There's more to managing an economy than avoiding a budget deficit.
PAUL Romer, one of the founders of what economists called new growth theory, used to pose a question which has deep implications, going well beyond economics.
Suppose all the world's stock of structures and equipment remained, Romer mused, but our knowledge of how to create them was wiped out. Then imagine a scenario B, in which all our structures and equipment were wiped out, yet our knowledge of how to build them remained. In the long term, which scenario would leave us better off?
The answer, clearly, is the second. It is the power of knowledge, of human intelligence, our ability to think, learn and create, that is the most valuable asset of any society. Far from knowledge being a limited store, as Western thinkers once assumed, Romer argued that it is virtually unlimited. What leads to growth is the ability to imagine, to think through conflicting propositions, to invent a better solution to problems than the one we inherited.
If only humans always did so. But in the real world, the innovative idea is so often dismissed as heresy. People don't think through conflicting propositions, but rely on prejudice or loyalty to a simple idea. To embrace a better understanding of complex events means discarding an old one. And often those old ideas are convenient ones for us to believe. Often they are in our financial or political interests or come from deep ideological convictions. Mere objective reasoning can find it impossible to break through.
Australia offers plenty of examples in which prejudices block our ears to better ways of doing things. But the riots in Athens over the past week, and the long standoff over how to reduce Greece's public debt, are a dramatic illustration - on an issue with huge implications for the world, and us - of how hard leaders and the public find it to accept ideas and solutions which clash with long-held, convenient prejudices.
Yesterday, Greek MPs voted 199-74 to endorse the latest austerity package negotiated last week by the leaders of the two main parties, slashing the minimum wage to ?560 (roughly $A700) a month, and making deep cuts to pensions and government spending across the board. It is forecast to cost 150,000 jobs over the next three years. That's what they were rioting about.
But the MPs' vote was just another reprieve. Even if the next Greek government implements the package in full, which many doubt, it would deepen the crisis, not solve it. The package dictated by the European Union won't work, for reasons that have been made clear repeatedly, but not accepted. The crisis will return the worst of it could still be ahead.
On both sides, comfy old prejudices are keeping minds closed to challenging ideas, innovative thinking, and better solutions.
The rioters illustrate why the rest of Europe doesn't trust Greece any more. They symbolise the refusal of Greeks to take collective responsibility for the crisis into which Greece has thrown the Continent, and which might take a decade to resolve. Year after year, the Greek government, on a huge scale, spent money it did not have, employed people it did not need, bought votes with lavish pensions, allowed its people to dodge paying taxes, and then lied to the EU and the world about its financial position.
Even before the crisis, after a decade of boom for the Greek economy, Greece was secretly running the biggest deficit in the advanced world, equivalent to roughly $80 billion a year in Australia. If that's how you run the business in good times, then the bad times are going to be awful. And so they were. No bank would lend to Greece any more only aid from the IMF and the EU has saved it from bankruptcy. But in the end, bankruptcy might be inevitable.
The EU has lent on the banks to write off half their debts to Greece but led by the German government, it wants to enforce deep austerity in Greece to start paying back the other half. Unemployment in Greece is already almost 20 per cent, and would get much worse if these budget cuts are implemented yet the Greek government would then be running a surplus on its primary balance - that is, excluding its debt payments.
I have deep admiration for Germany's economic achievements, which are little understood by politicians or economists here. But it is an illusion to think that countries can cut their way out of trouble as deep as this, unless they can devalue their currency to make them more competitive. Greece can't do that, because it's locked into the euro. Even in Britain, outside the euro zone, the Cameron government's deep spending cuts have pushed the country back into recession - and Britain started from a far better position than Greece.
Is there a better solution? Yes, and IMF managing director Christine Lagarde outlined it last month in a speech in Berlin. Her speech was all nuance, but to paraphrase: timing matters. Yes, getting budget deficits under control is critical, but so is avoiding a deep, self-perpetuating slump. Don't cut current budgets so deeply that you drive the country into recession. Rather, protect your sources of growth, and push through big, long-term reforms that will make your budgets sustainable into the future.
Her message should reverberate here in Australia. It is not getting the budget back into surplus in 2012-13 that matters events in Europe could make that impossible. As Treasury has shown, the long-term threat to the budget is from an ageing society. We should bite the bullet on this: phase out incentives to early retirement now, and start lifting the pension age, before the baby boomers retire. Timing matters.
Tim Colebatch is economics editor.
Frequently Asked Questions about this Article…
What did economist Paul Romer mean when he said knowledge is more valuable than physical capital for long-term growth?
Romer’s thought experiment contrasts two scenarios — keeping all physical structures but losing the know‑how to build them, versus losing the structures but keeping knowledge. The article explains the conclusion: knowledge, ideas and innovation are the key drivers of long‑term economic growth because people can recreate or improve capital if they retain the ability to think, learn and invent. For investors, that underlines why companies and economies that foster innovation may generate stronger growth over time.
How can strict austerity measures, like those imposed on Greece, affect jobs and economic growth?
The article highlights that Greece’s austerity package — including a cut in the minimum wage to about €560 (roughly A$700) and deep pension and spending cuts — is forecast to cost about 150,000 jobs over three years. It argues that deep, poorly timed budget cuts can deepen a slump, raise unemployment (Greece’s unemployment was almost 20%), and could worsen the crisis rather than solve it.
Why can’t Greece simply devalue its currency to become more competitive and fix its debt problem?
According to the article, Greece cannot devalue its currency because it is a member of the eurozone. Devaluation is a tool available to countries with their own currencies to boost competitiveness; Greece lacks that option while using the euro, which limits its ability to cut its way out of deep trouble through austerity alone.
What does the IMF’s Christine Lagarde mean by ‘timing matters’ when it comes to fiscal consolidation?
The article summarises Lagarde’s point that while reducing budget deficits is important, policymakers must avoid cutting current spending so sharply that they drive the economy into a deep, self‑perpetuating recession. Instead, governments should protect sources of growth now and pursue big, long‑term reforms that make budgets sustainable later. In short: balance short‑term demand support with long‑term fiscal reform.
What is a government’s ‘primary balance’ and why does it matter for debt sustainability?
The article defines the primary balance as the government’s budget position excluding interest payments on debt. Running a primary surplus means current revenues exceed non‑interest spending, which helps reduce underlying deficits. But the article warns that achieving a primary surplus through deep cuts can still shrink the economy if austerity is mistimed, which may undermine long‑term debt sustainability.
What lessons from the European debt crisis should everyday Australian investors consider?
The piece suggests Australians should focus on the timing and nature of fiscal policy: avoid short‑term, deep cuts that could tip an economy into recession and instead support growth while implementing long‑term reforms. It also flags the long‑term budget threat from an ageing population and recommends policy changes such as phasing out incentives for early retirement and raising the pension age — factors that can influence markets, fiscal outlooks and investment returns over decades.
How did political and cultural prejudices make resolving Greece’s crisis harder, according to the article?
The article argues that long‑held prejudices, political loyalties and convenient beliefs have blocked innovative or difficult solutions. Greeks repeatedly spent beyond means, misreported finances and resisted collective responsibility, while creditors insisted on deep austerity. This combination made compromise and effective, timely solutions harder to achieve and prolonged the crisis.
Why might deep spending cuts push countries like Britain and Greece back into recession, and what should governments do instead?
The article notes that deep spending cuts can reduce domestic demand, increase unemployment and trigger a recession — Britain’s experience after spending cuts is cited. Rather than immediate, deep cuts, governments should protect growth drivers in the short term and implement significant structural reforms that improve long‑term fiscal sustainability. This approach aims to avoid a self‑perpetuating slump while putting public finances on a firmer footing.
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