THE BLOG
05/10/2012 01:25 pm ET | Updated Jul 10, 2012

Austerity Now!: Bold Policy or Huge Blunder

Austerity has now become the global policy du jour. It was one of the major issues in the French and Greek elections of May 6th. Yet, by the Spring of 2013, unless the trend is reversed, Greece, Italy, Spain, Portugal, Britain, Canada and even France, will probably be subjected to various doses of this medicine. The US will also likely adopt some version of austerity unless the Democrats win the presidency, the House and have a filibuster proof majority in the Senate.

It is time to challenge the underlying assumptions of this ubiquitous policy du jour by asking three fundamental questions. (1) Is it fair? (2) Is it working? (3) Is it needed?

Greece received a mega dose of this medicine sine 2009 and is therefore a valid guinea pig regarding the effectiveness of this 'therapy.'

IS IT FAIR ? The criterion of fairness is easy. Are those who have run up the debt and enjoyed its fruits the ones who will be paying the austerity bill ? In Greece, the answer is an unambiguous No. The elites who have done all the spending are escaping largely unscathed, protected by legal tax avoidance and less legal, difficult to detect, tax evasion. The common people are the ones who are paying the bill through unemployment, reduced pensions, benefits and salaries and increased taxes. Although there was some prosperity for all during the fat years, the lion's share was enjoyed by the untaxed and untaxable elite. In some cases, austerity has become in Greece a life and death issue with more suicides, stress and diseases which can no longer be treated because of lack of money. Verdict: Not fair at all.

IS IT WORKING? Let us now turn Machiavellian, forget the hard luck stories and adopt a heartless philosophy: the end justifies the means. Has that happened in Greece ? The principal goal was to reduce the debt to GDP ratio. In 2009, before this medicine was introduced, it stood at a high 109% when the European average was about 80%. At the end of 2011 after three years of hardship it has gone up, not down, to 160%! The best case scenario is that by 2020, after eight more years of privation it will be 120%, higher than in 2009, before the miracle medicine was introduced.

Clearly the medicine has not worked and is more likely to kill the patient than cure him. The reason should be obvious for anyone who remembers their Economics 101. Government expenditures are between 30 and 50% of a modern country's GDP. If they are cut, unless the private sector takes up the slack, GDP will inevitably fall.

Consequently the debt-to-GDP ratio will rise because the numerator is fixed and the denominator is decreasing. The worst case scenario is when the numerator increases (because of higher interest rates) and the denominator decreases because of general demoralization, which is what is happening in Greece. Verdict : Not effective at all.

IS IT NEEDED? Conventional wisdom says yes by confusing entire countries with individuals or corporations. Economic history says no. There have been two proven debt killers over the ages. The first is economic growth which reduces the weight of a fixed debt. The second is rising prices, also known as inflation. Before readers raise their eyebrow in horror, they should note that when the price increases are under 4% they stimulate the economy without being dangerous. Right now, most western countries are well within their production possibility curve because of very high unemployment and idle resources. Economic growth can be fueled by employing these resources and alleviate the debt burden.

Conversely, there are two debt amplifiers: depression and deflation. What the Europeans are doing, soon to be followed by the Americans, is choosing this latter combination : a suicidal option as described by Nobel Prize winners Paul Krugman and Joseph Stiglitz.

There is one alleged counter-example in Canada's successful elimination of its fiscal deficit in the late nineteen nineties, at the time when I was its permanent representative at the OECD. The analytical evidence reveals that Canadian federal program cuts were responsible for only 20% of the debt reduction. The other 80% was due to tax revenues from a new country wide value added tax the GST, high exports due to a very inexpensive Canadian dollar (0.62 to the US dollar) and an expanding world economy with high demand everywhere.

In contrast the Euro-Atlantic economy in 2012 is suffering from high unemployment, low growth, the decline of the middle classes and general pessimism. Now is not the time to prescribe to this anemic patient a radical weight reduction program.

The Mayans at Chichen Itza, faced with drought, sacrificed their virgins on their pyramids to bring rain. What happened was pain and death with neither gain nor rain. Let's hope that the western governments will not emulate the Mayans and visit needless misery on their populations for nothing. Verdict: Not needed.

What, then, should be done? What would really help the entire Euro-Atlantic zone is a healthy dose of economic growth and development. With a good 30% of the labor force either unemployed or underemployed, there is ample room for growth without dangerous inflation. In Europe, an intelligent 'Marshall Plan'-type development strategy, fueled and led by a European Central Bank, endowed with a much larger mandate than controlling inflation, will do the trick. The Germans are currently opposed but they may change their minds in a year or two, as they witness the ravages of austerity or... change their government in the 2013 election.

For the United States the solution is even simpler. Introduce a nationwide value added tax like Canada did and quickly absorb the federal deficit and then use monetary and fiscal policy to reconstruct the aging infrastructure and encourage the private sector to live up to its potential of restoring growth and prosperity. No need to sacrifice virgins on pyramids...

Austerity Now, like Apocalypse Now, is neither desirable, nor effective nor needed.