Austerity Agonistes

The History of A Dangerous Idea

by Mark Blyth
Oxford University Press, 2013, 304 pp.

Debtors’ Prison:
The Politics of Austerity versus Possibility

by Robert Kuttner
Knopf, 2013, 352 pp.

More disheartening than the economic catastrophe in the United States and Europe is that government response is making the crisis worse. The response is austerity, which Mark Blyth, in Austerity, defines as “the policy of cutting the state’s budget to promote growth” and which Robert Kuttner, in Debtors’ Prison, labels “Agony Economics.” Both books—informed, passionate, at times angry—document the failure of austerity, detail the resulting human suffering and untangle the historical and ideological origins of austerity.

The Great Recession has led to the longest period of sustained high unemployment in the post-war era. It’s five and a half years after the crash, and 8.7 million jobs are needed to restore the U.S. economy to prerecession levels of unemployment. National output is about $1 trillion below what it could have been if the economy were at full employment.

In Europe, economic prospects are moving from bad to catastrophic. Unemployment is over 25 percent in Greece, Spain, and Portugal—far higher among young people in those countries—and most economies are either stagnant or shrinking. Relentless austerity policies have shredded Europe’s traditional social compact with its citizens, fueled a wave of debt-related suicides in the continent’s hard hit South—Greek suicide rates jumped 37 percent from 2009 to 2011—and locked much of the continent into a seemingly endless spiral: austerity means layoffs, fewer jobs equals less revenue, lower revenue leads to more austerity.

At the end of 2012, the European Commission reported that unemployment on the continent—now in excess of 25 million people—would continue to rise. “The economic outlook is bleak and has worsened in recent months and is not expected to improve in 2013.” The European Union is currently the only major region in the world where unemployment is still rising. One EU study found that the crisis threatens to turn 94 million Europeans ages between 15 and 29 into a “lost generation.”

All of this translates into a level of economic misery that Europeans have not seen in more than eighty years. Greece’s meltdown is worse in duration and scale than Germany’s was during the 1930s. The aid agency Oxfam reports that if the Madrid government’s austerity policies continue, the percentage of people below the poverty line in Spain could rise from 27 percent to 40 percent. UK chancellor of the exchequer George Osborne says he expects his country’s austerity programs to continue until 2018.

This lost output and human tragedy of unemployment are almost entirely a function of deficient economic demand—households, businesses, and governments are not spending enough to keep all workers and productive capacity employed. The rise in the federal deficits is a symptom of the weak economy.

The economic collapse in 2008 was, according to Blyth, a “crisis of the instruction sheet of the past 30 years.” This instruction sheet—call it neoliberalism—dates to the Reagan years, when Keynesian concerns with aggregate demand were rejected and finance was accorded a special place in the American economy. Policies promoting the free movement of capital across borders, the deregulation of finance, and the repeal of regulations separating commercial and investment banking were the order of the day. Neoliberal policy weakened workers and unions and strengthened the position of business. This policy led to stagnating wages and living standards for most Americans.

The puzzle was, how could falling wages and declining living standards provide the basis for a mass consumption economy? Two things propelled growth for a while: the growth of credit markets for poor and middle-income people and of derivatives and futures markets among the very wealthy. This combination produced what the sociologist and political scientist Colin Crouch calls “privatized Keynesianism.” Instead of governments taking on debt to stimulate the economy, individuals did so. “Purchasing power and economic growth,” Kuttner states, “were sustained by a steadily inflating bubble economy.”

The stock market boom and bust of the late eighties was followed by the dot-com boom and bust of the late nineties, which created a “wealth effect” that buoyed consumption and investment. The bubbles of the late eighties and nineties were replicated in the 2000s in the housing and commercial real estate markets. The rush of foreign dollars into the United States helped the Federal Reserve keep interest rates low. With interest rates plummeting, home sales rose. And as sales rose, the price of homes rose. Homeowners used their newfound home equity to purchase cars and second homes. Construction boomed even while manufacturing floundered. When home prices threatened to discourage new purchases, banks and brokers, encouraged by the Fed, offered new subprime mortgage deals. When the banks became worried about risk from these mortgages, they invented elaborate financial instruments to cushion and spread the risk. And when housing prices finally stalled, the whole Ponzi scheme collapsed, and the recession, the most severe since the 1930s, began.

In the immediate aftermath of the 2008 financial crisis there was widespread agreement on the need for stimulus, with the twenty largest economies (G-20) endorsing a coordinated fiscal stimulus in November of 2008 and again in April of 2009. However, the enthusiasm for stimulus barely lasted a year. By the end of 2009 and the beginning of 2010, we were hearing an increased drumbeat that the time had come to address growing deficits.

The stimulus packages of 2009 were replaced by austerity packages in most wealthy countries. Barack Obama made a disastrous turn to deficit reduction in 2009. In the eurozone, the crisis countries were handed austerity maps by the troika of the International Monetary Fund (IMF), the European Central Bank (ECB), and the EU as a condition of getting financial support. And in the United Kingdom the Conservatives came to power in the spring of 2010.

It was at this point, Blyth states, that the greatest bait-and-switch in modern history took place. “What were essentially private-sector debt problems was rechristened as ‘the Debt’ generated by ‘out-of-control’ public spending.” The cost of saving the global banking system—between three and thirteen trillion dollars—ended up on the balance sheets of governments…which is why we mistakenly call this a sovereign debt crisis when in fact it is a transmuted and well-camouflaged banking crisis.

Europe usually sits to the left of the United States politically, but it was acting far to its right economically by mid-2010. The basic reason for this was the same one we saw in the United States. If you think the risk posed by hugely levered US banks that were too big to fail was terrifying, then consider the following: in November 2011 the Financial Stability Board, a coordinating body for national financial regulators, published a list of systemically important banks, in other words, the too big to fail list. Of the twenty-nine banks named, only eight were US banks; seventeen were European. The Europeans have managed to build a system that is too big to bail, [emphasis in original] which is the real reason why a bunch of putative lefties are squeezing the life out of their welfare states.

Unlike the United States, the crisis in the eurozone has become a public sector debt crisis. The reason for this is the eurozone’s lack of a central bank that can act as government banker. This is due to the Euro’s flawed design that prohibits the ECB from helping governments finance their deficits and manage their debts.

Supporters of austerity make several claims. First, that out-of-control public indebtedness is ruining both the U.S. and European economies and second, that cutting spending would result in economic growth. Kuttner and Blyth demolish these arguments.

Public debt was not a cause of the collapse of 2008 nor is it retarding the recovery today. In fact, according to the Organization for Economic Co-operation and Development, average debt prior to the crisis was going down not up. It was private speculative debt that produced the crisis of 2008. And while government debt levels have risen because of the recession, the burden of the debt, that is, the interest payments on government debt as a percentage of total federal expenditures, are at historically low levels, lower than they were under presidents Ronald Reagan and G.H.W. Bush. The reason for this is the low interest rates, which have kept U.S. borrowing costs very low since 2009.

Blyth offers a detailed criticism of Harvard economist Alberto Alesina who purported to show that countries that had sharply reduced their budget deficits were rewarded with more rapid growth. Alesina claimed that the best results came when countries reduced their deficits primarily on the spending side; that deficit reduction that came about primarily through higher taxes did not lead to greater growth. He claimed that growth was best when the spending cuts were in social support programs, such as public pensions and health care.

Alesina’s analysis was a green light for austerity. All governments had to do was cut back on their spending, especially social spending, and then just sit back and watch their economies boom. This was precisely the pre-Keynesian view of the world. There was no need for the government to support the macroeconomy. The best thing the government could do was get out of the way.

Public debt was not a cause of the collapse of 2008 nor is it retarding the recovery today.

Fortunately, the IMF did a further analysis of Alesina’s findings. The IMF found that whether a fiscal contraction would be expansionary depended on the point in the business cycle where it was undertaken. A fiscal contraction that was undertaken in the upswing of a cycle did prove to be expansionary. The idea was that private sector spending replaced public sector spending, exactly the sort of crowding-out story that conservative economists like to tell. However, when the contraction took place in a downturn, or when the economy was stagnant, it ended up being contractionary.

The IMF had become an unexpected opponent of fiscal austerity. Its research demolished the intellectual basis for the claim that fiscal contractions could be expansionary. It also showed that, at least in the short term, there was no basis for preferring spending cuts to tax increases to reach whatever deficit goal was set as a target.

Carmen Reinhart and Ken Rogoff made a different argument for austerity. They argued that austerity might hurt today but they claimed it would help tomorrow—if it keeps governments from racking up debt equal to 90 percent of GDP, at which point growth supposedly slows dramatically. The result was never more than a correlation—slow growth more likely causes high debt than the reverse—but that didn’t stop policy makers from imputing magical significance to a 90 percent debt-to-GDP ratio. It became a fact that everybody who mattered knew was true.

However, Reinhart and Rogoff made several mistakes. They excluded some data in one case and used wrong data in another. Correcting for these basic errors the growth tipping point at 90 percent of GDP disappears.

The reduction in demand from fiscal austerity will not be offset by an increase in the other components of demand. In a weak economy, any increase in investment—driven by mysterious forces that Paul Krugman has labeled the “confidence fairy”—associated with lower interest rates will be minimal. Finally, net exports are unlikely to see a substantial boost, primarily because major trading partners are mostly in similar situations and are unlikely to allow one country to seize substantial market share at their expense. The bottom line on austerity is best summarized in a recent paper by Paul De Grauwe and Yuemei Ji: “Countries that imposed the strongest austerity measures also experienced the strongest declines in their GDP . . . The more intense the austerity, the larger is the subsequent increase [emphasis added] in the debt-to-GDP ratios.” Austerity is a policy without a justification.

Yet, austerity continues. Kuttner describes the politics behind austerity in the United States as “a witches’ brew of Wall Street conservatives who want to reduce social insurance, political moderates who mistakenly believe that deficit reduction will restore business confidence, economic innocents who view belt-tightening as the road to prosperity, far-right conservatives who want to use deficit reduction to further starve government and Democrats without the confidence to challenge the conventional wisdom.” The breadth of Kuttner’s review of the politics of credit and debt throughout American history is impressive. He argues that, after a financial crisis, nations have two choices. Either the creditor class—usually the wealthy and powerful—prevails at the expense of everyone else or the government finds a way to reduce the debt burden so that the productive power of the economy can recover. He illustrates this by highlighting what happened after the two world wars, two very different examples, one negative and one positive, about how to deal with unsustainable debt.

At the 1919 Versailles peace conference, the creditors prevailed, and Europe’s postwar economy stagnated. Britain and France wanted to force defeated Germany to pay off their war debts. Britain also pursued tight money to keep its own currency valued at prewar levels, in order to protect the creditor class. The policy wrecked the German economy and kept British unemployment above 10 percent for two decades. John Maynard Keynes’s 1919 book, The Economic Consequences of the Peace, prophetically warned that enforcing austerity on Germany would cause depression and a second war.

The experience after the Second World War was very different. “The victorious allies,” Kuttner argues, “recognized that an economically healthy Germany was the best protection against a lapse back into fascism.” The Bretton Woods system emphasized domestic recovery, the Marshall Plan, and debt relief. The United States combined expansive investment, a regulated financial sector, and low interest rates; and the economy grew.

Today, creditors are once again successfully driving an austerity agenda. Banks have been successful in getting cheap money for themselves while relief is denied to underwater homeowners. The lesson, according to Kuttner, is that “debt relief is necessary for economic recovery….Prevention of disabling debt is better achieved by adequate regulation of credit before the fact than by erecting prisons for the casualties of the last crisis. Intelligent people seem to have a very hard time grasping that paradox.”

After 1945 several developed countries managed to shrink debts of over 100 percent of GDP to just 20 percent by 1970. And they managed to do it while at the same time generating two decades of unprecedented growth. The term for how they achieved this is “financial repression,” and both Blyth and Kuttner believe we should purse a similar policy now. The way financial repression worked in the postwar world was that countries capped the amount of interest one could earn on savings. They made national capital markets illiquid, so that moving your money around became difficult—and then they unleashed high inflation for a period, which then wiped out the value of savings and thus the debt.

Financial repression involves more than just the Federal Reserve keeping interest rates low. Low rates by themselves have not been sufficient to end this recession. Recovery of the economy requires debt relief and public spending to compensate for the damage to banks and the shortfall of private purchasing power. While central banks could do more there is no substitute for more aggressive fiscal policy—public borrowing and investing.

There really is no alternative because, in the last words from Blyth, “austerity simply doesn’t work.” “The economics,” Kuttner concludes, “could and should be drastically different….we must begin by reclaiming democratic politics.”

Mark Levinson is chief economist at the Service Employees International Union (SEIU) and the book review editor of Dissent.