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Austerity: With or Against Growth?

A short route to higher spending, higher taxes, a stagnant economy and default...

EUROPE'S LEADERS now say they want "austerity with growth". Sounds nice, writes Nathan Lewis at New World Economics, in a story first published at Forbes.

They have no clue how to achieve it.

Back in 2008, I said that the typical response of mediocre governments to the economic problems would be a combination of "austerity" and "stimulus".  They actually use exactly those words. They can't even manage to make up some new words, for generation after generation.

I didn't expect things to follow this blueprint quite so exactly.

Governments find that they bounce back and forth between these "austerity" and "stimulus" strategies, discovering that they are both unsuccessful.

What tends to happen is that "stimulus" means more government spending. Soon, people discover that this "stimulus" spending tends to be directed to abject waste and crony capitalists, and the government's debt burden explodes. Thus, the political system careens back toward "austerity".

"Austerity" usually means less spending and higher taxes. The higher taxes are implemented, but it is soon discovered that nobody wants to reduce spending, especially when the economy is crumbling due to the higher taxes. What small reductions in spending there are tend to be directed toward genuinely beneficial services, while the waste, graft and crony capitalist payoffs continue unabated. The sagging economy leads to shortfalls in tax revenues, and the deficit may even expand.

The public soon complains that important services are being cut, while the excessive bureaucrat headcount and absurd benefits continue unchanged.  And the crony capitalists – today the banking and defense industries in particular – still receive a river of unearned largesse. Taxes, already too high to begin with, head higher – as if the problem was insufficient taxation! The economy crumbles, and the public begins to complain. The government immediately spins this into a story: "see, we can't reduce spending one little bit!" And we lunge back into a cycle of "stimulus".

The end result is: higher spending (from "stimulus"), and higher taxes (from "austerity"). This eventually leads to a moribund economy and sovereign default, as we have seen so clearly.

So, what's the solution? What is "austerity with growth"?

I suggest a different strategy: lower taxes (to help the economy), and less spending (to deal with the deficit).

"Lower taxes" should, in the first instance, take the form of a tax reform, which will probably turn out to be revenue-neutral in terms of tax revenue as a percent of GDP. Basically, a flat-tax type solution, as dozens of governments have implemented in recent decades, with repeatably fantastic results.

Perhaps the government or electorate would wish to go further than this, and reduce both government tax revenues and expenditures as a percent of GDP. However, quite a lot can be accomplished with even a "revenue-neutral" strategy.

"Less spending" should focus on maintaining the desired government services, but providing those services in an efficient and low-cost manner. Government employee headcount should be reduced to what is needed to provide the services desired, and compensation should be realistic and sustainable. Some aging programs (Medicare for example) could be restructured to provide an equivalent service (healthcare) with a much lower cost.

Payoffs to crony capitalists should be curtailed, or, ideally, eliminated.

How could a voter complain about that? They get a dramatically better tax system, the same services, and much less government waste and theft. The improved tax system helps the economy, and the reduced government waste and theft frees up more resources to be used in the productive private sector, which can then create more jobs.

Politically, it is far easier to reduce government spending when the private economy is booming, or at least has the potential to due to the better tax regime. Businesspeople will immediately sense that the wind has shifted in their favor.

There's nothing new about this strategy. It's the same as Ronald Reagan and Margaret Thatcher tried to implement (with varying degrees of success) in the 1980s.

It's the same strategy the Japanese leaders used soon after the Meiji Restoration in 1868. A tax code containing 1500 taxes was discarded and replaced with a minimalist system that derived almost all revenue from a simple property tax. Most of the remaining revenue was raised by a tax on alcoholic beverages.

The new Japanese leaders then eliminated their unneeded government bureaucrats in one mass purge.

The Japanese leaders also introduced a new, uniform national currency, the Yen, which was linked to gold and originally worth the same as the US Dollar (1/20.67 of an ounce of gold.)

The result? The first great era of industrial expansion in Japan. Even today, almost 150 years later, Japan remains the only ethnically non-European country to be fully and completely considered a "developed economy".

How could a government implement such a strategy today? Let's take Greece:

  1. Default and restructure the existing government debt. The consequences of past error are here, and now it's time for the enablers to take their losses. The inability to access debt financing will help a lot in the process of reforming spending;
  2. Put insolvent banks into receivership and restructure their liabilities, so they can emerge soon after fully solvent and fully capitalized. This does not need to cost the government anything;
  3. Institute a top-to-bottom tax reform, with something like a flat-tax-type income tax system with a low top rate of perhaps 18%, a VAT of perhaps 12% (compared to 23% today), and nothing else;
  4. Reform spending on a vast scale, with a focus on preserving the most important services while eliminating needless headcount, overly generous compensation, and various forms of crony capitalist payoffs;
  5. Maintain a stable, reliable currency, which today probably means keeping the Euro, while refusing foreign meddling in domestic affairs. At some point, the Euro may not be acceptably stable or reliable. Then, another solution may be necessary.

"You're dreaming," comes the response. Yes, so what? You can't implement a plan, successfully or unsuccessfully, if you don't have a plan. It sure beats bouncing back and forth between "stimulus" and "austerity" as governments are today, with the usual bad consequences.

As unrealistic as it may sound, government do sometimes manage to accomplish all this and more. Usually, it is during a crisis. Which is what we have in Greece today. Perfect timing.

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Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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