The wizards of austerity

Even on its own terms, austerity is a disaster. Greece, despite slashing government spending and ruining the futures of millions, has actually increased government debt as a percentage of GDP. Government spending has fallen, but GDP has fallen further. All that pain for no gain. Ireland, which imposed austerity after the financial crisis, is still languishing with high unemployment and miniscule growth. Iceland, which did not, is growing steadily. Here in the UK we barely avoided a triple-dip recession and even the IMF has suggested, albeit politely, that Osborne and Cameron find a plan B.

Meanwhile, the news from Japan shows that expansionary fiscal and monetary policy works even better than expected. The economic policies of Shinzo Abe, Japan’s new Prime Minister, have delivered 3.5 per cent annualised GDP growth in the first quarter, more than in any other developed nation. Wary Japanese consumers are finally opening their wallets. Exporters are enjoying a weaker yen. The contrast with austerity-ridden Europe could not be more dramatic. France has fallen back into recession, unemployment across the eurozone is over 12 per cent, and the entire European economy has been shrinking for the past six quarters. The publication of Mark Blyth’s Austerity: The History of a Dangerous Idea (Oxford University Press, £16.99) is well timed.

Today it may seem as if he is kicking a dead horse but in July 2010, when Mark Blyth was commissioned to write a book about the intellectual roots of austerity, it was about to become the dominant strain in economic thinking. Blyth, a professor of political economy at Brown University, reminds us that when the financial crisis hit, no one suggested cuts in government spending. At that point, the financiers now calling for austerity insisted governments had to bail out the banks—otherwise, the entire financial system could collapse. Purchasing banks’ bad debt inevitably increased government spending. It was not spendthrift governments that raised debt levels, it was the cost of moving troubled assets off banks’ balance sheets and onto the public sector’s. In 2007, Ireland’s government debt to GDP ratio was 25.1 per cent and Spain’s was 36.3 per cent, considerably less than Germany’s.

The austerity fad began in 2010, two years into the financial crisis. Banks no longer stared into the abyss, although it was not inconceivable that another bailout might be required. European banks, lacking a national “lender of last resort,” were especially vulnerable. Since governments had absorbed so much debt, markets worried that should the crisis return, nations without their own central bank might have trouble finding sufficient funds to bail out the banks again. If American banks were “too big to fail,” European banks were “too big to bail.” The motivation of austerity, according to Blyth, was to shrink government balance sheets by forcing cuts on workers and pensioners just in case the banks that had created the crisis required even more assistance.

Austerity: The History of a Dangerous Idea begins by explaining the current rise of austerity. Its second half explores its intellectual roots and 20th-century real world applications. Blyth considers both abysmal. The real world stuff is mostly familiar, including the disaster of Churchill’s return to the gold standard at pre-war parity in 1925, the rise of Hitler in the wake of German austerity in the early 1930s, and the collapse of the American economy in 1937 when Roosevelt was urged to balance the budget. Blyth is especially good on austerity in 1930s France, where central bankers so abhorred government spending that they were still calling for military cuts as late as 1940. It didn’t work out that well for them. In the 1930s, austerity blew up the world.

Less well known is the intellectual history of austerity. Blyth finds its roots in the early modern European fear of the confiscatory state. John Locke, David Hume and Adam Smith despised government debt, certain that merchants’ wealth would be wasted on royal frippery or war. By the late 19th century, financiers feared being repaid with depreciated currency and demanded “sound money.” In the 1930s, the “treasury view” in the UK and liquidationists in America insisted that in a slump, government had to balance its budget in order to restore business confidence. This philosophy failed miserably, turning a run of the mill stock market crash in 1929 into the worst depression the world had ever seen.

Keynes’s insight was that economies need not inevitably return to a full employment equilibrium. Cutting wages helps an individual firm but since my workers are your customers, lower spending throughout the economy merely reduces demand for everyone. Business confidence doesn’t depend on estimates of future tax burdens but rather on customers’ demand right now. Firms hire and invest when customers are buying up all their stock. In a slump then, when the private sector is cutting spending, the government needs to pick up the slack to restore demand. The Second World War proved Keynes right. It was government deficit spending that ended the Great Depression and for most of the post-war era, austerity became a fringe opinion—at least in the developed world.

But it never disappeared entirely. Milton Friedman once said that the role of economists is to keep ideas alive until political situations allow them to return. During the post-war Keynesian era, austerity hibernated among “Austrian” economists in America and the Bundesbank in Germany. Its re-emergence in 2010 has been a fiasco. Let us hope it is about to be exiled once again.