This is an article published in the LSE about the Austrian view of the Eurozone crisis ‘The Work of Hayek shows why EU governments can’t spend their way out of problems‘

I’ve attempted to summarise the article, but I advise reading it for yourself:

1. The recent boom and bust was caused by artificially low interest rates and capital flows which caused an inefficient use of resources.
2. The current period of high unemployment and low interest rates means there is much idle capital and labour unused – waiting to work out how best to be used. (analogy use of jigsaw pieces waiting to be put together by the market)
3. Governments always lack the knowledge of how to efficiently make use of these resources, but instead will choose the most electorally popular types of government spending. Therefore, if the government spends money it will inevitably go on the wrong areas of the economy and just make things worse. Therefore, the government shouldn’t intervene.
4. So what can we do? Allow private enterprise to decide how to use these idle resources. The only thing we should do is remove barriers to enterprise and competition, e.g. cut regulation, taxes and state intervention. In a free market, the price signals of profit, loss and prices will enable a return to market equilibrium and full employment. It may take time, but it will happen eventually.
5. ‘Before the advent of Keynesianism, most recessions were very short lived as producers were left free to shuffle the jigsaw pieces into better combinations’

Some things struck me about the article.

• There is a lack of specific examples relating to the current crisis. It is hard to find any examples of a country where government spending has fallen and there has been impressive economic recovery. In fact, the opposite seems to happen, with the deepest recession in those countries with harshest austerity policies.
• The main argument seems to be the unwavering faith in the inevitable failure of any type of government intervention.
• The idea that before the advent of Keynesianism most recessions were very short lived is highly dubious (to be polite). It inconveniently ignores (for example):

• The Great Depression  (1929-37) The great depression did last a long time. The Great Depression only really ended when countries embarked on Keynesianism (mostly in form of military spending). Those countries who embarked on military spending ended recession earlier than others.

• The recession of 1815–1821. widespread

• foreclosures, bank failures and negative market sentiment.

• The tendency to lump all government intervention together is lazy. Keynesianism doesn’t advocate tariff barriers. To impose tariff barriers can contribute to an economic downturn, but just because tariffs can be harmful doesn’t mean it is wrong to pursue countercyclical fiscal policy. It is a very different type of government intervention.
• Keynesianism isn’t about bigger government. A feature of the Keynesian fiscal policy is that it should be countercyclical. For example, in this piece Simon Wren-Lewis argues that EU fiscal policy was too loose in the run-up to the 2008 crisis.

” In my view, fiscal policy in many Eurozone countries outside Germany was insufficiently tight before 2008, but for most not because it implied a build-up of government debt.   The problem was that private sector demand was too strong, encouraged by large capital inflows from abroad and real estate bubbles

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Readers Question: Would a devaluation help Greece?

If you look at the Greek economy, their exchange rate has been effectively overvalued for several years. This overvalued exchange rate has caused Greek exports to be relatively uncompetitive and has caused various economics problems. Combined with efforts to tackle an unsustainable debt level, the over-valuation has contributed to prolonged recession.

Impact of Over-valued Exchange Rate

• Very high current account deficit (over 10% of GDP)

• Falling GDP – output shrinking since 2008.
• High unemployment close to 50%

If Greece was in a floating exchange rate, there is no doubt that their currency would have fallen rebalancing domestic demand and improving economic growth. (see: why Greece would devalue)

If Greece was in a semi fixed exchange rate (such as the old ERM), there is no doubt that they would have reduced the currency peg and devalued the currency.

The problem is that in the Euro, the only option to devalue is to leave the Euro 0 with all the economic uncertainty that leaving the Euro would entail.

For Greece, the choice has always been between the benefits of devaluing and regaining independent monetary policy vs the cost of leaving the Euro and experiencing the capital flight and uncertainty this would entail.

Summary of Greek Devaluation

Advantages

In theory, a devaluation would help increase Greek domestic demand and enable an economic recovery.

• Imports would be more expensive causing demand for imports to fall – instead people would buy more domestic goods.
• Greek exports (and tourism) would become more competitive. Therefore, demand for exports and tourism would rise. A substantial devaluation of 50-70% could create many long-term opportunities to develop new export industries and encourage more tourism.
• This boost to domestic demand would also help create jobs and tackle Greece’s dire unemployment.
• Without devaluation, Greece could face years of depression as they are unable to create any boost to domestic demand in the current situation.
• The current policies of austerity have failed to  tackle the deficit, but have pushed the economy into a very dangerous deflationary spiral with levels of unemployment which threaten the social fabric of the country.

Problems of Devaluation

• A devaluation of 50% would cause a jump in inflation as imported goods go up. This could cause inflation of up to 50%.
• Inflation of 50% will increase the costs of living and reduce living standards.
• Devaluation involves leaving the Euro. Therefore there is a risk of substantial capital flight as Greek savers try to protect the value of their savings by moving into Euro bank accounts rather than lose value. This capital flight would cause banks to run out of liquidity. There would need to be government backed support for banks.
• The devaluation would increase the effective debt to GDP ratio. It could see Greece’s national debt rise to over 200% of GDP. Therefore, there would need to be a substantial default because outside the Euro, bailout funds would dry up.

Overall

Exit would be very painful and difficult. But, staying in the Euro, only seems to be prolonging the economic pain Greece is facing. If Greece did devalue and leave the Euro, they would at least be in a position to avoid the current situation of trying to manage in a single currency which doesn’t work for them.

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Balanced Budget Fiscal Expansion is an attempt to increase aggregate demand through changing spending and taxation levels, whilst leaving the overall fiscal budget situation the same.

Essentially, the idea is that if you increase spending and taxes equally, the increased government spending has a bigger positive impact on economic growth than the negative impact of higher taxes.

A key factor in balanced budget fiscal expansion is the idea of the multiplier effect. Through the multiplier effect, higher government spending on capital projects may cause a bigger final increase in real GDP. (e.g. with a multiplier effect of 1.5 –  £1bn of government spending, may increase real GDP by £1.5bn) Therefore, by financing capital investment through higher taxes we can, in theory, increase economic growth without increasing the budget deficit.

To explain the idea of balanced budget fiscal expansion it is best to use examples. Two ideas spring to mind.

1. Reduce spending on pensions, increase spending on capital investment.

If the government increased the retirement age it would reduce government spending on pensions. The  money saved can be used to finance higher capital investment. Overall government spending remains unchanged, but people are working longer, and the government can finance capital investment which can increase aggregate demand.

2. Increase Income Tax for a temporary period and use the money to finance capital investment.

The social market foundation recently proposed bringing forward £15bn of tax increases and using this to spend on infrastructure spending. (PDF)

If income tax were increased for a short period, say three years, people would tend to spend less, therefore there would be a fall in consumer spending. However, the government could use the money raised to finance capital investment. For example, building schools, building roads or a new airport in London. Therefore government spending will increase and offset the fall in consumer spending.

If there is no multiplier effect, the fall in consumer spending will be equally offset by a rise in government spending. Economic growth and the budget will be unchanged.

However, if the multiplier effect of government investment is greater than one, then there can be an increase in economic growth.

For example, if the government increased spending on roads and railways, there would be a direct increase in demand from the government spending, but there could also be knock on effects to the rest of the economy. Construction firms would take on unemployed workers; these former unemployed workers would now spend more – causing a further round of increased spending in the economy.

Furthermore, they may also be a supply side impact from the investment. Business say the lack of another airport in London is holding back investment in the South East. If capital spending increases transport links, it can benefit the supply side of the economy in the long term, which is an additional benefit to long term economic growth.

Also high profile capital expenditure projects may help to boost consumer and business confidence. Therefore, this could increase spending and Aggregate Demand even more.

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Readers Question: what axioms underlie the theory of consumer behaviour? How reasonable are they? I have the axioms: completeness, transitivity, continuity, non-satiation and convexity. but we have never been taught about how reasonable they are and I can’t find any info anywhere! please  help

It is an interesting question. I am not really qualified to give a good answer as I am not familiar with some of the terms you mention. However, I will look at the issue from a more general perspective.

Rational preference

If a consumer prefers A to B and also prefers B to C. Then, it follows a rational consumer should prefer A to C.

E.g. you prefer Starbucks to Costa Coffee and you prefer Costa Coffee to McDonald’s then you should prefer Starbucks to going to McDonald’s.

Are there consumers who might, given the above, still prefer McDonald’s to Starbucks? It is pretty unlikely, but, consumers can always behave on a whim. It is not impossible.

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