The headline at ABCNews.com reads "President Obama, Bill Clinton Stump on Growth vs. Austerity Agenda." While referring to the economic debate going on in Europe, Britain's New Statesman displays the headline "The Austerity vs. Growth Argument is Hotting [sic] Up."
Here is the picture: The economy, whether here or in Europe, appears to be slipping into another recession. (Yes, we've been out of recession since June 2009.) At the same time, government debt and deficits, both here and in Europe, are at record levels. Austerity measures that reduce government spending, it is argued, will hurt the economy by stifling economic growth. Continuing the deficits and increasing spending, on the other hand, will stimulate the economy. What is needed? More "stimulus spending." This would keep the economy from slipping back into recession, making the deficits worse. Former President Clinton put it this way:
"If you do not have economic growth, no amount of austerity will balance the budget because you will always have revenues go down more than you can possibly cut spending."
Clinton is partially correct; economic growth in the private sector does increase revenues to the government. As income grows, so do tax revenues. The problem with the Obama-Clinton line of reasoning is that in their world there is a trade-off between austerity -- reducing government spending to control deficits -- and economic growth. But government spending does not stimulate; it depresses. Government austerity and private-sector prosperity are complements, not substitutes.
The premise behind the growth vs. austerity fallacy is that government spending has no opportunity costs. It is the same reasoning that prompted the president's recent "the private sector is doing fine" comment. It is also the kind of analysis that was the underpinning of President Obama's 2009 stimulus package and President Bush's stimulus bill the year before.
In the "growth vs. austerity" view, the focus is on spending as opposed to saving, which is considered a "leakage" from the economy. The economy, in this view, is the sum of aggregate consumption spending, investment spending, and government spending. Each of these is in its own hermetically sealed box.
So when the government spends money, it does so at no cost to private consumption or investment, so long as there is no corresponding tax increase, i.e., so long as it is financed with deficits. Oddly enough, if government spending is financed by taxes, it is acknowledged that the spending comes, at least to some extent, at the expense of the private sector. But if the money is raised through borrowing instead of taxing, it is treated as free. This defies logic.
Public-sector growth must come at the expense of the private sector, where real production, i.e., the provision of goods and services demanded by consumers, takes place. Government austerity leaves more income and resources in the private sector, available for entrepreneurs, investors, and consumers. The public sector cannot expand without diverting resources from the private sector.
Government growth is not just a one-to-one trade-off with private-sector growth. This is because of the inherent inefficiencies in the government allocation of resources, which is driven by political concerns and special-interest pleadings and lacks the incentives created by a system of profit and loss.
Unfortunately, the austerity vs. growth fallacy is the guiding force behind economic policymaking in the Obama administration. Unless and until this fundamental error in the understanding of economics is corrected, the country will not show significant progress toward vigorous economic growth and job creation.
Dr. Roy Cordato is the John Locke Foundation's vice president for research and resident scholar.