Austerity: The History of a Dangerous Idea (part 2)

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Chapters 4 and 5 of Mark Blyth’s Austerity discuss the intellectual history of that idea. Austerity didn’t become a distinct doctrine until the 1920s, after states had become “large enough budgetary entities in their own right to warrant cutting.” Much earlier, however, the idea was implicit in classical liberal economics, which assigned only a limited role to the state and feared its interference with the expanding market economy. Blyth characterizes the liberal attitude toward the state as “can’t live with it, can’t live without it, don’t want to pay for it.”

In the eighteenth century, David Hume voiced many of the economic concerns about free-spending governments that are still heard today: that democratic states find it easier to borrow than to tax, that government borrowing siphons off capital from private investment, and that foreign creditors have too much control over the economy. Already, the concerns were exaggerated, since Hume predicted that excessive debt would bring down the British economy “just at the moment that Great Britain was about to dominate the world for a century.” Adam Smith added a strong moral component to the argument by contrasting virtuous private saving with dangerous public borrowing. Smith’s great fear was that government would borrow too much of the wealth of the successful merchant class and repay the debts in currency weakened by inflation or devaluation, in effect destroying private property instead of performing government’s core function of protecting it.

By the late nineteenth century, liberals like John Stuart Mill had come to accept a larger and more positive role for the state in the economy. The “New Liberalism” in Britain was more supportive of government spending to increase income security, regulate industry, and address social problems. Then in the early twentieth century, John Maynard Keynes turned Adam Smith’s argument on its head. Saving wasn’t necessarily good, since too much saving could hurt the economy by reducing aggregate demand for products. On the other hand, deficit spending by government could jumpstart the economy by boosting aggregate demand and putting idle capital to good use.

Even when a kind of liberalism more supportive of state borrowing and spending came to dominate the English-speaking world, the economics of austerity found support in Germany and Austria. In order to catch up with the more industrialized economies of Great Britain and the United States, the German state played a larger role in promoting industrial development and capital accumulation. “Critical throughout Germany’s development has been the role of the state in suppressing consumption and increasing savings to provide adequate pools of capital for large-scale industrial investments, while also providing transfers to smooth, rather than block, such policies.” Wage and price inflation was kept in check to keep German goods competitive on world markets, but enough public assistance was provided to maintain popular support. German economics reflects and supports a successful strategy of basing economic growth on domestic restraint and global competitiveness. German economists and political leaders have tended to assume that all of Europe should adopt the same policies, without facing up to the fallacy of composition that implies. If Germany produces more than it consumes, some other country must consume more than it produces, so austerity cannot work for all.

Austrian economists like Ludwig Von Mises and Friedrich Hayek saw a natural cycle in which a period of austerity must follow a period of excessive lending. In their pursuit of profit, banks extend credit too recklessly, especially if they are enabled by a central bank that allows an easy expansion of the money supply. This allows too much money to chase too few goods, generating inflationary asset bubbles. Eventually “the bubble pops, the panic begins, assets are dumped, balance sheets implode, and the economy craters.” Then the proper policy response is austerity, since any attempt to stimulate the economy with more government spending or low interest rates can only be inflationary. When first proposed early in the twentieth century, these ideas gained little traction in the United States and much of Europe. Even if the expansion and contraction of credit explained economic booms and busts, austerity after the bubble burst seemed counter-productive. Irving Fisher pointed out that without some stimulus, the economy can get stuck in a vicious circle in which lower incomes make it harder to pay off debt and resume consumption. In the inflationary 1970s, however, economists became more receptive to criticisms of Keynesian stimulus as the basic policy response to recession. “Neo-liberals” like Milton Friedman argued that any gains in jobs and wages that workers gain from government spending will be offset by inflation, while”public choice” theorists saw a fundamental tendency of democratic politicians to stay in office by spending excessively on their constituents. Such views present a stark choice–austerity or inflation.

Another center for ideas about austerity was the Bocconi University of Milan. From there emerged one of the boldest arguments in its defense, put forth by Alberto Alesina and Silvia Ardanga. They tried to refute Keynes by showing that government spending cuts are more effective than spending increases in stimulating a sluggish economy, because of their effect on consumer confidence. Rational consumers respond to spending cuts by anticipating tax cuts, making them feel comfortable spending, while they respond to spending increases by anticipating tax increases, making them feel less comfortable spending. This view, which was very much in the spirit of German austerity, had a major influence on European Union leaders during the financial crisis.

Blyth acknowledges that austerity may be good policy under certain conditions, but he believes that it’s the wrong idea for the times. “Unfortunately, it works only under a highly specific set of conditions that, sadly, do not happen to describe the world in which we live at the moment.” Establishing that it does not actually work to restore economic growth following an economic contraction is his next objective.

To be continued

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