Growth, and Not Austerity Policies, Will Bring Recovery

Created: 28th September, 2007 14:37 | Last updated: 8th November, 2007 20:02	print	send

The political and governmental crisis in Hungary has a strong moral component, but in essence it is rooted in economic policy. Prime Minister Ferenc Gyurcsány gave his now infamous speech in Balatonöszöd in response to a severe economic crisis brought on by years of mismanagement. Now the insecure government is trying to justify its convergence package, which contains increases in the already burdensome tax rates, with outdated and faulty economic ideas.

If this austerity package is actually put into practice, the national economy would fall even further behind its own potential. Destructive consequences will appear; alarming indicators will include rising unemployment, inflation, a higher tax burden, and rising external debt. This would result in falling living standards, impoverishment, and the depletion of the national wealth, thus exacerbating social tensions. This vicious circle would further impede development.

When Prime Minister Gyurcsány's confession became public, revealing the secrecy, distortions, and deceptions concerning the state budget, the entire country erupted in a storm of indignation. At first it was the unprintable language in the speech delivered in Balatonöszöd that shocked people, and finally the humiliating feeling of being hoodwinked has fueled the rage of hundreds of thousands. This rage is justified when one considers that if a corporation is discovered to have published gross lies about the state of its finances those responsible would be removed. An example is the former Enron, whose leaders are in prison or awaiting the outcome of appeals. The demand that the prime minister step down or be forced to resign has become a popular movement, and an already tense political environment has become explosive.

Bad to worse

In this long-drawn out crisis the only arguments that support Ferenc Gyurcsány remaining in office are business and especially financial ones. Proponents say the convergence program is the only way to save the country from collapse; they argue that the PM is the only one who can restore stability and maintain the conditions for prosperity. Gyurcsány remaining in office—so the argument runs—is a precondition for earning the European Union's support, keeping multinational companies here, and attracting further investment.

But if Gyurcsány is really able to put into effect this package cobbled together from contradictory elements, pain will become torment. In its overall effect, the austerity policy will not only put a brake on economic development but it will drive it into a dead end. It is comparable to putting rocks into the backpack of a rambler who is toiling uphill; he will fall behind his own potential and any advance will be paid for in blood and sweat. The consequences of this under fulfillment remain even when normal progress becomes possible again and the damage can become historic in its scope.

To support this economic policy, a few faded scraps of theory are pulled out of the economic prop room, not an unusual practice in Central and Eastern Europe. After the bankruptcy of the Marxist economic theory, it is not surprising that the government is raking up precisely the western model that favors restrictions. The neoclassical, neo-Keynesian monetary-fiscal paradigm comes to the fore, variations of which were occasionally used by capitalist market economies. The outdated pillars of the structure, however, are collapsing.

However, there are ways out of the crisis other than starvation, window-dressing, and hoping for miracles. It is my intention to delineate the data from the theory and experience of economics, which can pull Hungary's economy out of its current crisis. As a start, it might be useful to sketch a vision of microeconomics and macroeconomics.

Four propositions

Microeconomics deals with the optimal operation of production and consumption in the framework of market economics. Thus, special attention is paid to defending the consumer against the abuses of monopolies. At the same time, macroeconomics examines the economy of the country as a whole or in the regions, as the case may be, with special attention to the budget. It concerns the financing of public services and redistribution through taxes and subsidies.

In analyzing the weaknesses and inconsistencies of the austerity package, I will make four propositions:

1) lowering the tax rate can increase tax revenues;
2) a rise in unemployment does not reduce inflation; on the contrary, inflation and unemployment move in the same direction;
3) restricting the economy will not moderate, but drive up inflation;
4) the rising revenue brought about by a lower tax rate can create a balanced budget in a relatively short time if government expenditures are kept constant.

The following is a brief explanation of the above theses.

First, a reduced tax rate can lead to increased tax revenues in two ways. On the one hand, it inevitably leads to less tax avoidance. And on the other, it can stimulate the activity of the national economy - that is, increase GDP - so that revenue from taxes can increase. How is it possible that revenue from taxes can increase without raising taxes? Here is an example that will illuminate this concept. An income of Ft 200,000 taxed at 40 % will yield tax revenue of Ft 80,000. If the tax rate is reduced to 30 %, prompting an increase in economic activity so that our income rises to, suppose, Ft 300,000, the tax payment will increase to Ft 90,000. Thus, increased tax revenue is not brought about by an increased tax burden, but on the contrary, a lower one. This is not a miracle, but "growth". (See the negative segment of the Laffer curve, approximately in the 40-30% tax rate.)

Second, the insight that reducing unemployment will also reduce inflation is relatively new. For decades in the second half of the past century, monetary and fiscal policies have been based on the belief that the reducing unemployment will stimulate inflation. The rationale was that when joblessness falls, the income of households rises, stimulating consumption, which then sets off inflation brought on by demand. On the contrary, however, I would argue that a reduction in unemployment - which is nothing other than growing employment - will increase the quantity of goods produced and that this growing supply will moderate inflation. (This idea is recognized by the 2006 Nobel Prize in Economics to Edmund Phelps of Columbia University.)

Third, there is the proposition that restricting the activities of the national economy will drive up inflation, not moderate it. Prices rise because production (overall supply) shrinks faster than consumption (overall demand). Clearly a person who is forced out of production does not cease to consume. Thus the mistake of the neoclassical paradigm becomes obvious when it claims that an economic austerity policy can keep inflation from rising. On the contrary! Prices rise and other troubles proliferate.

Fourth, the budget can be balanced by moderating the tax rate, provided budget outlays stay the same, because rising national product increases tax revenue. At such times, a balanced budget can be created at a higher total figure than would happen when reducing disbursements. The key is growth and this theory is based on consistent models and results. Among examples, special attention may be paid to the Kennedy tax cut of the early 1960s, which produced so much additional tax revenue that it created a fiscal drain on the economy. In another example from the U.S. during the 1990s, a balanced budget was achieved in less than five years by keeping tax rates and government expenditures constant but adjusted for inflation. And there are numerous similar examples in other countries.

Road to recovery

I would suggest that there are three road-signs on the way to correcting the budget during the recovery period:
1) the real value of expenditures should stay the same, albeit adjusted for inflation;
2) the tax rate should be kept constant or lowered moderately;
3) obstacles (excessive regulations, etc.) to a growing GDP should be removed.

When these guiding principles prevail, a balanced budget results.

Current Hungarian government policies, including economic policy, will probably try to deny the possibility of achieving this. And yet there are many examples of such achievements: in Finland, Ireland, China, and other countries.

Similarly, the thesis that it is possible to grow out of a budget deficit has also been proven and an abundant bibliography exists demonstrating both the theory and experience of the model. In the world of theory and experience, even the reluctant must realize that the convergence package recommended for Hungary today is mistaken. Instead of stimulating progress, it will aggravate stagnation, resulting in needless suffering. Increasing tax rates may lead to a temporary increase in tax revenues, but the increase will be short-lived. In the long-run, higher taxes will lead to a smaller economy - and thus less tax revenue. There is no question that it is growth and not the government's austerity package that will foster recovery and stability.

As a postscript, I believe that in the name of conflict resolution Prime Minister Ferenc Gyurcsány should pass over his office to someone less controversial. Such a move would benefit the economic wellbeing of the country, and bolster moral and social confidence. It would halt further downgrades in international rankings, and reestablish Hungary as a stable place for assessing business prospects. Then, instead of a declining reputation, Hungary could begin to regain its place in the world, and self-respect at home.

The author is a Member of Parliament for the opposition Fidesz. He is an emeritus professor of economics, and holds an honorary doctorate from Corvinus University of Budapest, and a PhD from Columbia University, New York. This opinion piece was submitted shortly before Christmas.

Budapest Business Journal, January 15-21, 2007. www.bbj.hu