Saturday, December 29, 2012

Economics Debate MCXXI

Wolfgang and I have managed to bait each other into another of our usually fruitless debates on the Eurozone. Rather than continue in the ever narrowing margins of the Disqus comment system, let me start by specifying a few points on which we may agree:

(a)Other things being equal, higher taxes tend to suppress economic activity.

(b)At some point, said Art Laffer, that suppression is so great that tax revenues actually fall despite the higher rates. I don't think that this is controversial either, though my understanding is that the available evidence points to this occurring at marginal rates about twice as high as the highest current rate in the US.

(c)Taxes are a lot higher today in Greece, Ireland, Spain and Portugal than they were in 2005.

I want to also specify what I mean by austerity: a combination of higher taxes and lower government spending.

That said, I still believe that the troubles of the PIIGS all stem from excessive borrowing/reckless lending. Greece is a special case, since both government and individuals borrowed recklessly and irresponsibly. That's not the case with Ireland, Spain, and probably Portugal. Ireland and Spain ran conservative governments, limited spending and taxes, and trusted the markets to manage their own affairs. The markets failed miserably.

Local banks lent money recklessly and borrowed more from Germans to exacerbate the problem. Once it became clear that the borrowers could not afford to pay, various devices were created to transfer the liabilities from the debtor banks to the national governments. That spared German lenders immediate pain, but forced the PIIGS into painful austerity - raising taxes and cutting expenditures.

The austerity occurred mostly because the countries were in the Euro zone and desperately wanted to stay. Iceland, which suffered an even more catastrophic collapse, wasn't Euro and told it's lenders to suck it, and it's doing much better.