‘Austerity’ isn’t an evil word

May 8, 2012, 5:26 PM UTC

Voters say no to austerity, yes to Francois Hollande.

FORTUNE — With François Hollande’s victory in France and the poor showing of both major parties in the Greek legislative elections, European voters are punishing parties and politicians that champion the economic reforms branded “austerity.” In France, Hollande won on a platform of shelving “l’austerité” in favor of policies that favor the his version of the real solution, “la croissance,” or growth.

The U.S. is now locked in the same “austerity versus growth” debate that’s the great divide in global economic policy. The anti-austerity crowd includes former President Bill Clinton, Treasury Secretary Timothy Geithner, and former Obama budget director Peter Orszag, as well as economist-cum-columnist Paul Krugman.

The goal of what’s called “austerity” is pretty clear: Measures that lower the budget deficits prevailing in the U.S. and most of Europe. The problem is that politicians and pundits invoke the word to portray any policies that shrink the gap between revenues and expenses as brutal growth-killers. “The proposals called ‘austerity’ are characterized as going back to the Stone Age, with the connotation of drastic, draconian, sharp, sudden reductions in spending,” says John Taylor, the Stanford University economist.

The alleged evils of austerity don’t stop there. It mislabels reforms to entitlements or unshackling rigid labor markets as barriers to growth, especially if nations embrace them immediately, and not years hence.

In fact, lowering spending right now — as long as the downward slope is gradual — will do nothing to choke economic growth, and could even enhance it. And the anti-austerity solution, raising spending immediately, then reversing course at some future date, will not lift GDP, even temporarily, and threatens to further hobble deeply indebted nations. “Spending more is mistaken and foolish when deficits are this gigantic,” says Taylor. “It signals that governments can’t get their act together.”

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It isn’t just that even enlightened deficit reduction is being condemned as “austerity.” It’s also that “growth” is being wrongly re-defined as “stimulus,” a quick surge in government spending, when the real elixir is fresh capital investment that raises productivity.

Nor does the blanket term “austerity” distinguish between the good and bad ways of lowering deficits. The southern European countries and the U.S. are in entirely different positions. Greece, Spain and Italy need to lower outlays rapidly to prevent capital from fleeing and bondholders from demanding lofty, budget-busting interest rates to buy their bonds. Spain, for example, is suffering from a “primary deficit,” meaning a shortfall between spending and revenues, of 5% excluding interest payments. That scenario invites disaster.

It’s not the objective of lowering deficits that’s wrong, but the way the weak nations are attempting to do it. They’re using a combination of tax hikes on the wealthy, including business owners, and changes to entitlements and pensions that lower spending for a year or two, but do nothing to impose structural reforms needed to place future deficits on a durable, downward path.

“The message is, ‘If you’re thinking of starting or expanding a business, don’t do it here because tax rates will soar,’” says John Cochrane, an economist at the University of Chicago’s Booth School of Business.

What’s really needed to cushion large spending reductions, and what’s not happening, is decisive labor market reforms that allow companies to hire and fire workers far more freely. “Germany has prospered because it reformed its labor markets with four different legislative packages,” says J.D. Foster, an economist at the Heritage Foundation. “The rest of Europe needs to follow Germany’s example, not raise spending.”

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By contrast, the U.S. has the luxury of taking a more gradual, measured approach to deficit reduction. It’s true that sudden, wrenching declines in government purchases can lower growth. “If the Defense Department suddenly stops ordering fighter jets, those plants are shuttered, and the workers aren’t trained to build houses instead,” says Foster. “So the idle capacity lowers growth.” On the other hand, reforming entitlements by gradually lowering growth in Medicare and Social Security outlays for middle class Americans will not curb economic expansion.

That formula has no connection with what’s being caricatured as “austerity.” Taylor says the U.S. should aim to spend around 20% of GDP on government, closer to the 19.7% it spent in 2007 and lower than the 24% it currently spends. It should get there not by spending less, but by controlling spending so that outlays grow more slowly than the economy. Taylor also advocates starting right now. But will capping the growth of government spending, especially in our slow recovery, further curb economic expansion?

Here’s why the answer is no. Slowing the growth in entitlements gives Americans time to adjust their budgets, and does not idle capacity like closing producers dependent on federal contracts. Every dollar the U.S. doesn’t spend in entitlements is a dollar it doesn’t have to borrow. The money spent on entitlements has to come from somewhere else — the system recalls the principle of conservation of matter physics, which states that matter isn’t created or eliminated, it just changes form. The money the government doesn’t borrow raises the savings Americans place in bonds, stocks or bank accounts. Those additional savings then flow into private investment by companies. Instead of being spent on salaries for federal workers, it’s spent on machine tools, tractors, or computers.

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What if the government borrows less not from Americans, but from China and other nations that buy most of our Treasuries? In that case, we’re importing less savings from abroad, enabling the U.S. to raise its exports. It’s all GDP math: The payments account must balance, so that if borrowing from abroad falls, our imports will fall, or exports rise, by the same amount. And either of those shifts will cause precisely the same growth in GDP, in the short term, as the government spending that disappears.

“The rise in exports and domestic savings that goes to investment rapidly and completely offsets the decline in government spending,” says Taylor. He adds that a short time later, the fiscal discipline actually leads to higher growth: “Fiscal discipline is more than offsetting, because it reduces concerns about future debt and future crises, and big tax increases down the road.”

The distinguished crowd that condemns austerity champions more spending instead. Once again, the extra dollars need to come from somewhere else. If they’re borrowed at home, they lower private investment. If they’re borrowed from abroad, they lower exports or raise imports. “It’s the law of addition,” says Cochrane. “If I take it from A and give it to B, the money B spends is money that A can’t spend. Money is just getting shifted from one pocket to another. The immediate effect on GDP is zero. And the longer term effect is negative.”

It’s no wonder Americans are confused by all the talk about the evils of “austerity” and the wisdom of spending more. It really isn’t complicated.  Let’s give the private economy more to spend, not by starving the government, but by ensuring it grows more slowly than the output of our plants and labs. That’s the true meaning of growth.

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