Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 10 March 2013

The Unlikely Friends of Austerity

Sometimes economists who support austerity have clear ideological or political motives. However I often come across economists who do not have these motives, and yet are deeply suspicious of the idea of Keynesian stimulus. In other words, they are economists who are quite happy to acknowledge market failure, and embrace the idea that governments have an important role in helping to correct that failure, and yet they are unhappy with what Jeffrey Sachs calls ‘crude Keynesianism’. (For a detailed critique of this Jeffrey Sachs piece, see this post from Mark Thoma.)

Where does this suspicion come from? Often there seems to be a view that the austerity/stimulus debate is a distraction from focusing on more important, longer term problems. Oddly this view is asymmetric: I do not think anti-austerity economists deny that there are also important longer term problems. I also think longer term issues are more difficult to fix at times of austerity, so in that sense the short and long term solutions are complements, not substitutes. There is the notion that some have that we need a crisis to get things done, but perpetuating and mis-diagnosing the crisis is precisely what those who want to use debt scare stories to reduce the size of the state are trying to do.

A particular and important example is a concern about high or rising government debt. Government debt is almost always a long term problem, whereas deficient demand should just be a short term problem. As regular readers of this blog will know, my current views about the (un)desirability of government debt in the long run are quite radical, but I have no problem combining this with a belief that in certain circumstances fiscal policy should be used to stimulate (or in the Eurozone, also cool down) the economy. [1]

There is an understandable concern about debt and markets. That concern should not be dismissed lightly. I remember being asked by economists working for the UK government in 2009 just how far can we let debt rise before markets panic? I knew that my answer, which was that in a balance sheet recession there was a higher demand for government debt (particular when it was accompanied by a flight to safety), was based on a solid macro model. But though I thought the chances of my being wrong were small, I also knew the costs of my being wrong could be very high, which should make anyone cautious. Now I am much more confident, because events have vindicated the model. [2] However I recognise that some people are hyper risk averse, or believe markets are totally fickle, which is partly why I have always stressed that fiscal expansion can be done without issuing more debt. So if this is your real concern, become an advocate for balanced budget fiscal expansion or other, more innovative, changes in the fiscal mix.

I suspect an equally important reason why economists are sometimes unenthusiastic about fiscal stimulus is that they have been trained to misread the problem we are currently dealing with. This is not just the idea that monetary policy rather than fiscal policy is the stabilisation tool of choice. More fundamentally, it is the line promoted - consciously or unconsciously - in almost every textbook that economic downturns are ultimately self correcting. We have a business cycle because prices are sticky, but eventually prices are flexible, so we are bound to get back to full employment once prices adjust (which cannot be that long).

The best thing to say about this message is that it is incomplete. It should say that what gets us back to full employment is monetary policy. Having an appropriate monetary policy is a necessary condition for returning to full employment. A monetary policy that, for example, kept real interest rates constant would not get us back to full employment following a permanent negative shift in aggregate demand. The moment you understand this, the seriousness of the zero lower bound coupled with inflation targets (which put a lid on inflation expectations) becomes apparent. We are not dealing with a normal recession that will end pretty soon, we are dealing with something that could last much longer.

So for someone like me, what I see at the moment is very simple. We have demand deficiency, and the normal means of correcting it is broken. We luckily have a backup system, but the levers of that system are being pushed in the wrong direction. What is worse, this backup system is not some mysterious or controversial mechanism - it is what we teach to students day in and day out. So to push the levers in the wrong direction just makes a mockery of macroeconomics.

[1] There is a concern about transition and persistence. That fiscal expansion today will be politically difficult to undo, and so will increase the longer term political challenge. I think that is one good reason for focusing on government spending rather than tax cuts or transfers, and more specifically on government investment, in any stimulus package. There are of course other good reasons for doing this.

[2] And because we have Quantitative Easing.


  1. Where does “stimulus suspicion” come from? I suggest one element, particularly in the minds of Austrians, is that they’ve make the big discovery that fiat currencies are inherently worthless (a point which is obvious to ten year olds). They then conclude, and cannot get away from the conclusion, that therefor increasing the quantity of fiat currency cannot possibly make us better off.

    1. "Fiat currencies are inherently worthless," are they? That's funny, I use mine every day and it gets me plenty of stuff of tangible worth. Do you barter in hides and furs to meet your daily needs?

      I have yet to meet a ten year old who will turn up his or her nose at a tenner on account of its "inherent worthlessness."

      Or perhaps you were just trafficking in the sort of counterintuitive absurdity that seems to pass for intellectual sophistication amongst educated British elites. (It was ably satirized in "History Boys.") It is just empty pretension pretending to be clever and original. Good grief, how tiresome. It makes you want to fumigate the conversation with pragmatist epistemology.

    2. Perhaps the substitution of "intrinsic" for "inherent" might help you to understand the original point. Paper money is made of paper, which has next to no value: it is intrinsically worthless. Fortunately for its possessors, it has value because the government says so ("fiat" = "make it so" roughly) and we believe it.
      Or you could just calm down a bit and give posters credit for having more intelligence than you do (even if they are members of British elites).

    3. I'm not sure the conclusion follows from the premise. I think its far more likey that the stimulus is not a stimulus if it doesn't end up in the real economy. My view (as a philosoher not an economist) is that QE is supposed to make lenders more confident, which in turn puts more cash into society. However, the problem with confidence tricks is they only work if the mark is conned.
      A cynic might argue that govt's have never had any power over the market, but sometimes they've been able to fool enough people at one time to nudge markets in a direction. I am not as optimistic as that cynic. The market is not rational, it is the expression of all the irrational senseless human fears and anxieties that happemn to prevail, and therefore behaves exactly like a sackful of monkeys, and always will.
      Economists should 'fess up, admit that they have no idea what's going to happen next and stop taking bets altogether. But Capitalism must be fed, and no one is better fed than those who stand with the shovels at the beasts all-consuming maw.

      Damn, left the best bit til last and everyone stopped reading two paragraphs ago.

    4. Bryn, Your point about stimulus not being stimulus “if it doesn't end up in the real economy” is fair enough. David Hume made very much that point in his 1752 essay “Of Money”.

      In reference to a money supply increase, he said “If the coin be locked up in chests, it is the same thing with regard to prices as if it were annihilated”. So regardless of whether stimulus is done with fiat or a commodity based money, it has little effect till it is actually spent.

  2. You imply that non-paper money, like gold specie, does gold have "intrinsic" value. Why? Because it is shiny? There is a sort of unintelligent vulgar materialism at work here that doubts the "reality" of socially shared understandings. What intellectual atavism is responsible for the idea that socially shared understandings with a symbolic basis cannot have a concrete and efficacious impact on the character of the material world? (Don't pretend that fiat currencies are a simple act of will by the state with no roots in broader social legitimacy--you no doubt are aware of the history of currencies with little or no direct consumption value which have existed apart from or even despite the action of states.)

    It is sad that this sort of unexamined stupidity passes for intelligence. The world is so much more interesting than is imagined by the glib pseudo-sophisticates on whom so many educational resources have been expended for so little yield. Think about the broader implications of the general observation that "symbolism" is so much more powerful than it is generally given credit for. Do most people in their everyday lives not thrive emotionally on the love and respect they get from others, things which are purely "symbolic" in a sense, but without which purely material goods seem pale and unsatisfying? To connect the observation with a behavioral outcome that even the most blockheaded materialist would recognize, ask yourself what proportion of suicides worldwide happen because of a lack (or perceived lack) of these "symbolic" goods and what proportion because of a lack of material goods?

    1. Bmoodie,

      I assume your comments are directed at me. There is certainly a sense in which lumps of rare metal have an “intrinsic” value not shared by fiat money: if civilisation breaks down, rare metals would be accepted as money, whereas fiat money might well not. But that’s not to deny your point that “socially shared understandings” have a “concrete” effect. I realised long ago that fiat money is a “social construct” (to use the popular phrase). It’s really Austrians, rather than me, who claim that fiat currencies are useless or dodgy – that was the point I tried to make above.

      Next, you claim there have been plenty of “currencies with little or no direct consumption value which have existed apart from or even despite the action of states”. That point is in dispute isn’t it? I thought G.F.Knapp in his book “The State Theory of Money” claimed that throughout history money has nearly always been a creation of the state.

      But if you can cite some works which disagree with Knapp, I’d be interested. Possibly you could argue that tally sticks are a form in inherently worthless money which arose independent of states.

    2. Can you provide any evidence for the premise that gold and other "precious" metals would retain value in a post-collapse scenario? One certainly can't subsist on gold and the spot price could vary dramatically in the face of other more necessary commodities. Isn't the precious metals hoarding idea simply another culturally based assumption reliant on folk tales of prior economic or currency collapses?
      Certainly the history of currencies described in the bible of Chicago includes a number of currencies that operated independent of state power including private bank notes, company scrips and tokens, and other symbolic units down to cigarettes in prison.

    3. Dear Ralph and bmoodie,

      you have, in my opinion, started a really interesting discussion. I would like to share my humble opinion thereon. However, before getting down to it I may express that you, bmoodie, could have put your argument in a more respectful manner. After all, no matter where we come from, being treated with dignity is a baseline of human interaction. It is an emotional need.

      Turning now to the philosophical debate of fiat money, I believe that it is largely a matter of how far you push the debate on intrinsic value. It becomes also quite philosophical. Some people call paper bills fiat money and would not consider gold to be the same. Strictly I disagree. I believe this conclusion is often made as gold has a world-wide exchangeability. It is, namely, in the end only supply and demand that gives value to whatever medium. There's stable demand for gold due to it's historical character of world currency. One cannot claim the same of a paper currency that suffers hyper-inflation. But the construct that gives value to paper bills and gold is the same, demand from people because they know it's sufficiently interchangeable and acts as a storage of value.
      Intrinsic value of something is hard to define explicitly. Has food an intrinsic value? What if nobody wants to eat? Would it then still have intrinsic value? I would say that one first needs to postulate an axiom such as say, humans want to survive/ live. Therefore, those things in life that directly (without exchange) support this will can be called having an intrinsic value. Thereby we can also establish that food has an intrinsic value. Similarly land (only if there exists property law!) and water. Nevertheless, the term intrinsic value is highly subjective. If paper bills give you a sense of emotional security. Does it then have an intrinsic value?

      The value of anything in a society of exchange is clearly defined by supply and demand. If nobody demands it, i.e. because it is not suitable as value storage or medium of exchange, then it is worthless. This can also happen to gold. It is, in the end, really the people attributing the value. The collective action of the people defines what is established as medium of exchange and what not. This clearly shows the importance of expectations in the work of central banks.

  3. An economic strategy that offers a refreshing alternative to austerity is presented and explained in This web site presents results from a new macroeconomic model. The approach used in modelling is somewhat different to the usual econometric (i.e. statistically based) approach. The basic assumption made is that, contrary to popular belief, it is fruitful to view the uk economy as a dynamic system with inherent characteristics that are sufficiently well behaved that they can be modelled directly by sub- systems of equations. Visitors to the website will be able to judge for themselves to what extent this new approach is successful.
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  4. ''Often there seems to be a view that the austerity/stimulus debate is a distraction from focusing on more important, longer term problems.''

    I think you underestimate that some countries with mixed economies have a tradition of dealing with short term problems with other solutions than stimulus, for example labor policy.

  5. I am always a bit baffled to read about UK "austerity" when in reality the public sector is still running a deficit of about 7.8%, which in turn means that the private sector is being stimulated by the same amount. What's more, the debt the BoE is - rightly - buying is being temporarily monetized.

    In other words, I think what we should be asking is not what damage "austerity" is doing but why a considerable amount of stimulus isn't working nearly as well in the UK as it is in the US, as anyone can see who looks at the charts Krugman periodically publishes in his blog.

    In other words, the debate isn't "austerity versus stimulus", but stimulus that doesn't work versus stimulus that does.

    If we look at the second formulation, we can see some things that could be factors here.

    Brown used stimulus even when the economy was growing strongly. Is it possible that this caused some long-term effects that make stimulus in the UK less effective now?

    The UK financial sectors is bigger as a percentage of GDP that the US financial sector, and this is a Minsky financial debt deflation recession - I think - so maybe having a proportionally larger financial sector leaves you with a worse hang-over. (See also, Ireland, Iceland and Cyprus)

    The UK export industries may still be too focused on producing what the EU buys, even though exports to the non-EU parts of the World are growing much faster than exports to the EU.

    Maybe a combination of oil revenue and finance drove the exchange rate of Sterling back up over $1.50 too fast, so that the strong growth in exports from Jun 2010 to Jan 2012 stalled, and is now flat. If exports resume rising now that Sterling has dropped below $1.50 I think we can say this is part of the reason.

    The UK now has a large temporary work-force. Is it possible that temporary workers find it difficult to get the long term mortgages they need to buy houses, leading to a very slow recovery in construction.

    Oh, and I checked, and my worthless fiat currency still works, at least to the extent of buying Peanut Butter and Cat Food, and really, what else would anyone want?

  6. Demand deficiency is only one of the 'unbalances'. There are several others:
    -bubbles (one been blowing up at the stockmarket at the moment by the rescue brigade, hardly will make them any more credible);
    -low interest especially in relation to risk (misspricing) and aging making saving for a decent old age nearly impossible;
    -a lot of countries have structurally too high deficits;
    -a lot of countries have current account problems (often the same);
    -several currencies important for the worldeconomy are heavily manipulated (and now even more);
    -wagescosts especially in the middle and lower sector in the Western world are simply not competitive by a few miles;
    -overborrowing in nearly all developped countries several sectors have borrowed more than is structurally acceptable for markets. There was most likley clearly some room here but what was done is go on with it until they fell of the cliff;
    -overborrowing in the Western world has created de facto a sort of artificial stimulus that accounted for much of the growth we have seen the last decades (as wallpaperpaper over the structural problems and challenges);
    -rise of the EMs with much lower wages while outsource possibilities have risen enormously.

    Summarised a huge mess especially in the Western world. A lot of these unbalances have to be restored and as this is a competitive world the weakest will have to move forward in a higher gear. UK simply in a sort of middle position for the Western world.

    Worldwide I agree completely that lack of demand is the issue. However from there we bump into the next set of unbalances in particular uncompetitiveness in the Western world. On a worldwide basis this will imho only be structurally solved if the EMs in particular start to pay higher wages and workers there start to spend that. Wages/quality level of say UK workforce is simply heavily out of balance.
    Wagescosts/Quality of workers level in a country as the UK is completely out of balance seen worldwide. Productivity wise it doesnot look that bad but that is mainly caused by huge investments. Which in the future are likely better allocated in EMs than in the UK. So that is likley to happen.

    Fully agree that in times like this debtlevel can be higher. Also pleasantly surprised that that has been confirmed.
    However you miss an important point.
    When you move to high or very high debtlevels (say everything over 90%) which is the discussion here you not only have to look at the present situation.

    You have to consider how markets will look at the debtlevel when it is lateron in the building off phase. Here is imho the real danger. We simply donot know that. But looking at marketbehaviour a big part of the market like building off debt better. Also because they not really trust the governments to do so.
    Bit difficult to judge I agree as markets are having an extreme short term view. Which one might see as: 'confirming that there is no problem', others however as making the danger even more difficult to judge. My idea would be that at first markets react positive (they like stimulus=good news), but if it doesnot work it will soon be reversed.
    Hollande's France is likely a good example. Markets were first rather positive allthough many saw him as a left wing weirdo (not to be exagurated btw). But at the first sign things didnot pick up the smart (usually smart) money went out. Of course he combined with several more than moronic policies 75% taxes are not the way to get Americans and Asian investors in as are heavily interfering with normal business.
    Anyway your occupation will have to come with an answer why it didnot work in France to have even a remote chance to have it adopted other than as General Custer with nothing else left.

    Re the lack of back up system. I would like to partly reverse the compliment. Fully agree there should be a back up system. However what we see is still what has at least the appearance of having a lot of symptoms of huge structural nature hardly structural measures are taken (and we are in year 6 of the crisis now). Still the same amount of red tape. The EU is creating nearly every week more. Lack of R&D; increasing educationlevels (in the UK not at the top end that is really strong internationally) but overall; languageskills (English will remain important but knowing something about other cultures often go via languages and simply the world is changing AngloSaxons will no longer make all the rules of international busines) only with the mouth but hardly any real action.

    Having a Plan C ready (so if it is necessary things have not to be arranged as ad hoc as your Keynesian spending). Lower taxes for business and subsequently heavy cuts. Properly consider who to throw before the buss.

    With the added problem if 'financial enginering' only partly seems to work politicians run away from the possible difficult choices they will have to make.

  8. "You have to consider how markets will look at the debtlevel when it is lateron in the building off phase."

    We have, I believe, all been considering how the markets look at debt levels for at least the past five years, and for countries that have their own sovereign currency, it's been a huge yawn.

    Even when rating agencies downgrade sovereigns, the markets ignore them. The US and UK have both been downgraded and the market reaction was to push yields even lower.

    The same is true of non-sovereign debt. Default rates on mortgage debt and commercial debt are extremely low, and the yields reflect that.

    The thing that is driving this is pretty simple, I believe. Debt markets are not a popularity contest, and investors who buy debt are not buying a country. They don't care how fast your GDP is expanding or what your unemployment rate is. All they care about is risk and return, and as long as yields keep falling, the total return on US Treasuries and Gilts is high - much higher that the raw yield. As for risk, a country with its own sovereign fiat currency cannot be forced into default, so the only risk you are left with is exchange rate risk, and you can hedge that.

    I've been reading Jeremiahs threatening us with debt market melt-downs for literally half a decade, and I keep wondering if and when they will finally admit that they have been wrong.

    1. I believe that this post reflects a serious misunderstanding of what "austerity" and "stimulus" mean. Republicans in the US make the same error when they say, "Look! We have had budget deficits of $4 trillion over the last four years! Isn't that enough stimulus? Clearly, Keynesism is a failure!"

      The problem is that running a deficit isn't "stimulus" if the only increase in spending is increased safety net spending (food stamps, Medicaid/Medicare, unemployment compensation) because that spending is just a replacement for private spending that would take place if more of the population were employed (and better yet, employed at higher wages). Hence, government spending can INCREASE without any stimultive effect because that increased spending is just a bandage on the bleeding economy, not an elixir to speed healing.

      In this situation, "austerity" in turn may be simply cutting off extended unemployment benefits, or reducing Social Security payments. This takes still more money out of the economy (since those poor folks would have spent it had they had it) and thereby may have a contractionary effect by reducing revenues further (since they don't buy peanut butter but share the catfood with Muffy) and actually INCREASE the deficity rather than reducing it. Instead, true "stimulus" would be to undertake projects with real long-term value (infrastructure, etc.) and in the short term putting more "spendable/taxable" money into the economy.


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