The Shifts and the Shocks

December 15, 2014

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Martin Wolf. The Shifts and the Shocks: What we’ve learned–and have still to learn–from the financial crisis. London: Penguin, 2014.

British economic journalist Martin Wolf provides a comprehensive account of the global financial crisis and its aftermath. The story unfolds slowly and covers a lot of ground, so the reader needs to read the entire book carefully to get the full picture.

Wolf’s own policy perspective is fairly moderate. He supported much of the economic liberalization and limitation of state power under Margaret Thatcher and Ronald Reagan, but he now believes that liberalization got out of hand and became a major cause of the financial crisis. “The financial driven capitalism that emerged after the market-oriented counter-revolution has proved too much of a good thing. That is what I have learned from the crisis.” He also faults naïve economists for exaggerating the efficiency of free markets and overlooking the signs of increasing instability, thus condoning the risky behaviors that led up to the financial meltdown.

The title of the book refers to Wolf’s distinction between the underlying shifts in the global economy that made financial markets less stable, and the actual financial shocks that caused a sharp contraction of economic activity and created a need for government intervention. In organizing the book, Wolf chose to cover the shocks in Part I and the shifts in Part II. I thought that made the book’s argument harder to follow, reversing the chronological order of events and putting the financial cart before the economic horse that was pulling it. Wolf describes the financial crisis in Chapter 1, but doesn’t discuss the reasons for financial instability until Chapter 4. He only sets the scene briefly by describing four features of an ultimately unsustainable global situation: “huge balance-of-payments imbalances; a surge in house prices and house building in a number of high-income countries, notably the US; rapid growth in the scale and profitability of a liberalized financial sector; and soaring private debt in a number of high-income countries, notably the US, but also the UK and Spain.”

When investors lost confidence in the value of the loans they had made and the assets they had helped inflate, major investment banks failed and credit dried up. That forced governments to intervene, very likely bringing to an end the era of financial liberalization. The US government took over the biggest mortgage lenders, injected capital into failing businesses, lent money to banks at zero or near-zero interest rates, and held down longer-term rates by purchasing private bonds.

Post-crisis recovery and its limitations

Judging from the size of the banks that failed, the financial crisis was even worse than the crash of 1929, but the rapid policy response kept the economic situation from becoming as bad as the Great Depression. Nevertheless, the success of the recovery has been limited by the failure of government to be even more aggressive. Wolf’s verdict is that it rescued the world economy “fairly successfully, but not successfully enough, largely because the fiscal stimulus was both too small and prematurely abandoned.”

The post-crisis recovery has been weak for many reasons: Borrowers reduced borrowing and spending and turned to paying down debt. Investors also pulled back as a reaction against previous overinvestment, especially in housing that buyers couldn’t really afford. Financial institutions became more reluctant to lend, and borrowers could no longer count on inflation to increase the price of their assets while reducing the real value of their debts. The result was a general state of economic “malaise” in which low consumer demand and low investment reinforced each other.

Wolf also discusses “sectoral balances,” the balance of income and spending within the household, corporate, government and foreign sectors of economic activity. When US households and corporations reduced spending and started generating large surpluses, the economy required deficit spending by government to avoid protracted recession. This turned on its head the old idea that government spending crowds out private spending by borrowing money that could be put to better use by business. With the central bank lending money for practically nothing and corporations failing to invest much of it anyway, Wolf argues that “the private-sector cutbacks crowded in the fiscal deficit.” He believes that if the government had followed the advice of conservatives and slashed the deficit, that would have caused an economic depression.

Nevertheless, world economic leaders became so concerned about fiscal deficits that they pledged to cut them in half at the Toronto Summit of 2010. In the US, ideological opposition to government intervention remained strong, heightened by Republican opposition to the Obama presidency:

In the US, for both electoral and ideological reasons, the Republican Party was irrevocably opposed to the idea that the government could do anything useful about the economy except by leaving it alone, and so could not tolerate the possibility that the Obama administration might prove the opposite in the aftermath of the biggest economic crisis for eighty years. It therefore dedicated itself in Congress to preventing the administration from doing anything that might improve economic performance.

The crisis in the Eurozone

While the United States was starting to recover from the financial crisis, “the epicenter of the crisis moved inside the Eurozone, where it subsequently remained.” The contraction of credit exposed weaknesses in European national economies that had been masked by the adoption of a common currency.

When each nation has its own currency, the strength of that currency can reflect the competitiveness of its economy. Weak demand for its products on world markets will usually weaken demand for its currency, and the low buying power of its currency should keep it from buying more than it produces and trades. Investors from stronger economies can lend to weaker ones, but usually at high interest rates to reward lenders for taking more risk. The common European currency papered over these national differences and encouraged an excessive flow of goods and credit from the stronger economies, especially Germany, to the weaker economies of Southern Europe, such as Spain. The fiction that every euro was worth the same made it too easy for the Spanish, Greeks, Italians and others to borrow from German banks and buy German goods. The various economies appeared to be thriving together, but only until the end of the credit boom brought the game to an end.

The credit crunch put the poorer countries in the position of either defaulting on their debts or adopting austerity measures that threw their economies into recession:

Given their difficulty in borrowing and their lack of access to central-bank financing, the crisis-hit countries could not offset these deep recessions, indeed true depressions, with fiscal or monetary stimulus, at least without external support. That was not to be forthcoming on any significant scale. This was partly because Germany, supported by other creditor countries and the European Commission, argued that necessary structural reforms would not occur without remorseless economic pressure and, for that reason, regarded greater external support as counter-productive.

Wolf criticizes Germany for refusing to accept any responsibility for the crisis:

Germany’s focus on the alleged fiscal crimes of countries now in crisis was an effort at self-exculpation: as the Eurozone’s largest supplier of surplus capital, its private sector bore substantial responsibility for the excesses that led to the crisis. As Bagehot indicates, excess borrowing by fools would have been impossible without excess lending by fools: creditors and debtors are joined at the hip. A country that chooses to run current-account surpluses, indeed, one that has built its economy around generating improved competitiveness and increased external surpluses, has to finance the counterpart deficits and must, accordingly, bear responsibility for the wastage of funds.

Wolf thinks it is misleading to blame the European economic crisis on government deficits in particular. What the troubled economies had in common before the crisis were not government deficits but balance-of-trade deficits, which were a consequence of policies in both creditor and debtor countries. After the crisis, private spending declined, but government deficits increased due to falling tax revenues and counter-recessionary spending. Fiscal austerity alone, without any other economic reforms, is a recipe for continued recession.

Emerging economies

Emerging economies in Asia and Latin America generally grew at a faster rate both before and after the financial crisis. Most of them managed to avoid credit booms that would leave them as heavily indebted as the United States or Southern European countries. On the contrary, some of them, especially China, ran large surpluses by exporting more than they imported and investing heavily in other countries. Although this has been a successful growth strategy in the short run, Wolf questions its sustainability. Again, if countries like Germany and China run surpluses, others must run deficits; and if too many countries embrace austerity at the same time, global output must fall. Like Michael Pettis, Wolf thinks it is silly to treat austerity and lending as moral goods, while treating spending and borrowing as moral evils. At the macroeconomic level, the problem is finding a balance, for example by having creditor countries increase domestic demand and debtor countries increase their exports.

My next post will deal with the global economic shifts to which Wolf attributes the financial crisis in the first place.

Continued

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Political Bubbles (part 2)

November 13, 2014

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Having described how political ideologies, interests and institutions help inflate dangerous financial bubbles, McCarty, Poole and Rosenthal turn their attention to what happens after a bubble bursts.

In the case of the bubble that burst in 2008, the political response was hampered for many reasons. Although the voters elected a moderate Democrat as President, the ideological positions within Congress changed very little. In fact, while the new Democrats elected in 2008 were mostly moderate candidates running in swing states, the new Republicans elected in 2010 were more often extreme conservatives from “red” states. After 2010, free market conservatism was even better represented in Congress than it had been before the crisis.

Although some large financial institutions failed, mergers and acquisitions–many of them arranged by government–created even larger ones that were truly “too big to fail,” giving them a kind of license to engage in risky behavior. The power of the financial industry to influence elections and shape legislation remained unchecked.

The institutional arrangements that make change difficult, such as the Senate filibuster, remained in place, and the number of bills that couldn’t be brought to a vote reached record proportions. By undoing some of the previous campaign finance reforms, the Supreme Court enhanced the political influence of powerful financial interests.

Responses to “pops” in American History

The difficulty of financial reform after the bubble popped in 2008 is fairly consistent with the historical experience. The authors draw four lessons from government responses in similar situations:

  1. Legislative responses to financial crises and economic downturns have generally been limited and delayed.
  2. The response often awaits a transition in political power. This partisan delay reflects the idea that the cause of the crisis is generally rooted in the ideology of the incumbent party.
  3. Future change in political power often reverses the initial legislative response. The reversal contributes to the next crisis. This point is central to the inevitability of future financial crises.
  4. Short-term reelection concerns undermine the search for longer-term solutions.

In the case of the most famous financial crisis, the crash of 1929, the legislative response was delayed until the election of 1932. By then, the economic damage was severe enough to generate a massive shift in ideology and voting, which gave Roosevelt large majorities of pro-intervention Democrats in both houses of Congress. In addition, the Republican Party included more moderates in those days, as a result of a progressive reaction against Gilded Age inequalities that had been building for some time. As a result, “FDR was able to do business with practical, compromising politicians. In contrast…Obama is faced with a pack of ideologues.”

As an example of the difference, the Roosevelt administration was able to provide debt relief to millions of farms and homeowners, with massive approval from the general public. The Obama administration’s efforts to restructure failing mortgages were not only hampered by a lack of cooperation from lenders, but attacked as a subsidy for irresponsible borrowers, a reaction that launched the Tea Party movement.

Legislative responses

Because of Congressional polarization and strong conservative opposition, the Obama administration’s major pieces of legislation–the economic stimulus package, the Dodd-Frank financial reform, and the Affordable Care Act–had to be carefully crafted to achieve a majority in the House and a filibuster-proof majority in the Senate. In all three cases, votes split along clear ideological and party lines, with only just enough votes to win. The bills couldn’t include anything unacceptable to their least enthusiastic supporters.

The authors regard Dodd-Frank as a very limited financial reform. It makes few hard-and-fast rules, instead leaving a great deal to the discretion of regulatory agencies, mostly the same agencies that have demonstrated low regulatory capacity and over-dependence on industry in the past. It didn’t bode well that the agencies missed most of their deadlines for issuing the new regulations required by the law. Dodd-Frank did little to eliminate the problem of “too big to fail,” or change the executive compensation practices that led to excessive risk taking, or regulate risky financial derivatives.

Another political response to the crisis, the Troubled Assets Relief Program (TARP) had a different political dynamic. It was proposed by the Bush administration as an emergency response to the banking crisis. The vote did not split neatly along liberal/conservative lines, since opposition came both from conservatives opposed to government intervention and some liberals opposed to government generosity toward big banks. It may have been necessary, but it wasn’t very popular at either end of the political spectrum.

Public opinion

The authors explore some of the nuances of political populism. In general, it “arises from mistrust of elites and the institutions they govern,” but it takes many forms. One populist current in American history is “distrust of big business, finance, and concentrated economic power.” Even stronger currents, however, are distrust of government and of cultural elites like intellectuals. Before the 1970s and the Watergate scandal, most people said they trusted their government to do the right thing most of the time, but in 2007 only about 20% still thought so.

When the financial crisis hit in 2008, the public generally supported government interventions such as more financial regulation and assistance to homeowners. Given the general mistrust of government, however, that support was hard to sustain in the face of limited and mixed results. Many people couldn’t see how the government was helping them, even as they heard about bailouts for big banks and low-income homeowners. In the face of relentless attack from the well-mobilized right, especially the Tea Party, public support for change withered. Meanwhile, the Occupy Wall Street movement was trying to mobilize opposition to financial elites and extreme inequality, but they suffered from an inability to agree on an agenda, disengagement with party politics, and hostility to any hierarchical organization.

I find it ironic that the economic failures of government–large deficits, wasteful wars, lax financial regulation–are clearly bipartisan accomplishments, and yet the resulting mistrust of government seems to benefit mostly Republicans as the most overtly anti-government party. Low expectations of government easily become a self-fulfilling prophecy.

Recommendations

McCarty, Poole and Rosenthal would like to see the political response to financial crises strengthened in these ways:

  • “Use simple regulatory rules,” such as a simple “Volcker rule” that commercial banks cannot trade securities on their own account. Dodd-Frank let regulators write a several hundred page rule that is much harder to interpret and enforce.
  • “Set rules that account for political risk,” for example that are strong enough to be useful even if total compliance cannot be achieved
  • “Limit the activities of taxpayer-insured financial firms,” since federal deposit insurance gives taxpayers a stake in the financial outcomes
  • “Reform compensation practices,” so that financial executives cannot receive large bonuses for making bad bets with other people’s money
  • “Prevent ‘Too Big to Fail'” by actually limiting the size and power of financial institutions
  • “Increase regulatory and prosecutorial capacity,” making regulators less dependent on the knowledge and talent of the industry they regulate

In order for reforms like this to occur, the authors see the need for a major shift of ideology, such as occurred during the Progressive Era around the turn of the previous century. Although Americans are generally agreed that the country is on the wrong track, they seem unable to define a more constructive role for government in setting a new direction. I suspect that a new generation will have to be heard from before this will happen.

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Political Bubbles

November 12, 2014

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Nolan McCarty, Keith T. Poole and Howard Rosenthal. Political Bubbles: Financial Crises and the Failure of American Democracy. 2013. Princeton: Princeton University Press.

This book is an indictment of the American political system, not for causing financial crises, but for making them worse through political action or inaction. In the authors’ view, financial bubbles have been accompanied by “political bubbles.”

Financial bubbles occur when the prices of financial assets rise far beyond their “fundamental” value, the value that could be justified by some rational economic analysis. They are driven by excessive optimism, or by the desire to encourage and profit from the optimism of others. In the case of the housing bubble, the overvalued assets were risky subprime mortgages and the complicated financial instruments that were based on them.

A political bubble is a “set of policy biases that foster and amplify the market behaviors that generate financial crises….Rather than tilting against risky behavior, the political bubble aids, abets, and amplifies it.” The authors identify three channels through which this political amplification of financial bubbles occurs: the three I’s of ideology, interests, and institutions.

 Ideology

The authors see an ideology as a belief system whose rigidity “inhibits the rational adaptation of policy to the circumstances of financial crisis.” Ideologues hold to their policy positions even when the results are unfortunate. The ideology of free-market conservatism is most conducive to financial bubbles, but other ideologies play a role. The egalitarian belief system more common on the political left supported efforts to broaden home ownership by making mortgage loans to lower-income buyers. This gave political cover to predatory lenders, who could claim to be promoting the public interest with tricky subprime and adjustable rate mortgages.

The authors use a spatial model of Congressional voting that places each issue and each legislator along a single dimension from liberal to conservative. The model is remarkably successful in predicting how most legislators will vote on most issues, accounting for over 90% of votes cast in the most recent Congresses. By calculating and comparing the average ideological scores of each major party over time, the authors conclude that ideological polarization is at an all-time high. This has occurred primarily because the Republican Party has moved more to the right. To put this in historical context, polarization has risen and fallen in tandem with economic inequality, the last peak having been reached in the Gilded Age. The authors see a reciprocal relationship between economic excess and political polarization:

In periods in which there are huge economic rewards to unfettered markets, support for free market conservatism increases–especially among those individuals and groups who benefit the most….Political polarization leads to political gridlock that makes economic reform difficult. Not only can the economic losers not form a coalition to redirect the allocation of resources, but the government cannot effectively respond to those economic shocks and crises which in turn further increases polarization.

I think that’s a pretty good summary of our political impasse.

Interests

Looking beyond legislators to those who influence them, individuals and organizations who are profiting the most from financial bubbles have strong motives to support policies that sustain those bubbles. As the financial services industry expanded and thrived in the bubble years, it also gained political power. “Campaign contributions from the financial sector increased almost threefold between 1992 and 2008, even after adjusting for inflation,” making it by far the largest source of contributions to political campaigns.

The book also cites the work of Larry Bartels, who demonstrated that actual legislative votes correspond most to the desires of high-income constituents, and hardly at all to those with low incomes.

Powerful financial interests influence politicians with information as well as money. Complex financial issues are often challenging for individual legislators to understand, and corporate lobbyists are only too happy to “help” them.

The interests of politicians easily come to overlap the interests of their most powerful constituents. Many have been rewarded for their pro-business policies with high-level positions in the very businesses those policies help.

Institutions

A variety of institutional arrangements make the American democratic system very sluggish in its response to financial crises. “The problem is that political power in the United States is so fragmented, separated, and checked that policy change requires extraordinary consensus and mobilization.”

For example, we elect our Congressional representatives with frequent elections conducted in rather small legislative districts. That can make representatives less responsive to national needs than to the demands of local constituents, especially the richest and best organized. In the Senate, permissive filibuster rules effectively require a 60-vote majority just to bring a bill to a vote.

Financial regulators suffer from a “low regulatory capacity.” They lack the resources and expertise to keep up with the growing and complexifying financial sector. Often they end up relying on the industry they regulate for information, talent and expertise, making them vulnerable to “capture” by that industry.

The political bubble in the recent financial crisis

In the period leading up to the financial crisis of 2008, ideology, interests and institutions combined to amplify rather than counter the growing financial bubble:

The lethal concoction that destroyed the investor society and the broader standard of living had five components— all rooted in our Three I’s. The first was deregulation that permitted innovative new financial instruments, such as exotic mortgage products, collateralized debt obligation tranches, and credit default swaps to emerge without meaningful regulation. The second was deregulation that permitted financial firms to engage in a riskier range of activities. The third was a reduction in the monitoring capacity of regulators, either through deliberate neglect, as reflected in the tenures of Alan Greenspan at the Federal Reserve and Harvey Pitt and Christopher Cox at the Securities and Exchange Commission (SEC), or as a result of the failure of staffing and budgets to expand at the same rate as the markets they were supposed to regulate. The fourth was the shifts in competition policy that allowed the creation of financial institutions that were too big (and too politically powerful) to fail. The fifth component was the privatization of government financing of mortgages through Fannie and Freddie, which created two additional too-big-to-fail institutions.

Financial deregulation took place during a period of three decades, heavily driven by ideology and interests. In the early 1980s, federal law deregulated interest rates, overriding state usury laws and allowing adjustable rate mortgages. These “quickly got distorted into ‘teaser’ loans with low introductory interest rates that later reset to usurious levels.” Exorbitant interest rates made it increasingly profitable to lend money even to people with a high risk of being unable to repay the principal. Complex financial derivatives whose value depended on subprime loans were exempted from regulation in 2000. Once these deregulations had occurred, institutional limitations combined with ideology and interests to block reform. All of the numerous attempts in Congress to curb predatory lending failed.

A number of forces came together to support risky lending as a way of encouraging home ownership. Free market conservatism generally opposed financial regulation. In addition, Republican administrations were anxious to promote the “ownership society,” in which more people could build private wealth instead of relying on government. For most people, wages were stagnant, but they could build wealth anyway if they could obtain a mortgage loan and leverage a small down payment into some growing equity. Bill Clinton and other Democrats also promoted home loans to broaden the middle class and create a more egalitarian society. So an expansion of home loans had much more bipartisan support than direct housing subsidies to low-income households, which would cost the taxpayers money.

Implementing the federal role in expanding home ownership was largely the responsibility of two “Government-Sponsored Enterprises” (GSEs), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Both entities helped finance home ownership by buying qualifying mortgages from lenders. “Lenders in turn used the proceeds of these sales to issue more mortgages, which lowered borrowing costs and stimulated housing demand. The subsidy embedded in Fannie and Freddie was enhanced by the ultimately correct perception that the government guaranteed their debt. This guarantee reduced their borrowing costs below those other corporate borrowers.” Congressional legislation under both Republican and Democratic administrations encouraged the GSEs to back more mortgages for lower-income households. Even if the mortgages they backed were fairly safe, the additional capital enabled private lenders to make shakier loans and sell them off to unsuspecting investors. The authors are certainly not endorsing the view that the financial crisis was all the government’s fault; they regard that as an ideological position appealing to those who think that free markets can do no wrong. They are only showing how political factors helped inflate the financial bubble.

In the end, this way of creating an “ownership society” was a colossal failure. Rates of home ownership peaked and then crashed, especially for the ethnic minorities who had the lowest rates to begin with. Free-market ideology, sprinkled with a few liberal good intentions and a lot of money in politics, amplified the worst financial crisis since the Great Depression.

Continued

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Austerity: The History of a Dangerous Idea (part 3)

August 28, 2013

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

August 27, 2013

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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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