Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 17 May 2016

A General Theory of Austerity

“If we cannot puncture some of the mythology around austerity … then we are doomed to keep on making more and more mistakes”

Barack Obama, New York Times, April 2016

I have just completed a working paper based on my talk to the Royal Irish Academy at the end of last year. (Yes, I know, that was six months ago - it’s all the media training I have to do :-)) It has the title of this post: in part an allusion to Keynes who had been here before, but also because its scope is ambitious. The first part of the paper tries to explain why austerity is nearly always unnecessary, and the second part tries to understand why the austerity mistake happened.

I start by making a distinction which helps a great deal. It is between fiscal consolidation, which is a policy decision, and austerity, which is an outcome where that fiscal consolidation leads to an increase in aggregate unemployment. If you understand why monetary policy can normally stop fiscal consolidation leading to austerity, but cannot when interest rates are stuck near zero, then you are a long way to understanding why austerity was a mistake. Fiscal consolidation in 2010 was around 3 years too early. A section of the paper is devoted to showing that the idea that markets prevented such a delay in consolidation is a complete myth.

I say that austerity is nearly always unnecessary because (given the title) I also cover the case of an individual monetary union member that has an unusually (relative to the rest of the union) large government debt problem. Here some austerity is required, but not for the reason you might think. It has nothing to do with markets: the Eurozone crisis from 2010 to 2012 was a result of mistakes by the ECB. If a union member’s government debt is not sustainable, there needs to be some form of default (Greece). If it is sustainable, then the central bank should back that government, as the ECB ended up doing with OMT in 2012. The reason some austerity is necessary is that to support financing this unusually high debt, the union member needs a real depreciation, and in a monetary union that has to occur via lower wages and prices relative to other union members.

None of this theory is at all new: hence the allusion to Keynes in the title. That makes the question of why policy makers made the mistake all the more pertinent. One set of arguments point to an unfortunate conjunction of events: austerity as an accident if you like. Basically Greece happened at a time when German orthodoxy was dominant. I argue that this explanation cannot play more than a minor role: mainly because it does not explain what happened in the US and UK, but also because it requires us to believe that macroeconomics in Germany is very special and that it had the power to completely dominate policy makers not only in Germany but the rest of the Eurozone.

The set of arguments that I think have more force, and which make up the general theory of the title, reflect political opportunism on the political right which is dominated by a ‘small state’ ideology. It is opportunism because it chose to ignore the (long understood) macroeconomics, and instead appeal to arguments based on equating governments to households, at a time when many households were in the process of reducing debt or saving more. But this explanation raises another question in turn: how was the economics known since Keynes lost to simplistic household analogies.

This question can be put another way. Why was this opportunism so evident in this recession, but not in earlier economic downturns? There are a number of reasons for this, which I also discuss here, but one that I think is important in Europe is the spread of central bank independence, coupled with a phobia that European central bank governors have about fiscal dominance. In the UK, for example, the Bank of England played a key role in 2010 in convincing policymakers and the media that we needed immediate and aggressive fiscal consolidation. Keynesian demand management has been entrusted to institutions whose leaders (but not those who work for them) threw away the manual. But as Ben Bernanke showed, it does not have to be this way. [1]

If my analysis is right, it means that we cannot be complacent that when the next liquidity trap recession hits the austerity mistake will not be made again. Indeed it may be even more likely to happen, as austerity has in many cases been successful in reducing the size of the state. My paper does not explore how to avoid future austerity, but it hopefully lays the groundwork for that discussion.

[1] Here is Bernanke is October 2010 saying “indeed, premature fiscal tightening could put the recovery at risk”, although no doubt he could have said it louder.


  1. Have not fully read article, much less paper, yet but the bsg website is ringing a lot of alarm bells on my system due to 'improper security certificate'. Feel free not to post this comment if you think it is too irrelevant, but I thought I should mention it.

  2. Only had time to skim, but looks like a very useful summary of the situation.
    As a sometimes argumentative commenter, I should take the opportunity to say how important all the hard work you have been putting in on these vital issues is, and that it is much appreciated.

  3. Isn't it Karl Whelan, not Carl Whelan (thanked in your paper)?

    1. Indeed it is - no idea how that happened. Hopefully he will not read that bit!

  4. A useful addition to the forthcoming best-seller ("General Theory of Austerity...")would be to mention the sheer scale of incompetence among some senior members of the economics profession. By way of illustration, Dean Baker suggests (rightly in my view) that Donald Trump, of all people, is more clued up about economics than Harvard professors of economics:

  5. In context of financial markets and the demand for safe assets rising in a downturn as people save more, I think it’s worth noting that UK pension funds are desperate to “de-risk”, move out of volatile equities and into boring, income producing assets like gilts. Low yields are increasing pension deficits (by virtue of a low discount rate) and encouraging schemes into equities or high-yield bonds etc. There was NEVER any likelihood of a gilt-strike. Hundreds of UK pension funds have committed to future gilt purchases once / if yields rise beyond certain triggers. Lack of government debt is the problem here, not too much of it. Government debt = private sector asset.

    Furthermore, this is just a hunch, but surely high pension deficits and uncertainty about future pension deficits is a deterrent to corporate investment. In fact this isn’t a hunch, but the extent to which it is a material problem in today’s landscape is worth exploring. My hunch is that it IS a material factor. Lack of investment is an important part of the productivity problem, the growth problem and the sectoral imbalances problem.

    1. Shortest Keynes: "When everybody stops spending, everybody stops earning."

      Austerity is the economic theory and practice striving to prove that:

      0 (private spending)+0 (government spending) = 2.

  6. I think, having lived through 2008-2013 as a close observer but not decision-maker, that the points you make are important but in different measure.

    The central bank independence issue is indeed significant because, as you now say, the respected Governors all (except Bernanke very quietly and rather late) pronounced that the cure for all ills - inflation, deflation, excess capacity, inadequate capacity - was always and in all circumstances austerity in government finance (if you think I exaggerate, please indicate any occasions when one of these gentlemen actually advocated increased government expenditure or deficits).

    But even more relevant to the Greek case in particular, and also the Irish one, was the refusal to allow the banks or government to default on their debt. This went directly counter to the founding principles of EMU, when "No Bailouts" was an absolute commitment insisted on by Germany. Yet when it came to the crunch, Germany was the most insistent on "No Default". As I and others have pointed out many times, local institutions within a monetary union (e.g. cities in the US or UK) have on occasion approached or even crossed the line into default, and financial institutions on many occasions. I can remember discussing with senior colleagues in 2009 that the clear solution to the Greek crisis was an orderly and structured default on the government and bank debt coupled with a managed financial support to keep the essential and viable parts of the economy going. This was not palatable to Greece but more importantly not acceptable to the principal creditor countries. What we ended up with was total protection for the creditors and new loans, initially way above normal market rates, for the debtors which - as was widely foreseen at the time - simply compounded the problem.

    There are other, and fundamental, problems with the Greek government system that mean that the solution was never going to be easy but it is clear, and not only in hindsight, that enforced austerity was not going to make things better for anyone.

  7. Not bad, but you never answer your own question: what made these policy mistakes possible in the first place (i.e. why the "deficit deceit" strategy)? Krugman figured it out, but then again, so would any students in Intro to PoliSci or Intro to Sociology: CLASS. You might want to reference a good starter book: G. William Domhoff, Who Rules America? (there should be a recent revision & reissue).

    1. I do answer my own question, so perhaps you would like to show why class is a better explanation or adds something to my analysis.

    2. Some more humility would be useful, Simon.

      You don't answer your own question, except waving your hands about "deficit deceit" (a nice turn of phrase is a poor substitute for causal relations) "right-wing opportunism" (pretty vague--are you talking ideology or interests, for example--but whose, with what institutional and other sources of political leverage)?

      Domhoff does a pretty good job; repeating him here makes little sense. Here is something for starters:

      But you, like Krugman, just cannot seem to conceptualize "structure." So you end up throwing around "deficit deceit," but that only begs the question of where that comes from, and why it matters. In other words, you kick the can further down the road. It's a major failing of economists.

      Mind you, this is a really quick & dirty reply. It would take more more time and energy than I happen to have at the moment for something more complete--but less than 10 blog posts wouldn't do this justice. Maybe tomorrow I can put together something will more substance. But then again, Domhoff can pull his own weight without my help. (I don't entirely agree with him, but I find much of his argument plausible.)

    3. I don't see how the Domhoff reference helps me in any way. I take the small state (noliberal if you like) ideology as given - why shouldn't I. The question is why did this manage to do through austerity what it had failed to do without. Was it luck (Greece) or something else? Why did it happen in this recession but not before.

      These are all important questions, it seems to me, and I still do not understand what you think my answers are missing.

  8. About the small state ideology. The last budget contained tax rises. There is a conflict here between Osborne's desire to cut expenditures as a share of GDP and his desire to get a surplus by the end of the parliament (by accounting trickery). As the IFS showed when they worked out the effects on the income distribution in this parliament and the last of his budgets, Osborne's and the Tories' agenda doesn't appear to be shrinking the size of the state as such. Instead, it's to make the tax system more regressive and the benefits system more miserly.

    As for complacency and the next recession I can't for the life of me see why anti-austerity economics blogs like yours are not going wild right now (though Ann Pettifor has). Both the IMF and OECD are now calling for "urgent collective policy action" (fiscal stimulus to be spent on investment) to avoid a "synchronised downturn". And according to Larry Summers there is a 50-50 chance of a new US recession in the next 2-3 yrs judging by past recoveries. Which would require a 400 basis point cut in interest rates, on average, which cannot currently be done. Therefore, fiscal stimulus has to be advocated for and prepared for NOW.

    Dunno if I can post a link but there's an article on it at Prime Economics.

    1. The case for public investment is very strong whatever you think will happen to the economy. You will find chapter and verse on that, in as wild a way as I can manage, in previous posts.

    2. I've been reading your blog for some time which is why I call it an anti-austerity blog. I think the IMF and OECD bolster your case even if their warnings turn out to be wrong because it takes your point about avoiding the austerity mistake during the next ZLB recession further. (Another is that if it happens before the recovery is incomplete for so many people the political consequences will be more severe; Scottish independence, Brexit, Trump, etc, which surely would disrupt efforts to get politicians to pass a stimulus fast enough.)

      "it may be even more likely to happen, as austerity has in many cases been successful in reducing the size of the state" -- yes, but in Britain at least polls show the public is sick of austerity (maybe just because growth is back for long enough to make it seem unnecessary to those who believed in it). If the public investment case won people over today, as a means of hastening the recovery, then it *would* be a way of avoiding the future mistake. Since it's a smaller step to do a stimulus in the next recession if you already were doing one to complete the recovery, than to continue to accept austerity and then do a U-turn during the next crash.

  9. I have a problem with wording of only one sentence, only the wording used, not with the meaning of that sentence;"the union member needs a real depreciation, and in a monetary union that has to occur via lower wages and prices relative to other union members."

    Since fall in wage doesn't include the fall in indebtness or monthly payment burden, this lowering of wages will increase defaults and it will start deleveraging process which turns an economy into depression.

    Proper wording should be " increase of wages of other EZ memebers so that devaluation of that member's wages happens without causing a deppression"

    The private debt burden should not be forgoten when disccusing a policy recomendation. But since mainstream economics is forbiden from discusing money, debt and banks, mainstreamers easily forget about private debt.

  10. "If you understand why monetary policy can normally stop fiscal consolidation leading to austerity, but cannot when interest rates are stuck near zero..."

    Is it not the case though that, for some level of fiscal consolidation, if it is expected to be permanent rather than temporary, any attempt to neutralise it through monetary policy will inevitably drive interest rates onto the zero lower bound anyway? (How else can the long-term government budget constraint still be met, other than a period of higher real interest rates?)

  11. " The reason some austerity is necessary is that to support financing this unusually high debt, the union member needs a real depreciation, and in a monetary union that has to occur via lower wages and prices relative to other union members."

    Curious economics student- sure there is a reason but I'm not sure where the improvements in the government debt situation occur. Is this because long term growth of exports due to lower wages leads to a greater increase in long-run growth, even with the austerity policy in place hindering growth, if so how do we know this, could lower wages not just lead to a deterioration of government debt situation due to reduced tax receipts etc? Also would the fact that it is in a monetary union reduce the positive effects of austerity due to a smaller effect on exchange rates than would otherwise occur due to what is occurring in other economies? Or am I not even close to thinking along the right lines?

  12. Professor-

    It seems to that many of the observations in your paper are based on static analysis that ignores the monetary offset. Here are a couple of examples:

    Your paper mentions that fiscal consolidation increased unemployment thats higher compared to what might have been otherwise. Doesnt this assume that monetary policy would have remained constant? If fiscal consolidation did not ensue couldnt monetary policy have tighten in response? I'm saying that the FED would have raised rates but perhaps less forward guidance and other unconventional polices?

    Also in your calculation of the counterfactual which assumes government consumption/investment in the U.S/UK/EURO had grown at trend rates from 2010 you calculate that GDP would have been over 4% in the U.S in 2013. This ignores the response of monetary policy. The last time the U.S even came close to 4% was back in the late 60's.

    thank you for your response in advance.

    1. The argument against austerity depends in large part on monetary offset, but it also assumes monetary policy is constrained at the ZLB. That means that monetary policy cannot offset fiscal contraction at the ZLB, but equally that it will not try to offset its absence.

    2. How strong is this assumption? it seems to me that monetary policy can offset fiscal contraction even at the ZLB if officials are willing to do so via forward guidance, more QE, NGDP targeting. Unlike Sumner, I see risks in these unconventional tools but it does challenge the assumption that monetary policy wont offset an ease of fiscal consolidation.


  13. This is a useful post to be sure. Just curious how you explain why "liberal" economists like Ken Rogoff got on the fiscal consolidation bandwagon? And what's wrong with Kalecki's explanation--the ruling elites do not want to ever admit that fiscal policy can be effective as it robs them of a source of power. (Maybe the paper gets into this more.)

    1. On your first question, I do not know the answer. On the second, I think Kalecki's argument was about any attempt to restore full employment. But there has been no attempt (except among a few monetarist nutters) to argue against monetary activism. Which would suggest something else going on.

    2. Kalecki's analysis (political aspects of full employment) is here:

      It is a good read. I would recommend reading it all - it applies even with the mainstream definition of full employment (5% permanent unemployment), though better shows why an MMT version (every who wants a job gets one) would be strongly opposed.

      Key quote:

      "We shall deal first with the reluctance of the 'captains of industry' to accept government intervention in the matter of employment. Every widening of state activity is looked upon by business with suspicion, but the creation of employment by government spending has a special aspect which makes the opposition particularly intense. Under a laissez-faire system the level of employment depends to a great extent on the so-called state of confidence. If this deteriorates, private investment declines, which results in a fall of output and employment (both directly and through the secondary effect of the fall in incomes upon consumption and investment). This gives the capitalists a powerful indirect control over government policy: everything which may shake the state of confidence must be carefully avoided because it would cause an economic crisis. But once the government learns the trick of increasing employment by its own purchases, this powerful controlling device loses its effectiveness. Hence budget deficits necessary to carry out government intervention must be regarded as perilous. The social function of the doctrine of 'sound finance' is to make the level of employment dependent on the state of confidence."

    3. Kalecki's analysis is also one of the main reason I support the MMT Job Guarantee. Quote from N. Wilson's blog:

      "Because they are working, the number of people on a JG becomes less of a social issue - no more 'bring down unemployment', no more 'shirkers'. Therefore normal businesses can be allowed to go bust, not pay redundancy, etc because the JG will catch people who lose their jobs during a retrenchment. That disciplines the spending and wage channels since there need be no bailouts or the 'special industries' that pump-priming requires. Overpaid workers get an imposed wage cut when they are forced to move to the JG as do greedy bosses. 'Corporate confidence' is no longer of overriding concern."

      We can see the effects of special industries in for example the steel crisis.

  14. .
    Interesting column, two thoughts:

    1) The drive to austerity may have been driven by political parties that have found electoral success by campaigning against deficits.

    Once empowered by this strategy, it became an unquestionable dogma to be applied in all cases.

    Thus, the only true antidote is for opposing parties to have the fortitude to vigorously and undiplomatically question this assumption.

    2) Regarding an insolvent member of a monetary union: there may be an alternative to classic default or debt forgiveness.

    A corporation, when it does well, can declare a dividend. A Central Bank, merely a special case of incorporation, does well when inflation is low. Thus, in a low growth low inflation economy, the Central Bank can reward each member of the union with a dividend.

    For example, the Central Bank Dividend yield would open a special account at the bank for each member of the Union and deposit a sum equal to 1000 euros per citizen of the member country. The money would be constrained to debt payments.

    This simple fair noninflationary mechanism could be employed to reduce debt throughout the monetary union.

    It would give the most indebted members of the Union the respite they need for internal improvements.

    It would be acceptable to governmental leaders loath to impose costs upon their own citizens to help other countries.

    As long as inflation remained quiescent, a small Central Bank Dividend could be repeated every few months.


    1. May I add an addendum:

      A dividend is a thing that the recipient feels entitled to and therefore does not suffer guilt upon that receipt.

      A Helicopter Drop, Printed Money and similar "Money from Thin Air" concepts, while defendable, clearly elicit guilt and misgivings among some people.

      Therefore, the psychology is extremely important. Phrase the mechanism as a dividend and it may be far easier to get approvals.

  15. This is what Obama said in July 2010 (I googled a little bit):
    While introducing his new budget director Jacob Lew, President Obama resorted to an old, tired, horrible analogy. Yes, it's the return of the dreaded Tight Belt.

    "Jack is going to be an outstanding OMB director. We know it because he's been one before. At a time when so many families are tightening their belts, he's going to make sure that the government continues to tighten its own."

    I remember vividly how disappointed I was with Obama in 2010 when the Democrats controlled both the Senate and the House of Representatives and when he started to save instead of spending just to try to compromise with the Republicans. This was a horrible mistake and due to the aborted recovery he then lost the House of Representatives in the next election and became a lame duck president.

    Michael from Switzerland

  16. Market Fiscalist18 May 2016 at 02:28

    "If you understand why monetary policy can normally stop fiscal consolidation leading to austerity, but cannot when interest rates are stuck near zero, then you are a long way to understanding why austerity was a mistake".

    Why would interest rate stuck at zero be an issue if the CB followed a policy of inflation targeting, and committed to make up any target misses with equivalent higher inflation in the future ?

    In this case, if zero interest rates ever caused an inflation target to be missed, this would lead future inflation expectations to be raised - which would cause a nominal interest rate of zero to become a negative real interest rate - and allow monetary policy to again stop fiscal consolidation.

    1. You are talking about price level targeting. That would reduce the chances of hitting the ZLB, but not eliminate those chances. The moment you hit the ZLB, you need fiscal policy.

  17. Simon,

    I am just wondering about your characterization of austerity as an outcome. It seems to me that in some European countries, austerity was forced on them as a means of achieving an internal devaluation (make the economy more competitive). It seems to me, that in this case, the outcome is the internal devaluation and austerity is the cause and policy, effected by strong fiscal retrenchment. Also, the people that practiced and promoted austerity came from the "the fiscal economy is like managing the family budget" school. This was to be effected at all costs as a matter of economic principle. In this case, the desired outcome was balanced budgets and debt reduction, the means was hard driven fiscal retrenchment, i.e. austerity. I don't think these are insignificant distinctions. By defining austerity as an outcome, you are whitewashing what went on in Europe.

    And in Europe, the question of monetary offset was resisted by the "family budget" school. It was only a recalcitrant Draghi that managed to enact QE. Is this not correct?

    In section 3 of your paper you conclude that there is no evidence that the markets demanded austerity. The private banks would have been travelling a very fine line - too much austerity and the whole house of cards could have collapsed, too little or the reverse then inflation might have been higher, eating into the value of their debt portfolios (probably explains the adage you mentioned about bond economists liking fiscal contractions).

    In section 4 of your paper, you ponder why German dominance in the EZ is not challenged. Surely that is easy - Germany is the main source of support funds for the indebted.


    1. 1) on outcomes and instruments, I think trying to define austerity as an instrument just leads to muddled thought. I think what you are suggesting is that policymakers in Europe were as subject to the 'economy as a household' fallacy as the population, and that a small state ideology had nothing to do with it. I'm happy to entertain both possibilities (which is why I have discussed knowledge transmission failures elsewhere), but I'm not sure how this debate means I'm whitewashing what happened in Europe.

      2) On German dominance, that is only true if you accept that the central bank should not be a sovereign lender of last resort. So it really just shifts the question back to why the European left seemed unable to apply basic macro ideas.

  18. "The reason some austerity is necessary is that to support financing this unusually high debt, the union member needs a real depreciation, and in a monetary union that has to occur via lower wages and prices relative to other union members". This peculiarity of a currency union means that there also, supposedly, has to be " some form of default (Greece)."

    It would be great if one day someone on the academic left conceded that lower wages in hard Euros isn't worse than "higher" wages in Drachmas, Escudos or Pesetas, and that the ongoing risk of "escape debts by letting rip inflation" raises the cost of capital for both companies and governments. "Internal devaluation" is always so awful, isn't it? There's nothing good to be said for breaking the back once for all of the nonsensical beliefs that ordinary people have about paper money and purchasing power, is there? But then, if running an economy on funny money, and constantly paying over the odds for hard currency borrowing, and constantly facing violent interest rate hikes to try and address the inevitable consequences of these policies, if this was such a great state of affairs why don't the Greeks leave the Euro and why isn't Venezuela a haven of peace and prosperity?

  19. Your paper is excellent, but I think even you underestimate the strength of "instinctive popular concern about rising government debt." Huge majorities of people, pundits and politicians have never questioned the household analogy. Not very many of them have in fact taken first-year economics. Including Barack Obama, whose public record is just full of comments like "families all over America are tightening their belts, so government must do so too." In February 2009, after one month in office, while he pushed through a stimulus package, he felt politically compelled to host a "Fiscal Summit" in which everyone shared their worries about skyrocketing national debt.

    It has always been this way, contrary to your assumption that the recession caused worry about deficits and debt to surface. I took my first-year economics in 1963, and every non-economist I've ever talked to since has been worried about the national debt. No American politician has ever failed to express dismay over deficits and the debt. More is always bad; less is always good.

    This is why I (and you, I believe) favor helicopter money. We will never convince ordinary (educated) people that a rising national debt is not ipso facto a terrible thing, a burden on future generations, and all that. "Common sense" is just too strong (as Keynes himself acknowledged). We need instead to be explaining more and more the idea that it is possible to stimulate (or even fine-tune) an economy with fiscal policy but without increasing the national debt, using newly-created money to finance deficits. I'm not saying this is easy. It's not. But defusing anxiety about huge national debts is impossible.

    Thanks for your good work! --Nick Estes, Albuquerque

  20. Simon,

    I agree that your small state thesis is sound. However, I am suggesting that policy makers were as susceptible to the "economy as household" fallacy as was the general population. And consequently, policy makers took austerity as policy not as outcome, i.e. austerity was pursued for its own sake. To argue as you have done that austerity is an outcome of fiscal consolidation misses the point that austerity also was about internal devaluation, internal devaluation as the outcome. I would say that the policy/outcome distinction is blurred and semantic - however, I am more focusing on the severity with which austerity was pursued in Europe and imposed on some states at the behest of others - to the point of being punishing. Defining austerity as an outcome detracts from this perspective.

    On point 2, don't the Germans and others argue from the position that the EBC is not a sovereign lender of last resort. Isn't the ECB legally constrained from bailing out state debt? So presumably all EZ states adhere to this principle in theory? So the only source of funds are private providers or other states - Germany being the predominant. And it's a recalcitrant Draghi who's thrown a spanner in the works with massive QE?


  21. My main question, is how you measure debt "sustainability" with all the variables of inflation, t-bond interest rates, foreign exchange, and the need for imports, ability to export/demand for exports. I would think the need for imports relative to your ability to export would be the biggest issue. Steve keen, compared to most MMTers suggests there is a significant reason to be concerned about balance of trade. I know you have discussed and debated at length various MMT arguments, so I don't necessarily want to get into that, but I am curious to here your perspective on how these variables: inflation, t-bond rates, and balance of exports/imports affect debt sustainability.


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