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Why Spain’s New Government is Drinking Austerity Kool-Aid and How This Threatens the Global Economy

European elites push economic myths that benefit the rich and screw the rest. Spain's program means even higher public deficits, fewer jobs, and slowed growth.
 
 
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Spain's new government said late last month that this year's budget deficit would be much larger than expected and announced a slew of surprise tax hikes and wage freezes that could drag the country back to the center of the eurozone debt crisis. The government plans to enact public spending cuts of 8.9 billion euros ($11.5 billion) and tax hikes aimed at bringing in an additional 6 billion euros a year to tackle the shortfall. Given what has happened to Greece, and now Italy, it is almost certain that this will have the opposite impact of that which the Spanish government wants: there will be HIGHER public deficits at the end of the day, as the cuts curtail economic growth even further.

Self-inflicted Catastrophe

Spanish employment fell by a whopping 72,075 in November, which came on the heels of an even bigger 82,944 decline in October. The Spanish employment data is really terrible. To get a feel for these numbers, you have to realize that Spain’s employment is about one-eighth that of the U.S. We are talking about employment declines in the last two months that would correspond to monthly declines of more than 600,000 if it were the U.S. economy. In the prior three months Spain’s employment declines corresponded to the equivalent of almost 300,000 job declines a month in the U.S. Would anyone doubt that the U.S. was in a deep recession if it reported such horrible employment data? Of course not.

The eurozone, indeed, the entire global economy, continues to experience a self-inflicted catastrophe, largely because of dangerously destructive myths about fiscal policy. In spite of the shrill rhetoric of the fiscal austerity brigades, the evidence in Europe continues to mount that a nation cannot have a fiscal contraction expansion when all other spending is flat or going backwards. Unless you want an economic disaster.

Let’s look at some macroeconomic issues in a simplified form:

1. In any given country, how many sectors are there that can spend? Answer: three.

2. What are they? Answer: The foreign sector, the private domestic sector, and government sector.

3. What happens if firms in the private domestic sector cannot sell their goods and services because people can’t afford to buy them? Answer: They lay off workers and refuse to spend on new equipment, etc.

4. What happens if income in the local economy is lost to the foreign sector – that is, is not recycled back into domestic demand? Answer: Drain on growth, fewer exports, more imports.

5. If the economy is looking bad, what happens to private domestic sector households? They will not spend.

6. If the foreign sector isn’t spending on a country, and the domestic sector isn’t spending, either, then the economy will ground to halt unless the one remaining sector fills the breach: the government sector. This is true, regardless of what the anti-government mythologists from Germany, the University of Chicago, and others, argue to the contrary.

Free Market 'Miracles' are a Myth

This is particularly true in a situation when an economy is suffering from the after-effects of a PRIVATE SECTOR debt bubble. And let’s set aside this nonsense about the miracles of “letting the ‘free’ markets work. The notorious ‘Invisible Hand’ –that mythical self-regulating aspect of the market–turns out to look like 1995-2000 with all that wonderful allocation of capital to tech and telecom, or perhaps more along the lines of 2000-6, with the brilliant decisions made by hundreds and thousands of equity investors, bank loan officers, and credit analysts made regarding real estate allocations (of which Spain was a notable example). Doesn’t work too well in reality -- and ordinary people are left holding the bag.

It’s time to wake up. Market allocation of investment has proven just plain idiotic too many times over the past two decades (plus) for anyone to believe such neoliberal fibs, except maybe the wettest behind the ears on Wall Street. The markets so glorified by free market fundamentalists are presently optimally designed to breed nonsense asset bubbles that make financiers as much money as they can before it all falls down. Everyone knows this. We've seen it in the deregulation of the financial sector, the failure of regulative oversight of real estate markets (including allowing private citizens to fund mortgages in foreign currencies), a bias towards budget austerity (under the European Union's  Stability and Growth Pact) which meant that growth had to rely largely on private credit expansion – etc.

The behavior of governments leading up to the global financial crisis was based on exactly the same logic that is driving the fiscal austerity: that free markets are best and government should have as small a footprint as possible. This game is over, except, it appears, in the minds of Europe’s policy making elites, which continue to champion this form of economic Kool-Aid.

Government Investment Must Fill the Breach

Remember, it wasn’t government overspending which created the financial crisis of 2008. In the words of Nomura economist, Richard Koo:

“When a debt-financed bubble bursts, asset prices collapse while liabilities remain, leaving millions of private sector balance sheets underwater. In order to regain their financial health and credit ratings, households and businesses are forced to repair their balance sheets by increasing savings or paying down debt. This act of deleveraging reduces aggregate demand and throws the economy into a very special type of recession.”

The private sector in Spain is now undergoing massive deleveraging. Its economy does not run a trade surplus, which leaves the government as the only entity which can offset the slack. A basic macroeconomic rule is that spending creates income and output which then stimulates employment. Leakages from the spending stream (for example, via saving) have to be offset or you slide right back into recession. But the new Spanish government is doing precisely the opposite and, even more perversely, is being applauded for “picking up the baton” and accelerating the spending cuts of the last Socialist administration while its GDP is plunging. It’s the economic equivalent of mediaeval blood-letting, with the same likely ultimate impact for the “patient” – in this case, the Spanish economy: weakness and possibly death.

Unfortunately, Spain’s new government is setting a policy plan for fiscal austerity which is likely to set yet another precedent for policy failure and yet more increases in unemployment and social misery. Forcing fiscal austerity onto an already weak economy will guarantee that the problem morphs into a full-blown crisis.

 
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