of the major economies." It's assumed that government spending has declined, but as Rahn clarifies, governments have been active participants in efforts to revive country economies. Despite all the government spending, the outlook in Europe remains bleak.

Government Spending Still Doesn't Stimulate

To regular readers of this column, none of what's coming to pass should surprise. It's perhaps shooting fish in a barrel at this point, but governments have no resources. And because they have no resources, in order for governments to spend they must necessarily tax or borrow precious resources from the very private sector that generates all economic growth.

Not only is every dollar, euro or yen spent by governments one less of each that could potentially be deployed by private market actors disciplined by profit and loss, it's also the case that government stimulus spending ignores the tautological reality that production is the driver of the growth and consumption that so transfixes economists. Wealth merely changes hands when governments presume to stimulate through spending, whereas true government spending cuts remove actually barriers to production for more capital being left in the private sector to fund real economic activity.

For draining so much limited capital from the private economy it could be argued that what economists refer to as "stimulus" is in fact an economic somnolent, or true "austerity," and recent years confirm the latter supposition. Figure the Obama administration has overseen large government spending increases and record deficits, yet the rate of unemployment in the U.S. remains well above what it would be if the economy were truly growing.

Worse, at 8.2%, unemployment has only fallen insofar as the labor force participation rate has declined.  As frequent RealClearMarkets contributor Louis Woodhill has calculated, if labor force participation were as high as it was when George W. Bush left office (65.8%), unemployment today would be 11.2%. If the labor force participation rate were as high today as it was in April of 2000, U.S. unemployment would be 13.2%.

Considering the limp outlook for the U.S. economy, it's well past time to more forcefully point fingers at the very government spending encouraged by so many economists as a necessary driver of rebirth. Certainly if government spending were a source of economic energy we'd be reading about substantial growth in profligate spending Europe and the U.S., yet the outlook for both remains rather depressed.

The good news, both for government finances and for economic growth, is that substantial reductions in government spending are actually very stimulative. There are two U.S. examples supporting the latter claim, along with one from post-WWII Germany, that should encourage those bothered by deficit spending that doesn't seem to be achieving anything to begin with.

Governmental Parsimony Is Itself a Stimulant

Considering the U.S., though federal deficit spending during World War II rose to 120 percent of GDP, the collapse in outlays (from $84 billion in 1945 to $30 billion in 1946) after the war did not drive the economy into recession. As economists Jason Taylor and Richard Vedder wrote in 2010, "The ‘Depression of 1946' may be one of the most widely predicted events that never happened in American history."

Simple logic would have predicted a major economic rebound. Not only do government spending cuts leave more funds in the private sector, but war itself is the opposite of stimulus for the humans that drive economic advancement killing each other, as opposed to producing for one another harmoniously.

With the de-mobilization of U.S. troops after the war a September 1945 BusinessWeek predicted an unemployment rate of 14%, but in fact unemployment averaged 4.5% in the first three postwar years. Far from an aimless economy without the alleged stimulus that was war, the U.S. economy quickly absorbed troops released from the military as evidenced by the low rate of joblessness.

Traveling backwards in time to 1920-21, the U.S. economy contracted substantially then too. But just as Americans aren't aware of a post-WWII "recession" that never was, so are most seemingly unaware that Americans suffered a brutal downturn not too long after the end of World War I.

Perhaps one reason so few are aware of the early ‘20s downturn has do with how short it was. Notably, and contrary to popular economic opinion today which says governments must spend economies out of slumps, federal spending declined from $6.4 billion in fiscal year 1920 to $3.3 billion in 1923. Classical economic theory prevailed in the early ‘20s, the federal government got out of the way, essentially reducing its spending burden on the U.S. economy, and the latter roared.

Considering West Germany in the aftermath of World War II, Howard Kershner observed in Dividing the Wealth that "This unfortunate country had been more nearly destroyed than any other in Europe. She had suffered the loss of many millions of her strongest young men, and had seen a great part of her homes, factories and business buildings destroyed.....In spite of all these handicaps, in a few short years Germany became the most prosperous country in Europe." Yet as the quote which begins this piece reveals in living color, West Germany revived itself despite keeping its budget in balance. There's seemingly a pattern to light government spending and booming economic growth, yet modern economists don't much pay it heed.

The Euro Isn't to Blame

Of course some blame the euro itself for Europe's problems. It's believed by euro naysayers that absent a fiscal union to match the currency union, that the euro was doomed from the start. Here lies a grave misunderstanding about the purpose of money.

Put simply, money is not wealth, rather money is facilitator of the exchange of real wealth. A euro accepted across many countries would almost by definition enhance the trade that defines wealth exchange for exchange rate risk being removed to some degree as a factor.

As for there not existing fiscal union in concert with currency union, that criticism of the euro has no relevance. Figure the dollar is an accepted unit of account across 50 states with 50 different fiscal policies. Rather than a hindrance, the common dollar has surely been a help when it's come to the evolution and growth of the U.S. economy.

Conclusion

The European economy is far less complicated than most would like to believe. Though its struggles are blamed on governmental austerity and a common currency that doesn't account for differing country economies, neither assumption stands up to the most basic of scrutiny.

Money is a merely a facilitator of the real product-for-product wealth exchange that actually occurs when individuals transact. Though the euro would ideally be stronger, and as such a lure for investment into the Eurozone, its existence as a common currency can only redound to Eurozone growth for exchange rate risk somewhat disappearing as a factor. Just as the U.S. economy would be much weaker if there were 50 currencies for all 50 states, it's hard to credibly argue that Europe would be better off with a different currency for each of its countries.

As for "austerity," though the word conjures up slow growth in the minds of many, economic history reveals spending restraint as a stimulant. Indeed, the problem today in a recessed Europe isn't governmental austerity, but the unsung reality that the latter hasn't yet been tried.