Cutting our noses to spite our faces

30/11/2010 by

The trouble with austerian logic is that it is grossly illogical. It does not even make sense in terms of the logic of microeconomics, let alone that of macroeconomics.

Consider the current conundrum facing Greece and Ireland, the eurozone’s set of failed states (so far): Both countries have been forced to slice 10% off government spending immediately, the assumption being that such a move will suppress the debt in the longer run. Now, a 10% cut means serious social pain, especially in countries already facing unprecedented unemployment and poverty rates. The merchants of austerity think that this is OK. That it is the price our nations must pay for their past carelessness. Perhaps. But will it do the trick? No, it won’t.

Some numbers are in order here: At about the interest rate charged to Greece and Ireland for the new EU-IMF loans(5%), the sacrifices involved in cutting government spending by 10% in one year will only cut into the national debt (even slightly) provided GDP growth is not affected adversely by the cuts to the tune of more than 0.45% of GDP. Put differently, if the 10% cut in government expenditure results in the loss of, say, 0.5% of GDP, the result of such draconian cuts will be to increase, rather than reduce, national debt. Put differently one more time, a sustainable reduction in the deficit of 0.5% of GDP has the same present value as a reduction in government expenditure equal to 10%, in a single year, of the nation’s GDP. Which means that such a spending cut will have no long term effect on the deficit if it causes even a very small dip in the growth rate (i.e. in the order to 0.5%). If the dip is greater, then the pain associated with the cuts will have been not only in vain but acutely counter-productive. Instead of invoking the ‘no pain no gain’ rhetoric, reality will have given us ‘pain for the sake of more pain’.

To recap, since everyone agrees that the spending cuts in Greece and in Ireland have had (and will continue to have) a sharper negative effect on GDP growth than 0.5%, it is a truth of arithmetic that the imposed austerity worsens our countries’ debt. Would a private company do such a thing to its own bottom line? Would it ever embark upon a cost cutting exercise, to the tune of 10%, if it knew that the net result would be an increase in its losses? Hell, no. But Greece and Ireland are expected slavishly to follow that particular path to nowhere as a condition for receiving their EU-IMF loans. The mind boggles.

Turning to the macroeconomic manifestation of this madness, first year macro students know the meaning of the multiplier. It is the multiplication factor that tells you by how much national income increases (falls) following an injection into (a withdrawal from) the economy of €1. As I showed before, the condition for austerity (i.e. savage spending cuts) to work is that Greece’s and Ireland’s multiplier is considerably less than one. Where is the evidence of that? What econometrician in her right mind would testify to this being so?

Is it, therefore, any wonder then that the recent announcement of the Irish bailout, or of the prolongation of Greece’s repayments stream viz. the EU-IMF loans, was followed by new record spreads? Wise commentators have remarked in eras past that when war breaks out the first victim is truth. Our era adds to that piece of wisdom the insight that when the euro crisis erupted logic was its first casualty. Perhaps for the first time since the industrial revolution, the clash of ideas is not between Left and Right but between Logic and Madness. As we speak/write, the latter is winning hands down and our governments are being forced to cut their noses in order to spite their faces.

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