Europe needs spending cuts, not tax increases

With Spanish and Italian yields surging, and with Spanish equities yesterday hitting a new post-March 2009 low, the Eurozone crisis appears to be entering yet another panic phase.

The basic problem is that while the ECB's recent efforts to provide sufficient liquidity to the banking system have improved conditions dramatically, the underlying problem facing the Eurozone has not yet been addressed: How exactly are the PIIGS countries going to implement the severe austerity measures that investors are begging for; how are they going to address their huge deficit spending problem? 

As I mentioned in a post last week, the problem with austerity is not so much the proposed cuts to government spending, but the proposed increases in taxes: 

It's tax austerity that is creating the problem: Spain's desire to raise taxes in order to help reduce its fiscal deficit—at a time when the economy is struggling and unemployment over 20%—is likely to harm the economy and aggravate the deficit, rather than reduce it. Raising taxes is the problem because that is basically an attempt to validate a level of spending that is already way too high; furthermore, it asks the weakened private sector to carry an additional burden and spares the bloated public sector from needed adjustment.

With a HT to Greg Mankiw, there is serious academic research by Alessina and Giovacci to back up my claim:

The accumulated evidence from over 40 years of fiscal adjustments across the OECD speaks loud and clear:

First, adjustments achieved through spending cuts are less recessionary than those achieved through tax increases.

Second, spending-based consolidations accompanied by the right polices tend to be less recessionary or even have a positive impact on growth.

These accompanying policies include easy money policy, liberalisation of goods and labour markets, and other structural reforms.

There remains a lot of work to be done on identifying the appropriate accompanying policies and understanding the channels through which they help spending-based stabilisations, but the fact is there, as shown for instance in a recent paper by Roberto Perotti (2011).

Third, only spending-based adjustments have eventually led to a permanent consolidation of the budget, as measured by the stabilisation – if not the reduction – of debt-to-GDP ratios.

And here's the key point: "... we should stop focusing fiscal policy discussions on the size of austerity programmes. A relatively small tax-based adjustment could be more recessionary than a larger one based upon spending cuts. Likewise, a small spending-based adjustment could be more effective at stabilising debt-to-GDP ratios than a larger tax-based adjustment."

If the economists and politicians of Europe are not brain-dead or totally ignorant of the facts behind successful fiscal adjustments, they will do the right thing and focus their efforts on spending cuts rather than tax increases. Doing the right thing is always the sensible thing, and in this case, the only thing that has a chance of working. Doing the wrong thing at this point is almost unthinkable.

How hard can this be? I refuse to believe that there will be massive Eurozone defaults and subsequent financial and economic chaos spreading throughout the world. The solution to today's problem is far easier and less painful than the consequences of failing to find a solution.

And by the way, the U.S. needs exactly the same kind of solution.