Analysis by Alex Wolinsky
Earlier this year, the Greek parliament voted to approve austerity measures in exchange for increased foreign aid in an attempt to resuscitate the country's moribund economy. Later that day, central Athens burned.
Given the origins of Greece's predicament -- a bloated welfare state and dishonest bookkeeping, in addition to an array of other factors -- one might conclude that austerity, in conjunction with greater external oversight, is an integral ingredient of any solution to the European economic catastrophe and, by extension, to that in the United States. Economist Paul Krugman, however, argues otherwise.
"This is not the time for that, because it is literally self-defeating," he said during a lecture before The Commonwealth Club in May. "Try to do austerity now, and it actually just deepens the depression."
According to Krugman, such action would trigger a reduction in the size of the economy as workers and businesses that depend on the government for wages and revenue cut their spending. As a result, the tax base shrinks, the deficit problem -- as well as the crisis as a whole -- worsens and the solvency of the government is placed further in jeopardy.
So, if expected results resemble those described above, why would anyone advocate a policy of austerity?
The answer is that the projected outcome is decidedly rosier. By classical economic theory, a reduction in government expenditures --a fiscal contraction -- does in fact cause a decline in GDP, but accompanying this is a bolstering of foreign confidence in the long-run solvency of the government and thus greater willingness to grant loans, which can be used for economic revitalization and a brighter future.
Though there are certainly examples of austerity being successful, more often in the post-recession world -- especially in Europe -- its results are similar to those described by Krugman. Indeed, as noted by former Council of Economic Advisers Chairwoman Christina Romer in an April 28 column for The New York Times, "[A]usterity is uniquely destructive right now."
With this in mind, what should be done to combat fiscal insolvency?
Many economists, including Romer, argue that less important than a government's total debt is its debt-to-GDP ratio. Intuitively, this makes sense: A country with a larger economy should be able to assume greater total debt than a nation with a smaller GDP before it suffers from insolvency concerns. This presents the novel conclusion that a country can mitigate insolvency either through cutting spending -- through austerity -- or through boosting its GDP. This latter action is most easily pursed by implementing an increase in government expenditures, which wholly contradicts the stipulations of austerity measures.
Overall, the debt-to-GDP ratio idea offers the immensely attractive concept of an economic recovery without further, government-induced pain. And, given the current state of the austerity-rife European Union, exploring related policies might be the tempting -- albeit admittedly unlikely -- next step.
• Related upcoming event: September 6, Economist Paul Saffo -- The Great Turbulence: Economics and the New Global Order