The death throws of austerity
Mar 13 2013
Watching the death of an idea, which many policymakers have clung to so tenaciously is always fascinating. In the case of fiscal cuts being considered as the road to economic salvation in the west, sometimes death comes quickly, sometimes it doesn’t. Over the past few weeks, we’ve seen both. While it may not be the most important economy in the world, austerity died in Bulgaria, literally overnight, with the fall of its reformist government. In the UK and elsewhere on the continent, austerity clings on, but even respectable opinion is now putting distance between itself and an idea that has dominated policymaking for three years. What killed austerity?
The answer in a nutshell is the failure to restore economic growth. Now, it wasn’t supposed to be like this. Government spending cuts were meant to reduce state borrowing, crowding out less private sector investment. Moreover, as the UK finance minister liked to put it, the private sector was supposed to charge in and effectively hire those sacked by a retreating state. While this reshuffling (doesn’t it sound so natural and painless?) of resources took place, mighty central banks would both stabilise financial markets and stimulate economic recovery.
So much for the ideas, what actually happened? Well, aggressive monetary policies across Europe and North America did free up once-frozen financial markets. The so-called tail risks that threatened to turn the Great Recession into the Great Depression were averted. Bravo! What didn’t go according to the plan was that the stock markets —pumped up by all the additional money printed by central banks — did not trigger a revival in consumer spending. Instead, consumers continued to pay down debt where they had it or saved more just in case they were the next to lose their jobs. Banks raised profit margins rather than lend much more. Potential borrowers fearful of the future too decided not to expand their liabilities, limiting private sector investment. This pain was heaped on that created by government spending cuts and tax increases.
Under these circumstances, most economies were lucky to go sideways. Slow or no growth meant tax revenues fell short of projections and unemployment levels remained stubbornly high, ensuring that welfare payments didn’t fall as fast as planned. As a result, governments like the UK consistently overshot their borrowing targets, adding to the sense of failure. Credibility waned and credit ratings were downgraded. To its credit, the International Monetary Fund — which is hardly known for its soft heart — was the first pillar of the policy establishment to realise that something wasn’t right. IMF’s economists recalculated the knock-on effects of cutting government spending on national income and found that, during the crisis, the adverse impact of austerity was larger than previously thought. Growth recoveries, such as they are, were much slower in countries that sought to cut their state budgets the most. The more severe the cuts, the more firms and employees feared being sacrificed on the altar of austerity and so they cut back their spending often in advance of the government’s retrenchment. Expectations matter in macroeconomics, just as Keynes said.
Then came the political repudiation of austerity — last year with the election of a Socialist president in France and more recently with the dismal electoral showing of technocratic Italian prime minister, Mario Monti. Pressure on the UK government is growing, not least from its supporters in parliament. Without growth in the next year or two, they worry that voters will kick them out in the next election.
Subtle shifts in respectable economic commentary have occurred. Last week’s leading editorial article in The Economist made the case for a dash for growth with — guess what — increased government spending! The argument was carefully dressed up in terms of spending on growth-promoting infrastructure projects, but the authors know very well that the growth payoff from better infrastructure is felt over decades. In a sleight of hand, this extra spending is being marketed as improving the supply side of economies, when in fact it is the short-term boost to demand that is really being sought. If what really matters, is the impact of greater government spending on short-term economic growth; why narrow the focus to infrastructure projects? Other forms of government spending might work just as well, even better. Of course, don’t expect answers to difficult questions like this. It’s a relief that those who have been willing to inflict so much pain on weaker elements of society — don’t think the cuts fell disproportionately on the well-connected or well-heeled —have climbed down from their tree and accepted the need for change.
We can take some heart that results still matter. For a while, macroeconomics was beginning to look like a branch of theology with the high priests consulting their undergraduate economics textbooks to assure their flocks that salvation through pain was the only alternative. Now the debate should shift to what spending works best and how the state needs to be reformed to better promote growth. These are not easy questions to answer. Since the private sector hasn’t delivered economic recovery, whether we like it or not, the burden falls on to the state.
(The writer is a professor of international trade and economic development at University of St Gallen, Switzerland)