As Greece Proves, Austerity IS Government Spending
Current headlines in the popular and business media keep reminding us about the ongoing economic crisis in many European countries, especially, Greece. The annual government deficits leading to the current and large government debt in these European countries is an important reason for their current bleak economic outlook.
Persistent deficits and a growing national debt have a significant negative impact on their economic growth and well-being. A euro spent by the government ultimately comes from the savings of a private European household. Hence, the question of whether or not government spending is better for economic growth is a question about whether the government's spending of the euro or the private household's decision to invest the saved euro will lead to greater economic growth. The private household can invest the saved euro in the stocks and bonds of private corporations or in their own businesses. These private corporations use these funds to invest in their business projects to hire employees, buy inputs, and produce goods and services. With the exception of public goods (like national defense and transportation infrastructure) it is difficult to point to examples where the government has been more efficient, in terms of price and quality, in providing goods or services compared to the private sector. Additionally, a large government debt has a negative impact on economic growth because the funds used to pay interest on the debt would otherwise have (ultimately) gone to new and ongoing investments of private businesses.
Deficit and debt reduction programs have two components: reduction in government expenditures, and increase in government revenues. Reduction in government expenditures would include cuts in social programs. Increases in government revenues would include increases in personal and corporate taxes.
Is a reduction in government expenditures, or an increase in government revenues the more effective policy for successfully reducing the government deficit and national debt? Related to the above question is another relevant question: What are the characteristics of successful debt reduction programs that include a mix of reduction in government expenditures and increase in government revenues? Alberto Alesina and Silvia Ardagna of Harvard University, and Andrew Biggs, Kevin Hassett, and Matthew Jensen of the American Enterprise Institute have separately studied the fiscal consolidations in OECD countries during 1970-2007. They conclude that successful fiscal consolidations are characterized by at least 85% reduction in government expenditures and no more than 15% increase in revenues.
However, recently commentators on both sides of the Atlantic have suggested that reduction in government expenditures, or austerity, will have a negative impact on their economies. As recently as 2006 Greece had a significantly higher GDP growth rate than the European Union. Perhaps, not coincidentally, 2006 was also the last year when Greece's government expenditures as a percentage of GDP was less than that of the European Union. From 2007 thru 2013, Greece's government expenditures (as a % of GDP) grew every year; this relation is especially stark when compared to the government expenditures in the other EU countries during 2007-2013. During 2008-2013, Greece's GDP growth rate was less than that of other EU countries, often significantly less.
There is a negative relation between the GDP growth rate of the European Union countries and their respective government expenditures in the previous year. Consider the government expenditures in 2013 and GDP growth rate in 2014 of three countries: France's government expenditure in 2013 was 57% and its growth rate in 2014 was 0.2%. Norway's expenditure was 44% and growth was 2.2%. Ireland's expenditure was 40.7% and its growth was 4.8%.
However, it is possible to find two countries that have a positive relation between expenditures and growth rates.
Hence, the need for statistical tests. They highlight that EU countries whose governments spent less experienced a stronger subsequent growth in their GDP. In short, austerity works!
