People of Europe, Rise Up!

The markets are down sharply today over a downgrade to the outlook for Italy's credit rating, as well as over the rout of the socialists in elections in Spain over the weekend.

Investors might wonder, Why would socialists getting voted out worry the bond market? Spanish voters apparently revolted against "austerity measures" that the socialist government was implementing, but investors might scratch their heads because it doesn't seem that voting in a center-right government would spell less austerity than a socialist government.

Let's try to untangle some of the strings between austerity plans, protests, and the market reaction.

Europe is increasingly being forced to deal with the issue that we have called "The Question of our Time," namely the realization that seemingly endless government benefits have to be paid for by someone, and that in many countries (and a few US states) these benefits have become so generous that they will break the budget completely unless they are reduced.

The erstwhile socialist administration in Spain initially passed laws giving out even greater levels of benefits than before: everyone could get a government-paid scholarship to college, universal health coverage was extended to everyone for procedures including sex-change operations, childcare was paid for by the government, young adults received government rent money so that they could afford to be "emancipated" from their parents even without a job, and the minimum wage was raised even higher.

However, the bond market has a habit of imposing a reality check on countries whose spending threatens their ability to pay the interest on their debts, and in order to prevent credit rating cuts and higher borrowing rates, Spain's government executed a dramatic about-face and instituted an "austerity plan" to preserve its ability to borrow.

In Europe, the phrase "austerity plan" signifies reducing government spending and raising taxes. In Spain, for example, the government spending reductions included lowering pay for government workers by five percent and pushing back the age for retirement benefits from 65 to 67, while the country simultaneously increased the tax rate on the highest bracket from 43% to 45% and created a new bracket below the highest bracket that would pay 44%. The government also increased the tax on cigarettes by 24% in 2011.

We believe that European-style "austerity plans" are terribly damaging, not because they reduce government spending (which we applaud) but because they raise taxes, which further cripples the economy by reducing the ability and incentive for business creation, innovation and growth. As we've written before, growth is really the best answer in the long run.

Cranking up tax rates simply crushes growth. We have also written about the fact that the tax rate on the highest brackets matters an awful lot to everyone in the economy, even though many people don't understand why (see here and here for an explanation).

The bulk of the protests against austerity plans in Europe, however, does not seem to come from a recognition that taxing the highest brackets even more excessively will crush growth, but rather from anger at the reduction of the lavish benefits that are apparently viewed as a right.

In Spain, the Puerta del Sol in Madrid is now filled with thousands of young adults who are indignant at the high rate of unemployment, and the new austerity measures that they see as passing on the pain to the people in order to spare the pain to "the bankers."

This NPR story on the indignados (as the young protesters are called) notes that the young people are angry at the austerity measures and notes that one young man who lost his job two years ago and has a heavy mortgage "blames the banks" (presumably for giving him the mortgage, not for the loss of his marketing job). He declares, "The bankers from Lehman Brothers, Barclays Bank, Spanish bankers — all must be in jail." The story describes middle-aged women and restaurant owners who sympathize with the protesters bringing them food -- "vegetables and fruit, because many people are vegetarian."

This story from South Africa's Sunday Independent notes that demonstrators are particularly angry with the austerity measures because they came from the socialist party that is supposed to support government spending. "It is a socialist government but they are implementing the same policies as Sarkozy in France, Merkel in Germany and Cameron in Britain," one spokesman complained. "This directly affects the welfare state." The idea!

But why would the voting out of the socialists worry the international markets? We believe it has to do with the mistaken Keynesian ideas that still dominate the thinking of many economists, even on Wall Street and in big international financial institutions. Many do not accept the argument that lower taxes and less government spending is good for growth. While the center-right governments of Europe are not exactly libertarian when it comes to taxes and the role of government, it is probable that many observers believe they will be less likely to raise taxes than the socialists would be.

The perception that government spending grows the economy and that cutting government spending means less stimulus and less growth is wrong, in our view, and yet it still operates as an underlying assumption for many modern intellectual descendants of John Maynard Keynes. There is plenty of hard evidence that government spending not only does nothing positive for economic growth, but in fact has a negative impact -- see this previous post which discusses evidence from history.

Keynesians in general believe that consumption drives the economy (which is why they think government spending helps the economy by stimulating more consumption). However, production is what really drives an economy and what Spain and other European countries such as Greece and Portugal need to stimulate.

It may seem like it's too late for some of these European nations to figure out how to become productive members of the economy again, but to this negative assessment we would reply: "It's never too late." There are plenty of examples of countries with moribund economies getting rid of bad economic policy and experiencing dramatic turnarounds. Israel and New Zealand are two that come to mind.

We would argue that human beings everywhere possess the potential for incredible and unexpected innovation and creativity. To unleash it, governments need to remove the shackles of high tax rates, and stop paying people not to work.

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