April 26, 2013
TORONTO, ON, Apr. 26, 2013/ Troy Media/ – With the world abuzz about mistakes in some influential research by economists Carmen Reinhart and Kenneth Rogoff, attention is being drawn to the case for austerity. Reinhart and Rogoff published several academic articles arguing that, among other things, high levels of debt negatively impact growth. More famously they popularized this idea in their 2011 book This Time It’s Different: Eight Centuries of Financial Folly.
While attention is mainly focused on issues of academic honesty and the accuracy of published results, most people are missing the forest for the trees. There are bigger issues at stake. In particular the question of what austerity or deficit spending implies are being overlooked.
The argument for austerity is precipitated on the very basic dictum that ‘there is no such thing as a free lunch.’ Every action has a cost associated with it, even if the cost is in the distant future and difficult to see.
Continued deficit spending does confer some very short-term gains. Few would argue otherwise, including the vast majority of so-called ‘austerians’ – those who advocate reducing deficits (and hopefully debts) today through spending cuts. Just like your personal consumption increases when you take on more debt, so to can we extrapolate this result to the greater economy.
The cost of this debt-fuelled activity is apparent in the future when the bills come due. Just as taking on a mortgage enables a short-term boost to your spending, in the future when you must repay the debt your expenditures must be decreased. Maybe one less vacation will be taken per year in your bid to pay off the interest on your mortgage.
The case that austerians build is mindful of this fact. Any debt taken on today will need to be repaid in the future. This repayment can come in one of two forms.
First, taxes can pay for the interest and principal repayments. If this is the case, either future tax-funded services will need to be cut or taxes will need to be increased. Take your pick, though I doubt that many out there look forward to less road maintenance or higher taxes. (Not to mention the worst-case scenario of higher taxes and less road maintenance!)
Alternatively, the Bank of Canada could monetize this increased debt spending by printing up the money to pay it off. This seems like a free lunch at first glance as the fiat money of today is almost costless to produce. Yet monetizing the debt entails higher inflation, and this is just a tax by another name. By reducing the value of all the money outstanding, every citizen who holds any cash balance is taxed to pay for today’s deficit. Inflation of 2 per cent is equivalent to saying that you paid a 2 per cent tax on all your cash balances.
The case for austerity recognizes that there are real costs to debt repayment. But it also goes one step further. Taking on debt can be a relatively painless activity if interest rates are low, or if economic growth is high. Likewise your mortgage of today could be a good idea if you lock in a low fixed interest rate, and also if your job prospects remain strong and your annual salary increases are decent.
Consider what happens when interest rates rise. As interest payments increase, it is more difficult for you to continue paying. To do so you must decrease expenditure on other goods that you would rather enjoy, like that winter getaway that you always wanted. Getting lured into too much debt when interest rates are low, such as is the case today, can prove painful when rates rise.
Interest rates rise as your economic situation deteriorates. Notice that this is quite dependent on the amount of debt, and hence interest payments, that you already have. As you take on more debt, the risk that you will not repay increases. As a consequence the interest rate to borrow more debt increases, and thus makes it more costly to borrow.
This is the future that austerians warn of. If we borrow a lot today it implies that we have to pay back a lot in the future. If we binge now and interest rates rise this will mean that we will have to repay even more in the future. If we spend more of our future tax dollars repaying interest on today’s debt it necessarily follows that we will have less money available to pay for other goods and services.
Carmen Reinhart and Kenneth Rogoff may have made some calculation errors in their study, but this doesn’t mean that the argument for austerity is any less strong. Borrowing today has a real cost in the future, and the decision to further indebt ourselves had better be mindful a future with more money paying off interest, and less spent on the goods and services we really want.
David Howden is an adjunct scholar of the Ludwig Von Mises Institute of Canada and Chair of the Division of Business and Social Sciences at Saint Louis University – Madrid Campus.
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