A poster promoting the virtues of austerity. But who really benefits? Photo: Flickr Creative Commons
Austerity isn’t working. From the Bundesbank to 11 Downing Street, in Ireland, Spain, Italy, and Greece, expensively educated men in suits are telling the rest of us that we have been living large for too long. Unless we cut government budget deficits, these Jeremiahs warn, inflation will take off, bond yields will skyrocket, business confidence will shatter, and the economy will never recover. Under their influence, we freeze wages, fire civil servants, close libraries, cut pensions. But reducing budget deficits doesn’t seem to be sparking growth. Indeed it is making things worse. Household income actually declined last year and Britain is falling into a double dip recession.
It is counter-intuitive but essential to remember that our current economic travails are caused by lack of demand, nothing else. No supply shock, no hurricane, no earthquake has devastated the planet. Our productive capacity remains pretty much the same as it was before the financial crisis. Only our confidence, or, as Keynes would say, “animal spirits” have collapsed. The solitary reason unemployment remains sky high is that households are paying down debt and firms are sitting on piles of cash. If either group found a reason to be optimistic and opened their wallets, the recession would vanish. In such a situation, with firms and households saving rather than spending, another sector has to pick up the slack. The obvious solution is increased government expenditure, especially on infrastructure and investment. Government deficit spending, targeted say, to education, would make British workers more productive twenty years in the future, while reducing unemployment today. It seems a no-brainer.
Instead, austerity-inspired spending cuts ripple through the economy, further lowering demand, reducing any incentive for private firms to invest, trapping the economy indefinitely below its productive potential. The public, currently tightening its belt, seems pleased by the notion that the government needs to tighten its own, even if well established macroeconomics and recent history teaches otherwise.
Austerity has always been the ideology of creditors. In Latin America in the 1980s, in East Asia in the 1990s, in southern Europe today, banks that had made imprudent loans were able to force governments to cut spending, so as to free up cash to repay debts. Unfortunately, these policies inevitably created massive unemployment and slammed the economy into reverse. Citibank profited from its misguided loans to Argentina, Brazil, and Mexico but Latin America suffered through a decade of hunger to repay them. Austerity serves the interest of lenders, of financiers, but harms the interests of borrowers, workers, and entrepreneurs. No wonder lobbyists for the banking sector proclaim its virtues. But for the rest of us, and for the prospects of growth, austerity clearly is the wrong strategy. Why then does this failed ideology remain so popular?
It strikes me that our affection for austerity is an atavistic throwback, in much the same way our passion for sugar and processed foods is a remnant of our history on the savannahs of East Africa, when hominoids who enjoyed the sweetness of fruit had a better chance of survival than those that didn’t. Back then, a taste for sugar brought us vital nutrients. Today it just makes us fat. Likewise austerity. For most of our time on the planet, scarcity was the bane of our existence. Lent comes in February because by that point in winter, our peasant ancestors had run out of anything tasty to eat. Religions that required lavish feasts in January probably had parishioners starve to death before spring. In hard times, we are hardwired to tighten our belts. Splashing out and spending seems wrong. Once upon a time, the wolf at the door wasn’t just a metaphor.
No longer. Today, obesity, not hunger, is the sign of poverty. Thomas Malthus had the bad luck to proclaim his theory just at the moment it ceased to be true. From the time homo sapiens learned language until the early 19th century, we did indeed live on the knife-edge of starvation. All that changed around 1820. The productivity gains engendered by capitalism and the industrial revolution transformed our world. One man could produce what took dozens before. And so the business cycle of boom and bust was born. Carolinian Europe (and Stalinist Russia) suffered no recessions. Famines yes, depressions no. Back then, every grain of wheat, every iron pot was consumed. Feudalism and communism were not nearly productive enough for supply to outstrip demand.
The Achilles heel of capitalism, the opposite of every other economic system, is overproduction. Inexorable productivity increases means every year we can make more stuff with less labour. Jobs disappear as our productive capacity increases. But as those jobs evaporate, unless they are replaced by equally lucrative employment, so do paychecks and so does aggregate demand.
In second season of The Wire union leader Frank Sobotka attends a meeting in which management demonstrates new machinery that will allow them to unload ships with almost no labour. Frank, and we in the audience, are horrified. Where will the jobs go? How will our heroes find work once muscle power is replaced by mechanisation? This is the downside of productivity gains. The ATM replaces bank tellers. Quantities of steel that used to require the labour of thousands can now be made by dozens. High-paying union manufacturing jobs disappear, replaced with less secure service jobs at a lower wage.
But the ship still gets unloaded, the steel still gets made. Productivity gains inevitably make the entire society richer, even if some people lose their jobs. That means the problem is purely distributional. If Frank Sobotka’s longshoremen could find other work, say as painters and decorators, personal trainers, massage therapists at the same pay scale, their Baltimore neighbourhoods would not crumble, and our backs would feel better too. Problems of supply are intractable. If there is no food, people will starve. Problems of demand, thankfully, can be solved purely through political will.
At Roosevelt’s inauguration in 1933, the reason one third of the nation was “ill-housed, ill-clad, ill-nourished” was because almost a third of the nation was unemployed. Traditional economics (what Keynes called the treasury view, what we now call austerity) insisted we drive supply down to the level of demand, even if that created unnecessary misery. Keynes and Roosevelt preferred to boost demand so as to meet the society’s productive capacity. Keynes facetiously suggested hiring men to dig ditches and others to fill them. Their pay cheques would get spent, giving firms reason to invest and this increased demand would end the depression.
The second world war proved him right. Fighting is the only activity even less productive than the digging and refilling of ditches. Weapons create nothing but destruction. Making bombs and blowing things up is the precise opposite of investment, but nonetheless it was the massive government deficits to fund war that finally ended the Great Depression. In 1938 unemployment in the US was still close to 20 per cent. By 1944 it was one per cent.
Just as government deficit spending got us out of the depression, from 1982 to 2007 it was ever-increasing private sector debt that allowed the world economy to expand. I like to call it private sector Keynesianism. For close to 30 years, debt-fuelled consumption was the global economy’s engine of growth. If an American did not max out his credit card, a factory in China closed. It is easy to understand why individuals with stagnant salaries wanted to borrow in order to fund consumption. The harder question is why banks were so happy to lend.
Here is the mechanism. Low inflation permitted central banks to flood the world with money, which lowered interest rates. For reasons too abstruse to go into here, low interest rates inevitably raise the value of assets, such as houses, shares, and bonds. This makes the owners of these assets feel richer and so increases their spending but even more important, it raises the value of their collateral should they be looking for a loan. Banks, seeing the value of collateral going up, are prepared to lend ever more, which both stimulates spending and pushes up the value of these assets even further.
Sound complicated? Let’s break it down. Low interest rates make your house more valuable. This means the bank is happy to lend you more money. This permits you to spend more than you earn, creating demand that further stimulates the economy. And with bank loans plentiful, potential buyers are able to borrow more, which pushes your house price even higher. So when you need to refinance, since the value of your collateral has gone up, the bank is pleased lend you even more money. This perpetual motion machine lasted from 1982 to 2007, only collapsing when fearful banks stopped rolling over debt in the wake of the sub prime debacle. Had their confidence not frazzled, had they kept on lending and had the rest of us kept on spending, the boom would have just kept on going.
The fact that we were able to stimulate the world economy successfully for close to 30 years with little more than the paper appreciation of assets tells us that nothing is stopping us from manufacturing sufficient public sector demand to bring us out of recession. Indeed, the creation of demand, through advertising and through monetary policy, has been the essential precondition for prosperity for most of the past century. That means we can build more schools, provide better health services, improve infrastructure, hell even start more wars. As long as we remain under our full employment equilibrium, these policies will not be inflationary and so are cost free. The real cost is in letting workers who want to be productive, sit idle. But our misplaced faith in austerity means that there is no political will to spend. And so our unnecessary economic malaise continues.