The reasons given for why we all have to be austere (we have spent too much, etc.) and the logics expounded for the supposed positive effects of austerity as a policy—that cuts lead to growth—are, as we shall see, by and large dangerous nonsense.
Part of the reason for this is, as we shall see, ideological.
Cutting the welfare state in the name of producing more growth and opportunity is an offensive canard. The purpose of this book is to make us all remember that and thereby help to ensure that the future does not belong only to the already privileged few.
Austerity is a form of voluntary deflation in which the economy adjusts through the reduction of wages, prices, and public spending to restore competitiveness, which is (supposedly) best achieved by cutting the state’s budget, debts, and deficits.
Austerity clearly is not working if “not working” means reducing the debt and promoting growth.
Having already bailed out the banks, we have to make sure that there is room on the public balance sheet to backstop them. That’s why we have austerity. It’s still all about saving the banks.
Austerity is not just the price of saving the banks. It’s the price that the banks want someone else to pay.
Austerity is a zombie economic idea because it has been disproven time and again, but it just keeps coming.
Partly because it enables conservatives to try (once again) to run the detested welfare state out of town, it never seems to die.
We have turned the politics of debt into a morality play, one that has shifted the blame from the banks to the state. Austerity is the penance—the virtuous pain after the immoral party—except it is not going to be a diet of pain that we shall all share. Few of us were invited to the party, but we are all being asked to pay the bill.
Austerity is first and foremost a political problem of distribution, and not an economic problem of accountancy.
Despite what Mrs. Thatcher reportedly once said, not only is there something called society, we all live in it, rich and poor alike, for better and for worse.
Austerity is not a well worked-out body of ideas and doctrine, an integral part of economic, or any other, theory. Rather, it is derivative of a wider set of beliefs about the appropriate role of the state in the economy that lie scattered around classical and contemporary economic theory.
Austerity doesn’t work but the fact that we are still being told that it does shows us one thing: facts never disconfirm a good ideology, which is why austerity remains a very dangerous idea.
The crisis was generated by the private sector but is being paid for by the public sector, that is, by you and me.
If all the trouble was generated in the private sector, why do so many people blame the state for the crisis and see cuts to state spending as the way out of a private-sector mess?
Part of the reason no one saw the crisis coming lay within the very models that the banks used to see things coming. Such models see the future only as a normally distributed replication of the past. This makes big, random, game-changing events impossible to foresee, when in fact they are all too common.
Note once again how none of this has anything to do with the state’s spending habits or individual morality. The causes are once again systemic and arise out of the interaction of the parts to produce an outcome that is irreducible to them.
We need to address the deepest cause of the crisis—the other reason no one saw it coming: the theories of a generation of economic thinkers who only ever saw markets as good and the state as bad, which takes us back to economics as a morality tale, albeit of a different type. *
The way we think about financial markets today is a consequence of the revolution in macroeconomic theory that occurred in the 1970s, when the old way of thinking about the world, Keynesian macroeconomics, was seen, by the standards of the day, to fail a critical real-world test.
In short, the world was seen to be at variance with the instruction sheet, so the instruction sheet had to be rewritten.
The new instruction sheet, which came to be known as “neoclassical,” or more popularly, “neoliberal” economics, was quite technical, but basically it started from the premise that individuals were not the shortsighted, animal-sprit, driven businessmen lampooned by Keynes, but were instead supersmart processors of information.
Consequently, government can’t do much at all except screw things up by getting in the way. Left alone with common and accurate information, such individuals’ expectations about possible future states of the economy will converge and promote a stable and self-enforcing equilibrium.
These ideas, formalized as the efficient markets hypothesis (EMH) and the rational expectations hypothesis (RATEX), are just as important politically as they are theoretically, they hold that free and integrated markets are not merely a good way to organize financial markets, they are the only way.
To the extent that the state has a role, it devolves to “doing nothing” since doing something will only produce price distortions that will upset market efficiency.
If you think markets work this way, the very notion of regulating finance becomes nonsense.
If you think markets work this way, then it follows that risk is calculable, sliceable, tradable, and best held by rational investors who know what they are buying.
There is no public sector, only the private sector, and it is always in equilibrium.
The flaw in the logic was once again the expectation that the whole cannot be different from its component parts.
But it turned out that the whole was quite different from the sum of its parts because the interaction of the parts produced outcomes miles away from the expectations of the instruction sheet, a sheet that was quite wrong about the world in the first place.
The crisis, then, was, much more than the stagflation that discredited Keynesianism, a crisis of ideas. It was a crisis of the instruction sheet of the past thirty years.
The rational expectations of sophisticated investors turned out to be shortsighted and bubble chasing, as irrational exuberance on the upside gave way to runaway pessimism on the downside, just as Keynes had warned about eighty years ago.
But most of all, what we couldn’t see coming was something that the instruction sheet said was irrelevant, a form of risk that wasn’t reducible to the sum of individual risks: systemic risk.
Systemic risk, the risk that cannot be foreseen, is what the different elements discussed here combined to produce. Systemic risk blew the efficient market down.
Smith’s invisible hand had just given the public the finger.
Not to put too fine a point on it, these ideas cost, once lost output is included, as much as $13 trillion and, on average, a 40 percent to 50 percent increase in the debt of the states hit by the crisis.
That seems to be a very large price to pay to save something that was too big to fail and that wasn’t meant to fail in the first place, especially when you and I are expected to pay for it.
To put it bluntly, the state plugged a gap and stopped a financial collapse. It did not dig a fiscal ditch through profligate spending.
Any narrative that locates wasteful spending by governments prior to the crisis in 2007 as the cause of the crisis is more than just simply wrong; it is disingenuous and partisan.
What happened was that banks promised growth, delivered losses, passed the cost on to the state, and then the state got the blame for generating the debt, and the crisis, in the first place.
The banks may have made the losses, but the citizenry will pay for them. This is a pattern we see repeatedly in the crisis.
Austerity is a great policy for the banks because the people who are to pay for the mess are not the same ones who made it. Nowhere is this truer than in Europe.
Just as we saw in the US case, the crisis in Europe has almost nothing to do with states and everything to do with markets. It is a private-sector crisis that has once again become a state responsibility.
Why, then, keep up the fiction that the bond market crisis is a crisis of spendthrift governments?
Cut spending, raise taxes—but cut spending more than you raise taxes—and all will be well, the story went.
Just to keep things on track, democratically elected governments in Greece and Italy were deposed and replaced by unelected technocrats who promised to keep the reforms going.
George Osborne, Britain’s new Conservative chancellor of the exchequer, made repeated comparisons to the fiscal situation of Greece and the United Kingdom as soon as he was elected.
Austerity’s moment in the sun had arrived courtesy of the Greeks.
Cause and correlation were confused, quite deliberately, on a massive scale.
What were essentially private-sector debt problems were rechristened as “the Debt” generated by “out-of-control” public spending. *
Private-sector weaknesses ended up creating public-sector liabilities that European publics now have to pay for with austerity programs that make the situation worse rather than better.
Banking bubbles and busts cause sovereign debt crises. Period.
The European monetary project was a bit mad from the get-go. It has only recently revealed itself to be an exercise in insanity.
Why, then, do European governments blame it all on sovereigns that have spent too much? Basically, it’s because in a democracy you can hardly come clean about what you are doing and expect to survive.
Imagine a major European politician trying to explain why a quarter of Spain needs to be unemployed, and why the whole of periphery Europe needs to sit in a permanent recession just to save a currency that has only existed for a decade.
Given what is at stake, we must wonder whether anyone ever really thought that austerity was a good idea, whether it was ever anything more than political cover for selfish interests.
Two answers present themselves. The first is a variant of the line popularized by Mrs. Thatcher—“there is no alternative” (TINA).
That is indeed how European policy elites see things, hence austerity.
Europe is at the moment undertaking a giant austerity experiment and the results, as discussed, are predictably awful.
Within the Eurozone, surplus countries have no problem running a permanent trade surplus but criticize others for running deficits, as if you can have one without the other.
Britain’s New Liberalism came into being when British Liberal Party elites essentially sided with Mill over Ricardo.
In short, if the primacy of private initiative and of liberal market institutions were to be maintained, then the poverty and inequality Ricardo regarded as natural and inevitable could no longer be tolerated.
The long-term consequences of this transformation of British Liberalism were dramatic. Universal pensions, unemployment insurance, and the intensification of industrial regulation all followed in the early twentieth century. Twenty years later, the heirs to this movement were the great social and economic reformers of the 1930s and 1940s, such as T. H. Marshall, John Maynard Keynes, and William Beveridge. They in turn pushed the New Liberalism still further, laying the foundations for a comprehensive welfare state.
The Austrian economists believed that liberalism was best defended, not through more redistribution and state management, but through the complete withdrawal of the state from its role in the economy. To borrow a term that is commonplace today, the Austrians were * the original “neo” liberals.
Austrian economists never shed their fear of the Leviathan state, which they continued to see as the ultimate enemy of liberal values.
In sum, while the New Liberals and their mid-twentieth-century heirs embraced the state and intervention, the Austrians, in particular, Friedrich Hayek, Ludwig von Mises, and Joseph Schumpeter, rejected these notions entirely.
The midcentury heirs of New Liberalism and the Austrian School still define the basic terms of the austerity debate eighty years later.
If these ideas sound familiar today, it’s because, like the ideas of Hume and Smith, the same arguments are being recycled again, eighty years later.
The need for “the return of business confidence” to start the recovery forms the centerpiece of contemporary British austerity policy, despite its yielding zero results to date.
Despite the expansion of the British state into the realm of pensions and insurance and regulation under the influence of New Liberal ideas in the first two decades of the twentieth century, the British response to the crisis of the 1920s and 1930s remained resolutely liberal and austere.
By the mid-1920s, however, as the postwar slump had turned into a full-blown depression, and as these doctrines increasingly came under attack for worsening the situation, the Treasury view began to take form as a defense of the status quo.
As Conservative chancellor of the exchequer Stanley Baldwin put it in 1922, “Money taken for government purposes is money taken away from trade, and borrowing will thus tend to depress trade and increase unemployment.”
The British elite’s rather monolithic view began to splinter in 1925 when Keynes criticized Churchill’s decision to go back on the gold standard after an eleven-year hiatus.
This conflict between Keynes and the Treasury was exacerbated in 1929 when Keynes, with Hubert Henderson, produced the pamphlet “Can Lloyd George Do It?”
This view was extremely threatening to the Treasury since it implied that supply-side factors were insufficient to drive the economy to full employment.
But the Treasury wasn’t just fighting Keynes and Lloyd George. It was also pandering to orthodox business opinion.
British austerity thinking, like its American cousin, proved remarkably immune to the economic facts of the day. It may have admitted the necessity of the state, but like Smith, it was in no mood to pay for the state’s actions.
Britain held on to austerity, and the Depression persisted until the start of World War II.
During the 1940s, in the context of massive wartime spending, pro-spending, anti-austerity ideas rose to prominence and pro-austerity doctrines faded into the background.
The most famous anti-austerity argument was Keynes’s General Theory.
Keynes showed that consumption via workers’ paychecks ultimately drove investment. Today we call this demand-side economics.
Not only is Smith’s world overturned, austerity as a sentiment, as a morality, and as policy is overturned with it.
By 1946, the world had gone Keynes’s way.
With the Keynesian view ascendant, conservatives had a choice: admit that they were wrong or find something else to talk about.
Anti-austerity it seemed, had won the day. But the victory was not complete. Austerity survived in one part of the world immune to Lord Keynes: the German-speaking world. Austrian school economists continued to give austerity a globalized intellectual home.
Why then did Germany become the refuge for austerity arguments during the long winter of the Keynesian era and the basic design template for the contemporary European variant of austerity.
In sum, postwar Germany prospered with austerity-focused ideas of a particular type at its core. Germany both possesses and professes a liberalism that embraces the state and transforms it. In doing so, it does the same for austerity.
Ordoliberalism may have modernized liberalism, but its economics in many ways remain as classical as Smith and Hume.
It rather spectacularly ignores the fact that for someone to be running an export surplus, someone else must be running a deficit. We cannot all run surpluses and save. Someone has to spend so that there is demand for these exports.
Germany’s focus on rules, obligations, a strong monetary authority, a weak parliament, and no spending to compensate for busts sounds familiar, it should. It’s the basic design of the EU. Germany’s response to the crisis, and the crisis itself, both spring from the same ordoliberal instruction sheet.
From the Maastricht convergence criteria to the Stability and Growth Pact to the proposed new fiscal treaty—it’s all about the economic constitution—the rules, the ordo. We must have rules and an independent monetary authority to ensure that states conform to the ordo imperative; hence, the ECB.
In the case of Greece and Italy in 2011, if that meant deposing a few democratically elected governments, then so be it.
All of which brings us to the role played by ordoliberal’s cousins, the Austrian economists, in pushing austerity arguments forward.
Although battered and beaten-down by the Keynesian revolution after World War II, Austrian ideas never quite disappeared from the American scene. They staged something of a comeback in the 1970s when Hayek was awarded the Nobel Prize in economics and served as a popular justification for Reagan’s supply-side policies.
The Austrian policy proposal that follows from this analysis—“maximum austerity as quickly as possible”—makes little sense given what we know about how actual economies perform when they go through busts.
Far from encouraging “self-healing,” nonintervention and noncompensation can produce the politics of permanent austerity, as Europe is finding out.
Politically attractive to some, especially to antistatist conservatives, such ideas resonate in theory, but they detonate in practice.
It is the rise of these neoliberal ideas that enabled the return of austerity as the commonsense thing to do in a slump.
Monetarism is a set of ideas developed in the 1960s and 1970s, most notably by Milton Friedman in the United States and by Patrick Minford in the United Kingdom.
Friedman assumed that unemployment was voluntary and was not due to a deficiency of demand. People choose labor or leisure at the prevailing wage.
In other words, the 25 percent of Spaniards who are presently without work simply don’t want to work at the prevailing wage and are on vacation.
By giving us a new set of reasons why state intervention to compensate economic downturns can only end up producing inflation, monetarism helped naturalize Austrian and ordoliberal ideas, pulling them off the fringe and into mainstream acceptance.
What must be done to save the liberal economy from the destructive forces of democracy? Banning democracy would be effective but might be unpopular. *
A second-best solution would be to have an institution that would effectively override such decision making. Luckily, such an institution already existed thanks to those ordoliberals, or neoliberals would have had to invent one: the independent central bank.
During the Keynesian era, central banks almost everywhere were the financing agent for the national treasury: they cut the checks that the politicians said needed to be cut. hat, according to neoliberals, was exactly the problem.
Kydland and Prescott argued that the key to solving this problem was for the central bank to be made independent from politicians.
As a consequence, policy making should be delegated away from democratically elected politicians to independent conservative central bankers.
The fact that these theories rest upon incredibly narrow operational premises and have scant evidence going for them is beside the point.
These “neo” neoliberal ideas revolutionized economic policy making in the developed world in the 1970s and 1980s. By the 1990s central bank independence, for example, had spread like a rash over the face of the planet, most notably throughout all of Europe *
When the ECB was unleashed on Europe in 1999, it was arguably the most independent central bank around, charged with only one goal: fight inflation, even in the middle of a deflation.
The problem is that what economists call moral hazard is what normal people call trust.
The EU’s political project was built on trust, not the elimination of moral hazard. That’s why it worked. Its monetary project is based on opposite principles.
The question of how the presumed preference for low inflation over all other goals becomes the preference of all society, especially when those enforcing that preference as policy don’t want to ask the voters, remains conspicuous by its absence.
Once the United States shut down gold convertibility in 1971, the world’s major currencies began to float against each other. The IMF, literally, had nothing to do.
But large bureaucratic entities do not cease to exist the moment their mission is either accomplished or disappears.
The IMF became the financial police force behind the implementation of what were termed “structural adjustment programs”…“codified in John Williamson’s well-known Washington Consensus”… and the results were, by and large, terrible.
The IMF’s sister institution the World Bank produced a report in 2005 that pretty much acknowledged the near total failure of the Washington Consensus checklist of reforms.
All of which brings us finally to the modern “Austerians” and their theory of expansionary fiscal contraction, the zenith of modern austerity thinking.
In such a world, the slump is the perfect place to cut while spending is always and everywhere the wrong policy.
As such, the welfare state has to go because “it is very difficult if not impossible to fix public finances when in trouble without solving the question of automatic increases in entitlements.”
This, then, is the essence of modern austerity thinking. The only remaining question we need to ask is, does it work? The answer, The only remaining question we need to ask is, does it work? The answer, is certainly not in the big cases of the past in the 1920s and 1930s, not at all in Europe at the moment, and only very occasionally and under very specialized conditions elsewhere.
Deploying austerity has helped propel Spain and Greece to the brink of economic and political collapse and impoverished millions of people throughout the rest of Southern Europe.
What we learned in the 1930s has been forgotten. That forgetting is perhaps the strongest reason why austerity remains such a dangerous idea.
If austerity’s intellectual history has been relatively short its natural history has been even shorter. It’s not until the early twentieth century that we encounter states that are both big enough to cut, and democratic enough to cause problems for austerity policy.
Austerity was tried, and tried again and it simply didn’t work.
Today, many seemingly sensible people seem to think that the solution to any and all economic problems lies in returning to something called the gold standard.
I can only assume that the folks peddling the return of gold as a good idea are ignorant of the actual history of the gold standard.
You can only really run a system like this, where domestic wages and prices do most the adjusting to external prices, if you are not a democracy.
It created conditions where the domestic monetary authorities, to maintain that all important gold cover, would pursue austerity policies to shrink deficits, keep gold at home, and defend the currency.
It was hardly surprising, then, that it was under the gold standard that labor across the world, both industrial and agricultural, started to join together in unions, political parties, and social movements to demand protection from the policies of their own governments.
The basic problem of running a gold standard and the Eurozone are one and the same.
There are (mainly) four ways to get out of a financial crisis—inflate, deflate, devalue, and default.
In both the gold standard and the Eurozone, states can neither inflate nor devalue. That leaves default—which you want to avoid—and deflation (austerity) as the only remaining way to adjust in both cases.
Unfortunately, once politicians had to answer through the ballot box to the mass publics that bear the costs of this adjustment, the credibility of the claim that “no amount of austerity was too much” became less believable, and less supportable.
Repeated attempts to get back on gold and stay on it in round after round of austerity in the 1920s made the already unbearable simply impossible, and the system fell apart in the early 1930s.
Austerity simply doesn’t work, no matter how many times you do it. Eventually it will fall apart because there are only so many rounds of austerity people will vote for before the system breaks down.
The parallel to the Eurozone as a gold standard without gold (you can’t devalue, inflate, or default there either) is both obvious and vitally important.
The Roaring Twenties began with a bump in Europe but not the United States, precisely because the Americans were not on gold.
Austerity not only didn’t work in Japan. It created the worst depression in Japanese history, provoked an assassination campaign against bankers, and empowered “the wonderful folks that brought you Pearl Harbor.”
Now, if you think this enough to demonstrate why austerity is a dangerous idea, see what happened in France around the same time.
The Bank of France continually vetoed budget increases that would have allowed the French military to modernize, and even mobilize, to meet the German threat.
By 1936 Hitler knew one thing. The franc would be defended at all costs. As for France, that was another matter entirely.
The interwar period taught us some valuable lessons about why austerity does not work and why its application is a dangerous idea. Building an entire international monetary order with an inherent deflationary bias that can’t work in a democracy is bad idea.
Repeated rounds of austerity in country after country was madness.
It made the depression deeper, longer, and, arguably, laid the foundations for the war that would engulf the world in the 1940s.
Austerity didn’t just fail—it helped blow up the world. That’s the definition of a very dangerous idea.
*** But even if the IMF has lost faith in austerity, it does not mean that its champions will not try to find other examples where it has supposedly worked. Too many reputations and too much sunk political capital are at stake for mere facts to get in the way of this ideology.
Austerity remains an ideology immune to facts and basic empirical refutation. This is why it remains, despite any and all evidence we can muster against it, a very dangerous idea.
This book has examined the case for austerity as both a sensible economic policy and as a coherent set of economic ideas, and it has found austerity to be lacking in both respects. Austerity doesn’t work. Period.
It has instead brought us class politics, riots, political instability, more rather than less debt, assassinations, and war. It has never once “done what it says on the tin.”
Austerity has been applied with exceptional vigor during the ongoing European financial crisis. The costs of this epistemic arrogance and ideological insistence have been, and continue to be, horrendous.
The joke doing the rounds at the beginning of the crisis, before Ireland blew up, was, what’s the difference between Iceland and Ireland? The answer was, one letter and six months. The joke, it turned out, was a prophecy. *
A comparison of the two is as close to a natural experiment of the effects of austerity and bailouts as you are likely to find.
In terms of growth Iceland has fared better than anyone would have dared hope. Unlike Ireland, employment growth in Iceland has been strong.
Iceland had ten times the bust of the United States’ worst-case-ever scenario, and it not only survived, it prospered.
Iceland not only survived letting its banks go bust, it became a healthier and more equal society in doing so.
When you do the exact opposite of the austerity playbook, you not only survive, you prosper.
Tax economists on both sides of the Atlantic are beginning to argue that higher taxes on top earners can pay for debt reduction. Apparently, there is no need for austerity, after all.
Austerity has been tried and will keep being tried, at least in the Eurozone, until it’s either abandoned or voted out. It doesn’t work.
Given that forgiveness is unlikely, and the other options, inflation and default, are even worse, it is pretty much inevitable that higher taxes on top earners will become a part of the landscape.
This is how we are going to deal with our debts—through taxes and not through austerity. Not because austerity is unfair, which it is, not because there are more debtors than creditors, which there are, and not because democracy has an inflationary bias, which it doesn’t, but because austerity simply doesn’t work.