Beneath the Surface

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Having surveyed the history of economic thought on the subject of austerity, Blyth turns to its “natural history,” the actual application of austerity policies in real economies. He finds little evidence that such policies are effective in ending recessions and generating economic growth.

Blyth begins with the observation, “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 policies are harder to sustain in a democratic society because they often place a higher priority on protecting the wealth of the haves than promoting economic growth and employment for the have-nots. Adam Smith, for one, endorsed that priority when he said, “In so far as it is instituted for the security of property, [government] is in reality instituted for the defense of the rich against the poor.”

A key issue in the early twentieth-century dispute over austerity was the gold standard. Rich creditors wanted their loans to be repaid in currency with a fixed value in gold. The focus on maintaining the value of the currency limited the government’s options for dealing with recessions, since nothing that weakened the currency and threated a run on gold was acceptable. Measures that risked inflation, such as lower interest rates to facilitate borrowing, or deficit spending to increase consumption and employment, were off limits. In troubled times, austerity policies protected creditors, but high interest rates and unemployment hurt debtors and workers. Such policies became increasingly hard to maintain in democratic societies. Blyth regards the European common currency as the functional equivalent of the gold standard, and he sees austerity measures there benefiting Northern European creditors at the expense of Southern European debtors.

During the Great Depression, countries that abandoned the gold standard and its associated austerity policies fared better than those who tried to maintain them. That experience convinced many economists that austerity was indeed a dangerous idea. The sad thing about that historical era is that so many countries relied on war spending to get their economies growing again. Keynes observed in 1940, “It is, it seems politically impossible for a capitalist democracy to organize expenditure on the scale necessary to make the grand experiment which would prove my case–except in war conditions.” Blyth argues that the previous failure of austerity policies enabled the aggressive militarists to come to power in both Germany and Japan. (He does not accept the monetarist argument that hyper-inflation in Germany was to blame, since it had been brought under control well before the Nazis came to power.) Meanwhile, continued austerity in France prevented modernization of the French military to deal with the German threat.

In the more recent economic crisis, Blyth focuses on the debate over austerity in Europe. The new advocates of austerity, such as Alesina and Ardanga, have cited Denmark, Ireland, Australia, and Sweden as examples of countries that have restored confidence and resumed economic growth by cutting government spending. While European leaders were quick to use this argument to support belt-tightening in even more troubled economies, the weight of economic opinion appears to be turning against it. Recent research by the International Monetary Fund has failed to find a positive correlation between deficit reduction and economic growth.

Other cases cited in support of austerity theories are Romania, Estonia, Bulgaria, Latvia, and Lithuania, since they managed to make deep fiscal cuts but achieve relatively high growth rates by 2011. Like many others, they were recovering from unsustainable economic booms characterized by loss of traditional industries, heavy investments in finance and real estate, dependence on foreign capital, and an overabundance of risky loans. Blyth doubts that those recent higher growth rates are sustainable: “The much-lauded catch-up is limited, fragile, and likely to be reversed.” The recovery doesn’t fit the austerity scenario in some important respects, since most of these governments have even more debt now than before, and the economic expectations of citizens (supposedly the key to resumed spending) remain very low.

Blyth makes it abundantly clear that this is an anti-austerity book. Although he says that “sometimes austerity can be the correct policy response,” I never found a clear statement of when that is. Certainly, he believes it isn’t now.

What then is the alternative? One country that seems to have found one is Iceland. When it experienced a huge financial collapse in 2008, it let its banks go bankrupt, letting “institutional creditors shoulder the cost of the collapse rather than the taxpayer.” It also increased taxes on the wealthy and strengthened its social welfare system. The result is that its deficit is falling, unemployment is low, and real wages have been rising. Blyth contrasts Iceland with Ireland, where the government guaranteed all bank assets at a cost of 45% of GDP and also cut spending, but where both public debt and unemployment rose substantially.

In the United States, it’s too late not to bail out the banks, but Blyth does like taxing the rich as a way of reducing debt without cutting useful government spending. The wealthiest 1% of the population amassed large fortunes during the economic boom; the richest 400 Americans alone own more assets than the bottom 150 million, nearly half the population. And  the Great Recession has not yet been followed by any reduction in inequality, as occurred after the Great Depression of the 1930s. Blyth seems sure that the country will eventually tap into that enormous pool of private wealth and turn some of it to public good. So a policy of protection for the wealthy, but belt-tightening and insecurity for the rest of us will be replaced by something more democratic and more workable.

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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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Mark Blyth. Austerity: The History of a Dangerous Idea. Oxford University Press, 2013.

Austerity has emerged as a dominant–if not the dominant–public policy response to the financial crisis and ensuing Great Recession. In Europe, leading politicians and central bankers impose austerity measures on struggling economies as a condition of receiving loans, forcing their governments to curb spending, reduce public payrolls and cut public-employee pensions. In the US, Republican lawmakers have become preoccupied with spending cuts to the exclusion of almost every other public policy besides national defense. Apparently, the economic crisis has encouraged the view that nations are out-of-control spenders who must be reined in for the good of the economy.

Mark Blyth, Professor of International Political Economy at Brown University, joins an increasing number of political scientists and economists who are questioning the rush to austerity. Is it really good economics, or is it a blend of weak economic arguments and strong political opportunism?

Blyth defines austerity as:

…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. Doing so, its advocates believe, will inspire “business confidence” since the
government will neither be “crowding-out” the market for investment by sucking up all the available capital through the issuance of debt, nor adding to the nation’s already “too big” debt.

Blyth regards austerity as a dangerous idea for several fundamental reasons. First, there is little hard evidence that austerity policies actually work to pull countries out of economic recessions. Second, austerity is unfair to the poor, who end up paying for the financial mistakes committed by the rich in their own self-interest. Third, the argument for austerity rests on fallacious reasoning and misrepresentation of economic facts.

The main fallacy here is the “fallacy of composition,” which assumes that what is true for the parts is also true for the whole. Although an individual household can improve its economic position by cutting spending, that is less true for an entire nation or the global economy. As Keynes explained with his “paradox of thrift,” too much saving by too many people at the same time reduces consumption, discourages investment and perpetuates high unemployment.

The main misrepresentation of economic facts is the characterization of the crisis as primarily a “sovereign debt crisis” brought on by too much government spending. Blyth views it instead as “a banking crisis first and a sovereign debt crisis second.” Austerity is partly a political argument intended to shift responsibility from powerful financial interests to ordinary citizens. It has also become a kind of morality play. “Austerity is the penance–the virtuous pain after the immoral party–except it is not going to be a diet of pain that we all share. Few of us were invited to the party, but we are all being asked to pay the bill.”

In Part One of the book, Blyth sets out to explain how the private sector generated the crisis in both the United States and Europe. With regard to the US, economists have identified many contributing causes, but Blyth focuses on the four he regards as most essential:

1. During the US housing boom, banks not only made too many risky mortgage loans, but the large investment banks relied too heavily on mortgage-backed securities as collateral for their own borrowing. When those securities lost value, there was a run on the banks in the “repo” market where businesses lend to one another. Credit dried up, and banks had to start dumping assets to maintain their liquidity and solvency.
2. The availability of “credit default swaps,” which in effect insured banks against mortgage defaults, both encouraged banks to be more reckless in issuing mortgages and mortgage-backed securities, and spread mortgage risk to the insurers.
3. Financial analysts grossly underestimated the probability that a large number of financial assets could lose value at the same time. They assumed that individuals acting in their own self-interest could manage risk, but what actually happened was that many self-interested actions combined to create a systemic risk too large for the private financial sector as a whole to manage.
4. The prevailing neoliberal economic ideas celebrated the rational individual and the efficient markets that result when such individuals are free to make their own economic decisions. They did not anticipate large-scale systemic failure or support market regulations to prevent it.

In Europe too, the crisis “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.” Ireland and Spain did not have excessive debts or deficits before they experienced privately funded housing bubbles. The problem in Portugal and Italy was not primarily public debt either, but low-growth, low-productivity economies. One country that did engage in excessive public borrowing and spending was Greece, where the government was trying “to increase personal income and public consumption, an understandable response to decades of instability, violence, and political polarization.” The advocates of austerity used the case of Greece to brand the entire European crisis as a “sovereign debt crisis,” with government belt-tightening the primary solution.

Leading up to the crisis, the European banks engaged in some of the same reckless borrowing and lending that brought down the US economy. But in this case, they were aided and abetted by the European Monetary Union. The replacement of local currencies by the supposedly stronger euro made lending to weak economies like Greece and Italy seem safer. Interest rates fell dramatically in the peripheral countries, indicating that debts owed in euros were considered less risky. Yet the yields remained high enough to motivate European bankers to flood the periphery with cheap money. “While the Northern lenders lent to local banks, property developers, and the like, periphery consumers used this tsunami of cheap cash to buy German products, hence the current account imbalances….” The stronger core and the weaker periphery seemed to be getting rich together, the core by exporting capital and goods, and the periphery by importing them. Relative to the GDPs of European countries, European banks held financial assets far greater than those of US banks, and those assets included many of the same shaky securities that brought down US banks. Once the banks started to fail, the credit crunch hurt all the weak economies, whether they already had heavily indebted governments or not. Now many governments faced higher borrowing costs, the expense of bailing out troubled banks, and the declining tax revenues and higher social expenses resulting from a contracting economy. So what began primarily as a private banking crisis quickly became a sovereign debt crisis.

One could argue that even if the financial crisis originated in the private sector, public austerity is still required to resolve it. In Part Two of his book, Blyth examines the historical record for evidence that austerity is good economic theory or good policy.

Continued