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Getting Out of Recession: European Austerity v. American Deficit Finance -- Which One Is Effective?

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Austerity is a form of punishment for spending beyond one's means. In the 1700s those who could not pay their debts would be incarcerated. Bankruptcy laws and deficit financing have been invented but austerity is still lingering especially in the old European mind set. Since the financial crisis, various governments and global financial institutions have been obsessed with reducing national debt levels. Austere policies have been implemented throughout Europe and the United States with the intent of reducing deficits by severely curtailing spending. While reducing wasteful spending is beneficial for the recovery, austere measures that widen unemployment and shred cohesion are inimical for it. Austerity has not worked because it has forgotten that debt has value and that during recessionary times countercyclical measures which may raise debt are needed to stimulate growth, GDP, employment and stabilize the economy.

In the wake of the financial crisis, austerity was pushed forward out of fear of the implications of soaring debt levels. In part, austerity was championed on the premise that it would restore the fiscal credibility of financially shaken countries and combat the rise of interest rates, which normally accompany growing debt levels. Rising interest rates have always been a scourge, especially during times of recession, since high rates tend to restrict credit flow to businesses and consumers and thus slow economic activity. More fuel for austerity came from academic publications like the Reinhart and Rogoff study, Growth in the Time of Debt, which claimed that nations with debt over 90 percent of their GDP faced significantly diminished growth prospects. Comments from reputable institutions like the IMF suggesting Greek debt levels were "unsustainable" also pushed austerity center stage. The whole crescendo of "we must have austerity now" helped usher in measures wildly obsessed with reducing national debt levels. The unintended of these policies was being trapped in a longer recession as Europe is experiencing and to a lesser degree the U.S. However, the austerity measures implemented so far seem to focus on curtailing spending in general, regardless of its productivity. That explains the long duration of the current recession.

This crude approach to spending cuts has weakened economies by increasing unemployment, destroying human capital, and prompting an exodus of talent. Blanket austerity has forced governments to butcher funding for social programs and shed government jobs. Countries under austere prescriptions, such as Spain and Greece, are facing youth unemployment levels close to 50 percent . And if that were not bad enough, such high unemployment is deleterious for future growth since it destroys human capital and encourages a brain drain. The longer people are unemployed it becomes increasingly more difficult to find employment of the same quality due to skill depreciation. In Greece, for example, more than 100,000 workers have already left in search of greater economic opportunity elsewhere. The resulting unemployment from austerity and the associated skill loss, or in the case of young people, prevention of skill development, will severely impact immediate and future economic productivity.

Moreover, the unemployment provoked by austerity deeply affects a society's social cohesion. Employment is closely correlated to personal well-being; in fact, joblessness was found to have the single greatest negative impact on a person's well-being, even above divorce. Political involvement and civic participation are also associated with employment, since those with jobs arguably have a greater investment in seeing their country prosper. Consequently, employment plays an influential role in defining the social cohesion of a country. Shredding employment undermines this social fabric; it is no wonder massive protests and riots have erupted in countries like Greece.

Austerity has failed since its proponents forgot the value of debt and its importance in economic recovery. Debt creates value and assets in the sense that borrowing money to invest, such as in education or infrastructure, or in businesses enables greater future returns, like increased productivity and competitiveness, which will ultimately more than compensate for the present borrowing. When employment is created through deficit financing, that employment creates assets. The inverse is also true: deleveraging debt by squeezing employment destroys assets. The severe impact of leaving millions unemployed as government programs and businesses shudder under the affects spending cuts is not a policy that is tolerable, at least for long. Recently, the IMF, a major proponent of austerity, conceded that it "badly underestimated the damage that ...austerity would do to Greece's economy." Even academic evidence, like the Rienhart and Rogoff study, which a few years ago seemed to show so persuasively that debt severely hindered growth, has been harshly criticized for making several calculation errors which greatly exaggerate the claimed effects. Austerity has lost its gusto as people realize that productive spending, which may increase deficits and overall debt, is not to be abhorred, for in fact the recovery and future growth depends on it.

We can learn from the failures of austerity to guide our continuing economic recovery. Instead, the Federal Reserve Board is continuing to buying bonds as a countercyclical measure that focus on reducing unemployment. Countercyclical macroeconomic measures help to stabilize inflation and output by leaning against the recessionary headwinds. Stabilizing output, or production, directly impacts employment levels. This mantra has been taken up the U.S. Fed, which promised to keep interest rates quite low until unemployment falls below 6.5 percent. By keeping rates near zero, the Fed hopes to coax credit flow to businesses, which allow them to keep producing and expanding, and in doing so grow employment opportunities. Employment has steadily climbed, even to the point where the Fed has recently acknowledged that it now may soon begin to slow its bond buying efforts. Certainly more could be done, especially if Congress summoned the courage to use deficit financing as a countercyclical tool to combat unemployment, rather than busying itself with debt reduction policy. Through deficit financing, Congress could expand tax credits to small businesses to promote hiring, or invest in infrastructure and draw employment via construction and development. There is a plethora of different ways that Congress can step in to address unemployment if it could only overcome its immediate fear of debt.

The fear that deficits and mounting debt will suffocate economic recovery and impede healthy growth has been tested over the last several years, and the results are not just unimpressive -- but painful when one looks at unemployment levels. Current prosperity and future growth demands that we put our fear of deficits aside, at least long enough to get people back to work.

Nake M. Kamrany is a professor of economics at the University of Southern California and Director of Program in law and economics and a member of California Bar. Samuel Kosyder is member of the Executive Committee of GIC-G studying economics and physics at USC. Haseena Qudrat is professor of business economics at the American University of Afghanistan.