What's the better austerity: more cuts or more taxes?

In the debate over the effects of fiscal austerity on growth, all sides can point to examples that seem to help their case.

Those who argue that deficit reduction can help growth can point to the Baltic states who pushed through even tougher measures than for example Greece and Portugal, and who are now booming, with Estonia seeing GDP increase 8.4% compared to a year earlier, Lithuania 6.1% and Latvia 5.3%.

On the other hand we can see that growth in for example Britain and Portugal has slowed considerably, and in Greece we have seen a 6.9% contraction the latest year (that came after a 4% contraction in the year to Q2 2010).

How can this difference be explained? Floating exchange rate advocates often claim that a floating exchange rate is vital for successfull fiscal consolidation but that is clearly not a theory supported by these facts as the Baltic states have all had fixed exchange rates to the euro, with Estonia recently formally adopting the euro as currency. There are 3 explanations.

The first is initial position in the business cycle. The Baltic states had in 2009 suffered a full blown depression with GDP dropping around 20% and unemployment increasing to nearly 20%, while Greece in 2009 had only had a very mild contraction, with countries like Britain and Portugal coming in between. Most of the malinvestments had been cleaned out in the Baltic states, while the process had only started elsewhere.

The second is the type of austerity implemented. While all countries had a mix of tax increases and spending cuts, the Baltic states had more emphasis on spending cuts while Greece had a big emphasis on consumption tax increases that hurted the competitiveness of its vital tourist industry

The third and perhaps most important factor is the response of the population. The prospect of no longer being able to live at the expense of others through the state have provoced large parts of the Greek population to act as spoiled cry babies in adult bodies in the form of riots and strikes that have scared away tourists and in other ways crippled the Greek economy, thereby only greatly aggravating the economic suffering of the people in Greece. As I've written before, if the purpose of the riots and strikes was to prevent their standard of living from falling, then the response of the Greek protestors was about as smart as turning up the heat because you think it is too warm.

Milder versions of this has also been seen in Portugal and Britain (though in the most recent week, small groups of hooligans in Britain have as most of you have probably heard resorted to more violent and disruptive means).

By contrast, the people of the Baltic states have realized that the tough measures are necessary and reacted in a rational and constructive way to help improve their economies. There were no riots and strikes in reponse to the austerity measures in the Baltic states, only increased efforts to increase exports and perform other productive activities. The reward for that rational response has been the strong recovery we now see there. One can only hope that Greeks, Britons and others learn from their example.