Austerity versus Growth

You must have heard the news media, newspapers articles and commentators talk about differences between the position of the German government of austerity and the French’s position of growth.  I could not find any written document that explains what the French president means by growth.  The confusion arises from using the two words, austerity and growth, at the same time.  It certainly suggests that the French president (and probably President Obama too) are not for austerity, and therefore are for increased spending.  But it does not necessarily and immediately follow that increased government spending causes higher economic growth.

The austerity argument is about reducing government expenditures, which could include reducing the size of the public sector by firing people, reducing and suspending some social programs, reducing the wage bill, salaries, pensions, perks, services and other expenditures.  Clearly, public sector employees do not like this approach, and who can blame them. But, what has this got to do with growth?  The government maybe able to induce a temporary increase in output, but that should not be confused with growth.

It is unclear what the growth program of the French president is. If it is meant to be the opposite of austerity, then all that is required is an increase in government spending.  What French President Hollande actually meant, and this should be explained, is that government expenditures could stimulate demand via spending, which would then get the economy out of recession, but it has nothing to do with economic growth either.

These economic thoughts are widespread, but confusing.  Some top economists also believe that government spending can resolve Europe’s economic problems and that government spending can cause economic growth, but careful empirical analysis by John B. Taylor and Valerie A. Ramey in the Journal of Economic Literature Vol. 49, No. 3, September 2011 shows that there is no credible evidence for this conjecture.  See a very interesting 5-page article by Edmund Phelps, the Nobel laureate, Keynes Vs. Hayek: Stumbling blocks to spending our way to prosperity, produced by Reuters, November 8, 2011.  You will get the message.

An increase in government expenditures, whether the level or the growth rate, cannot always cause real production of goods and services to grow faster. It could increase consumption and that would increase GDP level such that the economy gets out of the slump.  That’s not growth.  There is a significant difference in meaning between an increases in  the level of output and a sustained increase in output.  To affect the growth rate of output government spending must be directed at factors of production, or factors that cause technical progress such as education, R&D etc but that’s not as easy as politicians think and cannot be guaranteed.[1]

Growth of the production of goods and services is the speed at which the economy’s production increases from one year to another, and can only increases if technical progress grows.  It took economists decades of research to understand what that thing is and what might drive it.  Growth economists demonstrate that it is driven by knowledge and new ideas of producing new goods and services—innovations if you will.  These ideas do not come from thin air. They vary from one country to another.  They might depend on productive investments such as investments in human capital, investments in better quality of human capital or investments in research and development. 

No one would have believed in the 1950s that one could ever send a copy of a piece of paper (the modern fax) around the globe in a few seconds. This is knowledge producing a new commodity and creating markets.  Communication technology, which we are observing today like the iPad and smart phones, smart TVs, the internet, medical tools, fabrics and materials etc. are examples of technical progress leading to economic growth. 

Economists went further to suggest that there might be other variables that affect the growth of technical progress, such as geographical location and distance from big markets, the set of laws that regulate the markets and the businesses, the culture where some are savers and others are spenders, government policies, etc.  None of these  testable theoretical propositions include government expenditures.

Governments could invest in science, knowledge, human capita, etc. and these investments might affect the growth of technical progress in the long run.  They might be important in early stages of developments, but I am not sure this is what the French politicians, the news media and some top economists have in mind when they talk about growth policy, presumably, as an alternative to austerity

The major problem Europe needs to deal with is how to reduce unemployment, and this will not be solved by increasing government expenditures or the money supply.  It will not be reduced by inflating the economy.  I checked the IMF world economic outlook data set; the historical French aggregate time series data do not show a negative correlation between GDP growth and unemployment over the period 1980 to-date.  It means that an increase in GDP growth rate is not expected to be associated with a lower unemployment rate. 

Ed Prescott’s[2] explanation, which is confirmed by others such as Shimer and Nickell among others,[3] is that the Europeans are taxed relatively higher than Americans—presumably so that the government can finance social programs and the large public sectors—therefore, people work fewer hours.  Sadly, a lot of people will be unemployed for a long time unless the European governments, especially in France and the Southern European countries, reduce the size of their public sector, reduce taxes on labor and make their labor markets more flexible. But this won’t happen because people elected governments that promised just the opposite.

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[1] Johnson, R., W A Razzak and Steve Stillman, “Has New Zealand Benefited from Its Investments in Research and Development?” Applied Economics, Volume 39, Issue 19, November 2007, 2425-2440, show that 40 years of R&D spending in New Zealand did not result in any spillover.

 [2] Prescott, E., Why Americans work so much more than European? Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 28, No.1, July 2004, 2-13. 

[3] Shimer, R., Convergence in Macroeconomics: The Labor Wedge, American Economic Journal Macroeconomics, Vol. 1 No. 1 (January), 2009, 280-297.

Nickell, S.,Employment and Taxes, CESIFO Working Paper No.1109, 2003 (December).