Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 24 June 2013

The intellectual bankruptcy of the austerians

It is both amusing and tragic to watch the advocates of fiscal austerity try and deal with the fact that the thin intellectual foundations for their approach have crumbled away, while at the same time the empirical evidence of their folly accumulates. I say thin not for dramatic effect: the economic textbooks tell us that this policy was foolish in the first place, so the austerians were always arguing something like ‘forget the accumulated wisdom of the past century, on the basis of two or three papers we know better’.[1]

So we have the latest annual report from the Bank of International Settlements, which is telling central banks to stop all this unconventional monetary policy stuff and get back to the serious business of eliminating... no sorry, ‘controlling’ inflation. Ryan Avent has an excellent commentary on the same report from last year, most of which could equally apply to this year's edition. Here I just look in detail at one of the report’s six chapters on fiscal consolidation. (As Mervyn King once said, central bankers’ obsession is fiscal policy rather than inflation.) In a section on the costs and benefits, after a first paragraph outlining the case against, we have this:

“There are reasons to be sceptical about all these arguments. First, even if the short-term adverse effects of fiscal policy on output (or fiscal multipliers) are somewhat greater than in the pre-crisis period, there is considerable uncertainty about their magnitude and no compelling evidence that they are large enough to render fiscal consolidation more difficult (or actually self-defeating).”

Just look at the language here: ‘sceptical’, ‘somewhat greater’, ‘considerable uncertainty’, ‘no compelling evidence’. You could write a paragraph like this about virtually any economic idea. Notice also the target and how it changes: it starts off in the wrong place, by implicitly assuming that if multipliers were smaller the policy would be costless, and then at the end the target is the much stronger position that fiscal consolidation is self-defeating.

It gets worse. In the next paragraph we have:

“Second, other factors almost surely contributed to unexpectedly weak growth. Especially in the euro area, investors’ worries about fiscal sustainability and liquidity drove up sovereign bond yields, putting a strain on bank and sovereign balance sheets and leading to more restrictive credit conditions.”

The first sentence is a non-sequitur. And then we get the euro periphery countries, but no mention of how this crisis was brought to an end not by fiscal consolidation but by the actions of the ECB. You would think the BIS would want to give credit to a successful central bank policy! Next paragraph:

“Third, larger multipliers do not necessarily undermine the case for an early or relatively fast adjustment. The argument for back-loading or slowing the pace of fiscal consolidation relies on the expectation that fiscal multipliers will decrease in the future or that economic growth will rebound significantly. However, if these expectations do not materialise, shifting the bulk of fiscal consolidation to the future would mean greater debt and higher debt servicing costs, making future adjustment even more costly and prolonged.”

Notice the language again: “do not necessarily”. The only way to make sense of this paragraph is that we are going to be stuck at the zero lower bound forever.

In the next paragraph we get that old chestnut, credibility:

“The case for back-loading fiscal adjustment also relies on the credibility of fiscal plans. Current governments will have to make commitments on behalf of future ones.”

This is just wrong, unless you are only thinking about the Eurozone periphery again. For ‘backloading’ fiscal consolidation to work, current governments do not have to commit to anything. You just need to believe that future governments, once the recovery is assured, will focus on stabilising and then reducing debt, rather than allowing debt to explode. As they invariably do. [2]

Don’t worry, its coming to an end:

“Finally, the impact of fiscal consolidation on growth extends beyond the short run. By restoring sound financial conditions, eliminating the risks associated with high debt and reducing the resources needed to service the debt, consolidation will lead to higher sustainable economic growth. As a result, its long-term benefits will more than offset its short-term costs.”

This is more like a recitation of an article of faith than an argument. It first says reducing government debt is good for long term growth. Let’s accept that: the main arguments against austerity have never involved suggesting that long term high government debt is good for you. It’s all about when is the best time to stabilise and reduce government debt. It is the final sentence that just does not follow. Because there are long run benefits to reducing government debt, it must be the case that the sooner we start the better? No. Exercise is good for you, but you don’t start when you are down with the flu.

This kind of thing is amusing sport for academics who are trying to put off getting down to serious work on a Monday morning. But of course it is tragic because the austerians, even though they have been soundly defeated on the battlefield of ideas and evidence, continue to call the shots on policy nearly everywhere. What to do about this tragedy? Just keep plugging away at the arguments I guess, although a bit of ridicule also helps convey the poverty of the austerian argument. But it is also up to others with more effective voices to point out that this emperor has no clothes. 

[1] There may also be an element of Keynes famous academic scribbler in this too. (“Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”) There was a period - in the 1980s - when those economists studying at masters/PhD level might have been taught that the undergraduate textbooks were wrong, and that Keynesian economics was doomed. That proved to be a temporary aberration, Keynesian economics rejuvenated itself and in most departments it was restored to its rightful place at the centre of macroeconomic wisdom. But perhaps some of those now running policy did their PhDs during the 1980s, and never kept up with what happened subsequently.

[2] This is where obsession comes in. Occasionally a government fails to prevent debt exploding, and forces the monetary authority to monetise the debt, leading to hyperinflation. This is the central bankers’ nightmare. If you want to avoid this remote possibility at all costs, then you might be willing to sacrifice anything to do so, including the health of the real economy.  


  1. Maybe I am too influenced by reading Galbraith's The Great Crash but I struggle to see how the austerity approach is going to help. My only hope is that it only slows rather than stops any recovery over the next 2 or 3 years.

    I am not a "defecit denier" but I do like your sporting analogy of when you start to exercise.

    One thing that does interest me is when will the academic books to support the austerity/non-Krugman view be written?

  2. You were quite right not to blame the last labour government for profligacy. But neither should you blame the current government for austerity. They are, after all, only doing what their economic advisers tell them. Those advisers read the same books you do, but being close to the raw data, they sense something is wrong and fiscal stimulus is not going to work, even though they cannot explain why. They were so shaken by the lack of response to the initial stimulus they have simply lost confidence in the textbook approach. Right now they are busy with their DSGE models, trying to figure out why these were giving such unreliable and optimistic forecasts. So, who should we blame?

    "We like clear principles and sound thinking derived from them". No, you don't. And that is the real problem we have faced this last decade. Personally, I blame academic economists for our current mess. We should have been warned years ago that globalization might cause deep structural problems for the developed economies. Instead, academics were so intent on knocking down the arguments of protectionists that they forgot their own.

    It is clear that productive capital is now internationally mobile; it is also clear that the developing countries now have sufficient infrastructure to match the developed world in productive efficiency. So what does theory say will happen? That is unequivocal; productive capital will transfer to where capital is scarce and labour is abundant - where rents are high and wages are low, resulting in a permanent capital drain. In a recession, capital formation slows while the capital transfer continues. Not only is there the usual problem of a fiscal stimulus pulling in imports, now we have the added problem of a poor investment response as domestic owners of capital invest abroad to meet local demand. The main impact of a fiscal stimulus is then to pull in imports and add to national debt. The vital investment response is missing. In the recovery phase, the capital drain progressively erodes the output gap making further stimulus even less attractive. In this context, a fall in labour productivity is unremarkable - with less capital to work with labour is less productive. Consequently, real wages fall in line with a declining marginal product of labour - further protracting any recovery.

    My point is, professor, that the vast majority of academic economists reject out of hand an argument that is backed by their own "clear principles and sound thinking". It is backed by mathematical models of trade and even more strongly by computer simulations. It explains all of the current "mysteries" and "puzzles". Practically everyone in the street understands it as they watch well paid jobs exported abroad.

    No, professor, academic economists dislike clear principles and sound thinking. They prefer obfuscation and sophistry (SBTC anyone?).

    All the emperors of economics have no clothes and are in dire need of simple attire - even if it is made in China.

  3. "You were quite right not to blame the last labour government for profligacy. But neither should you blame the current government for austerity. They are, after all, only doing what their economic advisers tell them."

    Nonsense. Many of those economic advisors Osborne found to justify his dogmatic approach have seen renounced their earlier views. Result on policy? Zero.

    Blaming academic economists misses the target entirely. Economic policy in both the UK and the US is primarily ideological, and economists are picked out to provide backing for things people want to do.

    1. Thanks for your response - but on blaming academic economists I totally disagree. I think I am right on target. They have argued for decades that free trade and globalization are beneficial; that this is not the source of our economic difficulties, be it wage stagnation, slow growth or growing inequality. The point I make - and it seems to me a very good point - is that in the current environment this stated position is in flat contradiction to their own economic theory. Remember the stuff about capital seeking its best returns, labour being paid its marginal product, factor mobility equalizing factor prices? In our "global village" productive capital is internationally mobile and that is bound to cause structural problems for a capital rich country like the UK.

      My own interests are in theory and argument - not in ideology or defending an entrenched position. I am not in any way an economic radical. I essentially believe in standard microeconomic theory as taught in most universities. That is why I find it so baffling that academics choose to ignore an argument, based on sound economic principles, that explains so well our past and current dismal economic environment. I do worry that they are defending entrenched positions when even they cannot find a viable alternative explanation.

      Of course, I do not expect to be believed when a trade heavyweight like Paul Krugman asserts a week ago that "globalization is not an issue". But I am truly grateful to Simon, Paul and others who provide a forum where a small voice can, at least, be heard.

  4. Let's have a look at the 3 major stimulus nations.

    1.US. Worked sort off. Mainly caused by being politically undecisive, as such that doesnot matter that much. However allocation is a mess, mainly because the political decisions on what exactly to do cannot be made. So likely with a proper allocation things would have been slightly better.

    Disadvantage: a lot of 'stimulus' is in long term programms that are difficult to reverse politically.

    US runs an acceptable risk with the extra spending. Until now at least if deficits would continue all bets are off. Markets look very short term at the moment only woken up by the fact that QE would sometimes come to an end (while all people that looked deeper into it predicted more or less these policies when QE3 started). Debt level looks seen the reserve currency status looks acceptable. However seen that reserve currency status not a thing that can easily be copied elsewhere. US is simply different from the rest.

    2. Japan. Plain disaster. Never got the economy running again even with 10% deficits (while the government is smaller already than in Europe.
    Abebomics will fail. If the economy starts to work interest will be say 4% (2% inflation and 2% premium, assuming riskfree (which is clearly not certain). Simply requires 10-12% GDP interest payments no country has ever been able to survive that longer term (not even close). If it doesnot work stimulus will further increase debtlevel so the country will somewhere drive into the wall the other way.
    Not a really unwise decision however imho. As the country is bust anyway (in whatever form that will be), inflation is likley the least painful way and Abenomics is much closer to full throttle printing and in the meantime some feeling with the market can be gained.
    But hardly something to copy if your sentence is not yet clear (debtlevel lower). Imho better a lost decade than a huge economic and financial crisis.
    Seems hard to pump up inflation and keep interest low. BoJ missed that it is not only about new issues, it is also present bondholders not selling (which is much more difficult to control).
    Summary stimulus didnot work and is effectively to blame for the high debtlevel and the future bust.

    3. China. Looked like the ideal country for stimulus (not much deleveraging to do). Did a huge stimulus but again it didnot really work well. As China is now in trouble because of that.
    Lesson imho that stimulus in the worldwide village when the rest is not doing it or overall only marginally is not really working.
    Its banking sector was not helpful it has less grip (but more power) on it than say the Westerm world.
    Looks as well that as the money was pretty inefficiently spent that the duration and hight of the multiplier effect was lower than could have been. But efficient stimulus is very difficult basicaly it are always mainly ad hoc investments or spending (the latter mainly social to keep the population quiet).
    Basically stimulus not really successful and got things running again (as the worldeconomy sucks) and at the end brought the country also in difficulties.

    Simply stimulus is also not a great alternative from the current proof.
    Question being what now?

    1. There was a stimulus in China? Why? China just didn't have a recession, full stop. The Keynesian recipe for China is that there's a bubble, and China should be looking into deflationary policy before there's a bust. No one prescribes stimulus for China.

    2. China did a huge stimulus. There were huge incentives for domestic consumer spending. The government basically paid consumers to buy domestic consumer items (TVs, etc) to suck up excess production; which they couldn't export.

      Instead of slowing down production (causing unemployment), they paid people to buy it.

    3. A subsidy is a different thing from a stimulus.

    4. Keep up with the news and then come back.

    5. Speaking of the US, Rik writes: "Disadvantage: a lot of 'stimulus' is in long term programms that are difficult to reverse politically."

      This is as wrong as wrong ever gets. Have you ever actually looked at the US stimulus program?

      More than one-third of the roughly $800 billion package consisted of temporary tax cuts which are, by their nature, easy to reverse. And all have now been reversed, in most cases by the legislative expedient of doing nothing.

      The rest of the package consisted of a grab-bag of public works expenditures and other ad hoc spending measures, none of which involved the creation of 'long-term programs'.

      This is not a defense of US performance - a better stimulus would have focused more on infrastructure investment, and far less on tax reductions - but your criticism has nothing to do with reality.

  5. If they want government debt, private debt and money creation all to be reduced, they have to say which sector's savings they also want to be reduced, unless they ignore simple arithmetics.

    Every piece of debt is someone's savings. Every time debt is paid off it has to be paid with someone's money.

    On an aggregate global economic scale, it can not work to pay off all debt at the same time without printing tons of money or sharply reducing people's savings.

    If we try to push towards that kind of austerity, we get economic gridlock, disinflation, liquidity traps, widespread market distortions, unemployment, lost production and lost wealth. You cannot break the laws of arithmetics. They can wish all they want, 2 + 2 will never be equal to 5.

  6. Seen especially japan and China stimulus is also hardly the silver bullet. It simply seems not really to work in an enviroment that is deleveraging (slow growth). And with both of the above stimulus brought them in the danger zone (while it didnot do its presumed job).
    Question what now?

  7. I’m not an economist but will say that austerity as I understand it means the reduction of public spending as dictated by those that won’t be too adversely affected by it.

    We have lived through a few years already of minor austerity measures in the UK which seems to not have had the effect it was designed to do, namely any real reduction in government spending or borrowing.

    QE seems to only have had the result of propping up banks and property asset valuations and when considered along with ultra-low interest rates, has or will lead at some stage to another banking crisis.

    In London and the South East an enormous property bubble is currently underway mostly if not entirely driven by foreign investment entirely based on the single fact that this market is a good place to put your wealth (a vicious circle).

    Austerity to me then cannot ever provide an answer to the above, what’s needed is a re-evaluation of assets which will (interest rate rises) have a detrimental effect on the entire banking system (this is where it all started in the first place) so we need to solve the problem (banks) and not treat the effects.

    QE and austerity measures to me then are the same thing, for each pound you throw at Banks = higher public spending when translated through the system.

    I think we need to let some financial institutions go, allow the market to operate in their normal way (bankruptcies) and allow the value of money once again to have “real value”.

  8. The hyperlink to the Economist corresponds indeed to an excellent discussion of the BIS Annual Report by Ryan Avent. I´m afraid, however, that it is not the comment on the latest of these regular reports but on last year´s report, published in June 2012, one year ago. Key messages have not changed that much, so no wonder the confussion. An interesting exercise would be to run the "what if" counterfactual scenario; e.g. what if the "sermon from Basel" would have been heeded then by central banks and other policy makers. History repeat itself!!!

    1. It was an oversight, and I've changed the text to make things clear. Thanks.

  9. I see that Skidelsky on his blog at Project Syndicate (Jun. 3, 2013 'Unrepentant Economists') laments the mildness expressed in the letter of repost to the 20 economists, Rogoff et al, who backed the Tory 2010 expansionary austerity.

    Indeed, last year's 'A Manifesto for Economic Sense' had more A4 pages of economists than the Coalition could muster in individuals.

  10. “Third, larger multipliers do not necessarily undermine the case for an early or relatively fast adjustment. The argument for back-loading or slowing the pace of fiscal consolidation relies on the expectation that fiscal multipliers will decrease in the future or that economic growth will rebound significantly. However, if these expectations do not materialise, shifting the bulk of fiscal consolidation to the future would mean greater debt and higher debt servicing costs, making future adjustment even more costly and prolonged.”

    If the expectation of economic growth rebounding isn't met!? Is there some other alternative to permanent high unemployment? If so, what is it? Do you care?

    1. anonymous...
      I disagree with the austerians. Yet I want interest rates to rise for a different reason.

      As I see it, wages need to rise. Labor share is too low and constraining demand. But capital is cheap with low interest rates. Thus if you raise the cost of labor in the face of cheap capital, you put labor at a further disadvantage. Thus, if you raise wages, you really need to raise interest rates too.
      but there is a deeper reason to raise interest rates. Social efficiency in the economy has fallen due to low interest rates, low wages and other factors. Social costs are growing and weighing upon economic growth. The falling social efficiency of our economies must be reversed, or there is no hope.
      The solution really is to raise wages and interest rates together.
      Link to an explanation...

  11. “The case for back-loading fiscal adjustment also relies on the credibility of fiscal plans. Current governments will have to make commitments on behalf of future ones.”

    --Does credibility even matter here? My understanding of the New Keynesian liquidity trap model is that at the ZLB, spending now is expansionary regardless of whether the government can credibly commit to future responsibility.

  12. Nice Post, Great information is given about the intellectual bankruptcy. New rules and terms are discussed here very briefly. i will read this article once again , Thankss.


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