Government spending cannot generate economic growth. At a fundamental level the economy is the sum of transactions between buyers and sellers, a giant marketplace where people and businesses trade goods and services for money.
You cannot buy a product unless somebody has manufactured it and is ready to sell. If supply is unchanged, an increase of demand results in bidding among buyers and higher prices. More demand without more supply does no good. Therefore, economic policy should focus on the supply side, encouraging businesses to invest and create.
Yet proponents of Keynesian-style government deficit spending still believe that increasing government spending can produce economic growth. They argue against austerity, claiming that European government spending cuts have led to slow or negative growth and sky-high unemployment rates. We read how Greece, for example, is being forced to cut government spending as a condition of international aid.
The only problem with these arguments is that all the purported facts are misstated. In reality, few countries in Europe have reduced government spending. For those that have, growth is generally better than it is in countries that have continued to expand government spending.
Data on 30 European countries from Eurostat, the official statistics agency of the EU, show that only eight countries cut government spending between 2008 and 2012. Of the eight, only Iceland and Ireland faced significant outside pressure to impose austerity. The others are Bulgaria, Latvia, Lithuania, Hungary, Poland and Romania.
Many countries that have purportedly tried austerity and failed are not on the above list. Greece, Spain, Italy and Portugal increased state spending. Italy is the only one of those four whose hike in government spending (4.1 percent) is below the EU average of 4.9 percent over 2008-2012. Greece (8.3 percent), Spain (13.3 percent) and Portugal (5.8 percent) were more profligate than the average European government.
Eurostat also contains data on GDP growth rates from 2008 to 2011 (2012 data are not ready for all countries). In terms of GDP growth only two of the eight countries that practised austerity were below average: Iceland and Ireland. Iceland had a meltdown of its banking system, so it is a special case. Ireland had a big real estate bubble that popped, causing a bank crisis and enormous government deficits. Both were among countries with the severest recessions.
The other six austerity countries recorded above-average performance. Further, the two countries with the best performance in Europe, Poland and Lithuania, are both in the austerity group along with Bulgaria, with the fourth-best GDP growth.
As further evidence, the correlation between government spending growth and GDP growth is negative (–0.14) for these 30 European countries, meaning they move oppositely—higher government spending growth leads to lower GDP growth. If Keynesians were correct—that government spending increased growth—the correlation would be positive.
The Europe-wide negative correlation between government-spending growth and GDP growth, combined with the fact that three of the four countries with the best GDP growth tried austerity, suggests that austerity has some empirical support in Europe. This brief look at the data is not enough to prove austerity works, but it certainly has not been the widespread failure Keynesians claim.
Austerity can indeed work if a country is willing to try it. Trying austerity means actually cutting government spending, not just slowing the growth in government spending. Austerity cannot have failed in countries where it was never tried.
Jeffrey Dorfman is a Forbes contributor, professor of economics at University of Georgia, and author of Ending the Era of the Free Lunch
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(This story appears in the 20 September, 2013 issue of Forbes India. To visit our Archives, click here.)
\"More demand without more supply does no good.\" Fine, but where is the demand to come from? It cannot come from people whose disposable income is falling farther and faster than it has ever done. It cannot come from people who only work in low-paid, part-time jobs, or have zero-hours contracts. There is no point in \'investing and creating\' for a non-existent customer base. Henry Ford paid his people $5 a day so they could buy his product. If you want an economy based on the mass consumption of goods and services you have to accept that people need the resources to make the system work. Reducing their spending power won\'t do it.on Sep 16, 2013