Ask a lab rat: austerity hurts

What do you think about the British Chancellor of the Exchequer George Osborne's austerity programme? No, I am not trying to be funny. When he says he is tackling the United Kingdom's large budget deficit through a mix of spending cuts and tax increases, are you more or less likely to go out and spend money?

The answer appears obvious to most people. Austerity makes consumers and businesses more ­cautious. It leads to less spending and throws deficit reduction programmes off track. That, though, is not what Osborne thinks. It is not what the European Central Bank thinks. It is not what the Tea Party in the United States thinks. It is not what most mainstream economists think.

What they all believe is that any pledge by governments to cut spending imparts a warm glow to those toiling away in the private sector. Confidence blossoms because individuals and businesses expect healthier public finances to result in lower taxes. Businesses will invest and this will lead to higher consumer spending.

Conversely, any attempt by governments to spend their way out of a slump is worse than useless. Perfectly rational economic agents understand that higher public borrowing today means higher taxes tomorrow, and they will prepare for that dread day by reining in investment and spending. The economy will shrink.

Mumbo jumbo
You are thinking that this sounds like complete mumbo jumbo. You think that expansionary fiscal contraction — the economic idea used to justify austerity — is a contradiction in terms. You think that there is not one shred of evidence to support the idea that government belt-tightening in a deep slump does anything other than make that slump deeper and longer.

And you are absolutely right. There is no evidence that austerity works in the fashion promised by those who support it so vehemently. Britain, used as a laboratory rat to prove that expansionary fiscal contraction works, is proof of that, as are Ireland, Greece and Portugal.

The British experiment began three years ago when the coalition came to power. The timing could hardly have been better for the new breed of expansionary fiscal contractionists at the treasury. The deficit was at a peacetime record, the economy appeared to be on the turn and, as an excellent new book by Mark Blyth shows, it was the time when the brief one-year dalliance with Keynesian economics had just hit the buffers.

What happened was this. In the northern winter of 2008-2009, following the collapse of Lehman Brothers, the world economy contracted at a rate not seen since the early 1930s.

Governments co-ordinated the biggest expansion of monetary and fiscal policy on record. The Americans, the Chinese and the British all cut interest rates and announced stimulus packages. Even the fiscally conservative Germans joined the party.

Unprecedented intervention
The unprecedented intervention by central banks and finance ministries prevented a second Great Depression, but the healing process had only just begun by early 2010. At that point, the narrative changed. As Blyth correctly points out in Austerity: The History of a Dangerous Idea, the crisis began with the banks and only when states moved in to recapitalise institutions on the brink of bankruptcy did a private sector debt crisis become a sovereign debt crisis. With the sole exception of Greece, the financial problems faced by Western governments did not stem from state profligacy but from taxpayers picking up the tab to bail out the banks.

But this view was quickly challenged. Within months, as Blyth says, it was rechristened a sovereign debt crisis by political and financial elites. Why? In part, it stemmed from the ingrained belief that markets are infallible and governments can never do any good. In part, it stemmed from a genuine if misguided belief that government debt levels would explode to unacceptable levels unless austerity was introduced. In part, it was a way to ensure that the people who were actually responsible could shift the burden of clearing up the mess on to those who were blameless.

Armed with economic evidence
Those determined to push back against the Keynesian experiment came armed with economic evidence. The Italian economist Alberto Alesina made the case for expansionary fiscal contraction in a paper to European Union finance ministers in April 2010, citing countries such as Ireland in the late 1980s where the approach was supposed to have worked.

Jean-Claude Trichet, then president of the European Central Bank, was impressed. So was Osborne, who drew on Alesina's work in his emergency budget of 2010. Blyth's book traces austerity back to its roots in the works of John Locke, David Hume and Adam Smith, but is particularly impressive in the section that takes apart claims that the past 30 years have provided examples of expansionary fiscal contraction working.

Alesina's version of what happened in Ireland in 1987-1989 is that an austerity-minded government delivered growth by cutting welfare, taxes and the public sector wage bill, with the fiscal tightening offset by a devaluation of the punt. This explanation, however, fails to mention that Ireland's biggest export market is Britain, which was going through the wild excesses of former chancellor Nigel Lawson's ill-fated boom.

International Monetary Fund (IMF) economists have done a good job in challenging the claims of the expansionary fiscal contraction brigade. It found that the notion that spending cuts are less harmful to growth than tax increases, one of the chancellor's key claims, only holds true if central banks can compensate for the contraction with interest rate cuts — impossible when official borrowing costs are just above zero.

In short, the IMF believes that austerity isn't working. It believes the US has recovered more quickly than the eurozone because of Washington's belief that growth leads to deficit reduction rather than the other way round. It says Britain's economic recovery is feeble and wants Osborne to boost spending on public infrastructure to offset the £10-billion of tax increases and spending cuts he has lined up for 2013-2014.

So ask yourself one final question. If Osborne borrowed £5-billion to £6-billion to build houses and fix potholes, would that be a good or bad idea? Most of us, I would suggest, would think it was good, which is why austerity has failed and why the economic thinking that underpins it is bunk. — © Guardian News & Media 2013

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