01/25/2011 12:33 pm ET Updated May 25, 2011

Lesson From Europe: Fiscal Austerity Kills Economies

There's more evidence that fiscal austerity should never be a government policy objective. The UK has just released its 4th quarter GDP numbers and the results are predictably grim: a -0.5% decline in GDP for the last three months of 2010, versus a market expectation of +0.4%.

This comes as no shock to anybody who understands basic sectoral flows. Taking income out of the private sector in the absence of any countervailing flows from the government or external sector means lower output, slower growth and higher unemployment. The UK economy's performance is totally consistent with this analysis.

Yet the FT is flooded with articles from the likes of Roger Altman and Robert Rubin. Why let evidence get in the way of a good neo-liberal theory? Neither Altman nor Rubin understand that it would be ruinous for this country if the federal government took their advice and pursued budget surpluses at a time when the external sector is in deficit and the private domestic sector needs to save to reduce its damaging debt levels. They, like virtually all mainstream economists/policy makers, haven't taken the time to understand the sectoral balances. If they had, they would know that they are pursuing a strategy that would force the private sector into further debt. That's precisely what's happening in the UK.

Mainstream economic theory (which Rubin embodies totally) claims that when private spending is weak, it is because we are scared of the future tax implications of rising budget deficits. This is Ricardian nonsense. As Bill Mitchell has repeatedly noted, "the overwhelming evidence shows that firms will not invest while consumption is weak and households will not spend because they are scared of becoming unemployed and are trying to reduce their bloated debt levels."

We already have overwhelming empirical evidence in the European Monetary Union -- Ireland's government has collapsed as a result of its ongoing embrace of misconceived austerity and the economic crisis has morphed into a fully fledged political and social crisis. But now we also have the UK, which is some six months or more into the period of fiscal austerity even though many of the cutbacks have not been introduced. And the VAT was only recently increased in January! But British households and firms have known since the election in May what was ahead of them and so have had time to make adjustments to their spending and saving patterns to take the expected future into account. It doesn't help when you've got a series of Cabinet ministers saying that Britain faces a "Greek problem" or is "bankrupt," as Chancellor of the Exchequer George Osborne announced shortly after the Tory/LibDem coalition took over last spring.

Now to be fair to Rubin (I can't believe I'm writing this), he's not advocating the cuts right away. But he's definitely still part of the problem, not the solution. And his faux reasonableness is one of the things that has made him so persistently dangerous over the years. We'll probably have more of this nonsense tonight in the SOTU, but President Obama must heed the dangers posed by the British approach, despite the fact that virtually every single mainstream economist and talking head is advocating that the president ultimately adopt the UK's ruinous course of action.

Cross-posted from New Deal 2.0.