With much of the global economy apparently trapped in a long and painful austerity-induced slump, it is time to admit that the trap is entirely of our own making.
We have constructed it from unfortunate habits of thought about how to handle spiraling public debt.
People developed these habits on the basis of the experiences of their families and friends: When in debt trouble, one must cut spending and pass through a period of austerity until the burden (debt relative to income) is reduced. That means no meals out for a while, no new cars and no new clothes. It seems like common sense — even moral virtue — to respond this way.
However, while that approach to debt works well for a single household in trouble, it does not work well for an entire economy, for the spending cuts only worsen the problem.
This is the paradox of thrift: Belt-tightening causes people to lose their jobs, because other people are not buying what they produce, so their debt burden rises rather than falls.
There is a way out of this trap, but only if we tilt the discussion about how to lower the debt/GDP ratio away from austerity — higher taxes and lower spending — toward debt-friendly stimulus: increasing taxes even more and raising government expenditure in the same proportion.
That way, the debt/GDP ratio declines because the denominator (economic output) increases, not because the numerator (the total the government has borrowed) declines.
This kind of enlightened stimulus runs into strong prejudices. For starters, people tend to think of taxes as an infringement on their freedom, as if petty bureaucrats will inevitably squander the increased revenue on useless and ineffective government employees and programs. However, the additional work done does not necessarily involve only government employees, and citizens can have some voice in how the expenditure is directed.
People also believe that tax increases cannot realistically be purely temporary expedients in an economic crisis, and that they must be regarded as an opening wedge that should be avoided at all costs. However, history shows that tax increases, if expressly designated as temporary, are indeed reversed later. That is what happens after major wars.
We need to consider such issues in trying to understand why, for example, Italian voters last month rejected Italian Prime Minister Mario Monti, who forced austerity on them, notably by raising property taxes.
Italians are in the habit of thinking that tax increases necessarily go only to paying off rich investors, rather than to paying for government services like better roads and schools.
Keynesian stimulus policy is habitually described as deficit spending, not tax-financed spending. Stimulus by tax cuts might almost seem to be built on deception, for its effect on consumption and investment expenditure seems to require individuals to forget that they will be taxed later for public spending today, when the government repays the debt with interest. If individuals were rational and well informed, they might conclude that they should not spend more, despite tax cuts, since the cuts are not real.
Such tricks do not need to be relied on to stimulate the economy and reduce the ratio of debt to income.
The fundamental economic problem that currently troubles much of the world is insufficient demand. Businesses are not investing enough in new plants and equipment, or adding jobs, largely because people are not spending — or are not expected to spend enough in the future — to keep the economy going at full tilt.