WHEN THEORY AND REALITY DIVERGE



Logical Flaws or Mistakes in Reasoning in the Economic Debate



by Jens Berger



[This article published on October 2, 2012 is translated from the German on the Internet, http://www.nachdenkseiten.de.]



Europe groans under the yoke of austerity policy. In the last days, both Spain and Portugal announced they missed their deficit goal “despite the greatest efforts at saving.” The initiative propagated above all by the German side that a country is fit for the future through budget cuts and neoliberal reform to revitalize state finances may correspond to market-radical theory. However this approach does not function in praxis although this is repressed. Politics forces crises and prevents ending crises every day by holding to its ideological blinders.



In the German mass media, austerity policy is wrongly described as a savings policy. The term “savings” has a positive sound and suggests that one who saves will later have more money. Whoever is sparing on the spending side suffers fewer losses and thus reduces his or her deficit. That is a theory which from a national-economic perspective ranks intellectually on a level with Angela Merkel's model of the Schwabian housewife. The state is not a private household and spending cuts always strike back on other actors of the national economy. Austerity policy is more than “only” cuts of spending in public budgets. Neoliberal reforms are also part of a genuine austerity policy. The state withdraws from different areas and leaves these areas to “the market.” For example, the deregulation of the labor market and the privatization of formerly public fields belong to austerity policy.



Advocates of the austerity policy often say the Red-Green agenda policy was only one form of austerity policy and should have protected, not damaged, Agenda Germany. However this statement is not tenable. On one side, the expenditures of public budgets were not cut during the agenda policy – contrary to what is often communicated. On the other side, the worldwide economy was very strong in the time of the agenda policy so the stagnating demand of private households was compensated by an increasing demand from abroad. When the agenda policy is judged a success – against all logic -, one should at least admit that Germany as a strong export economy reacts differently to political-economic reforms than national economies with a strong domestic economy. The damages inflicted by austerity policy depend on many factors of which the global economy is the most important.



AUSTERITY IN THEORY



In theory, austerity policy is an answer to the missing trust of the markets. A deficit in the market conformity of democracy is balanced with austerity policy. When investors find a market-conforming democracy, ac cording to the theory, they are more convinced this country can repay its debts and that investments in this country are worthwhile. Enforcement of an austerity policy should regain the trust of the markets and bring investors into the country.



The investments ventured thanks to increasing trust should then lead to an economic upswing and bring more people wages and bread. The spending of the state should then fall while the tax revenues increase simultaneously through the surging economy. At the end this should lead to budget surpluses and reduction of state indebtedness which aids the markets with falling interest-rates for the state bonds of this country.



AUSTERITY IN REALITY



Supporters of austerity policy cannot prove the first step of this causal chain – particularly when austerity policy occurs during a global crisis. Investments are made on the basis of a hard-as-nails cost-benefit analysis, not for ideological reasons. Every form of austerity policy always leads to declining aggregate demand. Since the income of private households declines, these households have less money for consumer spending. The state cannot balance this deficit since it cuts its spending and consequently also demands less. In a recession, businesses usually invest less since the declining demand and the uncertain future negatively influence a cost-benefit analysis. In times of a strong world economy, the demand from abroad can balance these factors. In crisis times, the opposite is true. Businesses do not invest in a time when foreign demand declines alongside domestic demand. Spending- and wage-cuts intensify the decline of demand taking place everywhere during a global crisis. Economists speak of a “pro-cyclical” effect; economic swings are intensified, not balanced.



As a first consequence, all this leads to increased unemployment and a decline of demand. The country is on the way into recession if this decline cannot be cushioned by “anti-cyclical” economic policy or a rising foreign demand. The higher unemployment leads to rising state expenditures in the social realm. Parallel to this, state revenues decline. Falling wages and rising unemployment lead to falling income tax revenues; revenues from excise duties (consumption taxes) diminish on account of falling demand. Since corporate profits also fall in a recession, the revenues from the corporation tax also decline.



Increasing spending and falling revenues do not lead to a revitalization of the state budget but to missing the envisioned “savings goals” and to another ascent of the budget deficit and the state debt rate. At the end of the causal chain, there will be higher interests, not lower interests, for the state bonds and in the worst case even state bankruptcy.



WHEN EMPIRICAL REALITY CONTRADICTS THEORY



The most recent developments in Spain and Portugal are another empirical evidence that the theory behind austerity policy is not tenable. Both Spain and Portugal have submitted to the German austerity dogma up to self-castration and the crisis has intensified. In Portugal, the unemployment rate doubled in the course of the crisis from 7.3% to 15% today. In Spain, the unemployment rate has more than tripled from around 8% to 25% today. In both states, the state revenues shrivel faster than expenditures can be cut without compensating economic effects. Every additional spending cut leads to a higher deficit in state revenues. Both the absolute state indebtedness and – even more strongly – the state debt rate rise.



The harsh austerity policy in southern Europe is like a cruel field experiment whose authors don't want to admit their failure. When theory and reality diverge, the theory is wrong, not the reality. Admitting this would be the first step to clearing up the crisis. But we are still far removed from that.