David McWilliams Explains Why Austerity Is Doomed In Europe

A very interesting video by an Irish economist explaining how the current reduce government spending (“austerity”) approach to the Eurozone debt and currency crisis is doomed to fail. It is doomed because cutting government spending in a recession only makes the recession worse, which in turn, reduces tax collections which then makes the government deficits worse not better.  But not only is the austerity approach all wrong to solving the debt crisis, it carries very significant risk of social upheaval.  (hat tip to Philip Pilkington and New Economic Perspectives).

Now I’ll offer one pre-emptive comment.  Critics of the arguments McWilliams makes often claim that either government spending isn’t really effective, that somehow only private investment spending will stimulate an economy.  Or, the critics claim that any resources the government puts into use through spending actually detract from the economy by denying those resources to some supposedly better, privately chosen use. Both of these criticism fail.  We are clearly discussing a situation in which there are excess, unused economic resources in the economy.  In plain language:  there’s high unemployment and people are out of work.  The criticisms are all based on an idea called “crowding out”.  For crowding out to occur, the economy must be at full employment – the opposite of being in a recession.

Stimulus Requires More Than Taking Your Foot Off the Brakes

Last week I discussed how I think the President’s jobs proposal, the American Jobs Act, will be less than stimulating.  I updated it here.  I based my analysis on what economists call “back of the envelope” calculations – quick simple estimates of the key variables using rounded numbers.  Now the folks at Goldman Sachs research have put the proposal through their more sophisticated and complex econometric models.  And they come to … roughly the same conclusion.  Paul Krugman at the NY Times observes:

Goldman Sachs (no link) has a nice chart showing just how much fiscal policy has been a drag on the economy since the second half of last year, and also shows that the Obama jobs plan, even if enacted in full, would only be enough to put it in neutral:

Just worth bearing in mind.

The graph (the line) shows the effect that total government fiscal policy, including federal, state, and local, has had / will have on GDP growth rate.  In 2009, Q1-Q3, governments were having a very positive effect on GDP growth, adding up to 2.5 percentage points to the GDP growth rate.  By 2009 Q4, though, this stimulus effort had deteriorated and was starting to have a negative effect, slowing GDP.  Initially this was because state and local spending cuts were overwhelming the federal increases in spending.  But the 2009 stimulus bill ran it’s course and the feds joined the austerity party and started cutting spending along with state and locals in late 2010.  In 2011, our problems have been the austerity programs, the spending cuts at state, local, and federal level. Government has had it’s foot on the brakes trying to slow an already weak economy.  It’s worked. The economy is coming to a halt.

Unfortunately, the proposed jobs program isn’t really much of a stimulus. It’s too weak. It’s too small. And it’s focused too much on tax cuts that won’t be spent instead of spending.  The blue line above shows the likely effects.  Even if passed (a near impossibility given the Republican majority in the House), it will only reverse the contractionary effects of spending cuts without adding any new stimulus to grow GDP further.

Stimulus is supposed to be about speeding up GDP growth – hitting the accelerator.  Simply taking your foot of the brakes isn’t the same thing as hitting the gas.


The Federal Government HAS Been Cutting Spending – And That’s A Major Problem

One of the my major frustrations as a blogger and as a follower of economic news is the way in which misinformation and falsehoods get repeatedly passed around as they were facts.  For example, one common meme that we hear a lot is that the  government, especially under Obama, has engaged in a massive spending spree.  The idea is pushed that government is growing out of control.  This idea has been pushed heavily by Republicans and Tea Partiers. It is often combined with the conclusion that “stimulus doesn’t work”.  The unfortunate part is that this idea of a government spending spree is completely untrue!

Look at this graph from the FRED database at the stlouisfed.org.  This shows the annual change in real dollars in government consumption and investment expenditures.  In other words, it shows how additional spending was added each year by all layers of government in the U.S.  During the recession, 2008 and 2009, governments were spending more.  They were spending approximately $60 billion a year more.  But notice that once the “official recession” ended in 2009 (the end of the shaded bars) governments began cutting back.  By late 2010 government has cut back so much that it is now spending less each year than the last year.

It’s no coincidence that this is the same exact timing when two things happened: the Republicans asserted control over the House of Representatives and began pushing to cutting spending, and the economy began to slow again and the recovery stalled. These two phenomena are related.  Cutting government spending when there is high unemployment and a slow economy is a sure-fire recipe for an even slower economy and even higher unemployment.

A critical thinking reader might ask “how can this be true (that government spending is lower than a year ago) if the federal government deficit is so large?”.   Well there’s two explanations.  The first is that the federal government deficit in the economy is largely due to the slow down in tax collections and the tax cuts that delivered little economic stimulus since they were saved, not spent.  Second, government in the U.S. is more than Washington D.C. There’s as much state and local government as there is national government, particularly when it comes to spending (as opposed to transfer payments).  State and local governments are cutting back and cutting back big time.  The 2009 “stimulus” bill of the national government actually had a large component that involved the national government transferring money to states and locals so they wouldn’t have to cut as much.  State and local governments cannot run deficits the way the national government can (they don’t have central banks).  That’s over now.  Now state and local governments are cutting big time – over 345,000 jobs lost at the state and local government level in just the last 12 months.  Of those, the majority are teachers in education.

Learning From the Past – Or Maybe Not.

It looks like we are going to repeat the past.  In this case, it’s 1937.  In 1937 the general discussion in U.S. politics had turned to concerns about debt and deficits.  The conservative view that opposed  both the New Deal and efforts to alleviate the Great Depression began to get the upper hand.  Keep in mind that the economy had not fully recovered from the Great Depression and Great Crash of 1929.  But the economy had been growing some in 1933-36 due largely to the New Deal and government deficit spending.  The spending effort was too weak though and the economy struggled to grow.  By 1937 it still hadn’t recovered to pre-crash levels.  But politicians began to claim that deficits were bad and that all that was needed was “belt-tightening” by government.  The result was disastrous.  The economy plunged downward again and only began to resume a growth path once Europe went to war and started placing orders for food, equipment and materiel.

Sound familiar?  We had a great crash three years ago.  We stopped the downward spiral in 2009 due largely to a federal government stimulus program.  But the program was too small relative to the size of the recession. Worse  yet, the stimulus was 40% made up of tax cuts which in a financial crisis are no help.  Even worse, the federal increase in spending barely offset the decline in state and local government spending.  Result: we stopped the crash. We ended the decline. But there hasn’t been enough true stimulus to really recover.  Now in 2011 the stimulus spending is being withdrawn and government spending is declining.  Government employment is dropping significantly every month, putting a severe drag on aggregate demand.

Even the central bank appears to have lost the history lessons.  Reuters ran a story recently called “That 1937 Feeling All Over Again” (bold emphasis mine):

(Reuters) – Federal Reserve Chairman Ben Bernanke, an expert on the Great Depression, once promised that the central bank would never repeat its 1937 mistake of rushing to tighten monetary policy too soon and prolonging an economic slump.

He has been true to his word, keeping interest rates near zero since late 2008 and more than tripling the size of the Fed’s balance sheet to $2.85 trillion. But cutbacks in government spending may end up having a similarly chilling effect on the economy, and there is little Bernanke can do to counter that.

Back in 1937, the U.S. economy had been growing rapidly for three years, thanks in large part to government programs aimed at ending the deep recession that began in 1929.

Then the central bank clamped down hard on lending, and federal government spending dropped 10 percent. The economy contracted again in 1938. The jobless rate soared.

“Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again,” Bernanke said back in 2002 at a conference honoring legendary economist Milton Friedman’s 90th birthday.

Bernanke convenes the Fed’s next policy-setting meeting on Tuesday, facing growing concern that the United States may be slipping into another recession while Europe staggers toward a deeper debt crisis. Standard & Poor’s decision on Friday to lower the U.S. credit rating adds yet another element of uncertainty.

His options are limited.

Nigel Gault, chief U.S. economist at IHS Global Insight, said the Fed could promise to keep interest rates near zero or its balance sheet swollen for even longer than investors anticipate. Or it could buy even more U.S. government debt.

“It is hard to see any of these options as ‘game changers,'” Gault said. “The Fed would be doing them not because it could be sure they would make a huge difference, but because it would feel the need to do something.”

Gault put the odds of another recession at 40 percent.

“Having said that, there are still plenty of headwinds, like Europe. I am also very encouraged to see the upward revisions to the previous months. This report pulls us back from the ledge a little bit.”


Full employment is one of the Fed’s prescribed goals, and it is clearly falling short. Government spending cuts are making matters worse. Friday’s employment report showed a net loss of 37,000 government jobs last month.

State and local governments with balanced budget rules had little choice but to cut jobs in order to make ends meet. The federal government has no such restriction, but its spending outside of defense fell at a 7.3 percent annual rate in the second quarter, crimping economic growth.

Michael Feroli, an economist with JPMorgan in New York, said he had held out some hope that Congress would approve some form of additional fiscal support in the coming months, but the debt ceiling fight showed lawmakers dead set against that.

“It now looks likely that growth could hit a pothole early next year,” Feroli said.


And as we all witnessed with the debt-ceiling debate fiasco, both parties in Washington D.C are battling to see who can be seen as the budget cutter.  It’s 1937 all over. Let’s

Learning From Austerity In the Past. A Warning?

A poor economy is never popular with the populace.  But when the economy is slow and people are suffering as a result of government policies that impose austerity on them, people get downright upset.  They even get violent.  It’s something we should think about as virtually all major developed nations have embraced policies of cutting spending in the face of high unemployment.  History shows government budget  cuts do not restore growth.  That is a myth.

But history also shows that budget cuts go hand-in-hand with social violence, unrest, rioting, social instability and even revolutions. A new major historical study by budget cuts do have real effects.  Jacopo Ponticelli and Hans-Joachim Voth have just published their study in Voxeu.org.  Here is the abstract  (bold emphasis mine):

Austerity and Anarchy: Budget Cuts and Social Unrest in Europe,

Does fiscal consolidation lead to social unrest? From the end of the Weimar Republic in Germany in the 1930s to anti-government demonstrations in Greece in 2010-11, austerity has tended to go hand in hand with politically motivated violence and social instability. In this paper, we assemble cross-country evidence for the period 1919 to the present, and examine the extent to which societies become unstable after budget cuts. The results show a clear positive correlation between fiscal retrenchment and instability. We test if the relationship simply reflects economic downturns, and conclude that this is not the key factor. We also analyse interactions with various economic and political variables. While autocracies and democracies show a broadly similar responses to budget cuts, countries with more constraints on the executive are less likely to see unrest as a result of austerity measures. Growing media penetration does not lead to a stronger effect of cut-backs on the level of unrest.

Here’s another interesting passage:

Expenditure cuts carry a significant risk of increasing the frequency of riots, anti-government demonstrations, general strikes, political assassinations, and attempts at revolutionary overthrow of the established order. While these are low- probability events in normal years, they become much more common as austerity measures are implemented. … We demonstrate that the general pattern of association between unrest and budget cuts holds in Europe for the period 1919-2009. It can be found in almost all sub-periods, and for all types of unrest. Strikingly, where we can trace the cause of each incident (during the period 1980-95), we can show that only austerity-inspired demonstrations respond to budget cuts in the time- series. Also, when we use recently-developed data that allows clean identification of policy-driven changes in the budget balance, our results hold.

The timing of this release is extraordinary.  We saw riots in 2008 and 2009 in Iceland, Latvia, and Bulgaria driven by austerity and “tax the people to pay the bankers”.  Of course the “Arab spring” was partly driven by bad economics in Tunisia, Egypt, and other mid-east countries.  We’ve seen Greece this year turn violent and lawless in areas due to the hopelessness of the austerity policies being forced on it by the EU.  Spain has been having extensive, largely peaceful protests until police decided they had enough. Now Britain has experienced riots, too.

This paper and the riots we are seeing illustrate an important concept of political economy.  Redistribution of income by government to the less fortunate and the unable is not just a question of altruism, or charity, or “caring” for them.  Redistribution also serves the interests of the rich, elite, and powerful.  When income inequality becomes too great and the government persists in policies that benefit only the existing holders of financial capital (like today’s austerity policies), social unrest soon follows.  Sooner or later the wealth and safety of the elites becomes endangered.

Why the Austerity Talk?

Brad DeLong is as puzzled as I, but is more eloquent in expressing it.  In so doing he does my classes a favor in expressing a quick version of the history of addressing macro economic crises.

For nearly 200 years economists from John Stuart Mill through Walter Bagehot and John Maynard Keynes and Milton Friedman to Ben Bernanke have known that a depression caused by a financial panic is not properly treated by starving the economy of government purchases and of money. So why does “austerity” have such extraordinary purchase on the minds of North Atlantic politicians right now?

Let me speak as a card-carrying neoliberal, as a bipartisan technocrat, as a mainstream neoclassical macroeconomist–a student of Larry Summers and Peter Temin and Charlie Kindleberger and Barry Eichengreen and Olivier Blanchard and many others.

We put to one side issues of long-run economic growth and of income and wealth distribution, and narrow our focus to the business cycle–to these grand mal seizures of high unemployment that industrial market economies have been suffering from since at least 1825. Such episodes are bad for everybody–bad for workers who lose their jobs, bad for entrepreneurs and equity holders who lose their profits, bad for governments that lose their tax revenue, and bad for bondholders who see debts owed them go unpaid as a result of bankruptcy. Such episodes are best avoided.

From my perspective, the technocratic economists by 1829 had figured out why these semi-periodic grand mal seizures happened. In 1829 Jean-Baptiste Say published his Course Complet d’Economie Politique… in which he implicitly admitted that Thomas Robert Malthus had been at least partly right in his assertions that an economy could suffer from at least a temporary and disequliibrium “general glut” of commodities. In 1829 John Stuart Mill wrote that one of what was to appear as his Essays on Unsettled Questions in Political Economy in which he put his finger on the mechanism of depression.

Semi-periodically in market economies, wealth holders collectively come to the conclusion that their holdings of some kind or kinds of financial assets are too low. These financial assets can be cash money as a means of liquidity, or savings vehicles to carry purchasing power into the future (of which bonds and cash money are important components), or safe assets (of which, again, cash money and bonds of credit-worthy governments are key components)–whatever. Wealth holders collectively come to the conclusion that their holdings of some category of financial assets are too small. They thus cut back on their spending on currently-produced goods and services in an attempt to build up their asset holdings. This cutback creates deficient demand not just for one or a few categories of currently-produced goods and services but for pretty much all of them. Businesses seeing slack demand fire workers. And depression results.

What was not settled back in 1829 was what to do about this. Over the years since, mainstream technocratic economists have arrived at three sets of solutions:

  1. Don’t go there in the first place. Avoid whatever it is–whether an external drain under the gold standard or a collapse of long-term wealth as in the end of the dot-com bubble or a panicked flight to safety as in 2007-2008–that creates the shortage of and excess demand for financial assets.
  2. If you fail to avoid the problem, then have the government step in and spend on currently-produced goods and servicesin order to keep employment at its normal levels whenever the private sector cuts back on its spending.
  3. If you fail to avoid the problem, then have the government create and provide the financial assets that the private sector wants to hold in order to get the private sector to resume its spending on currently-produced goods and services.

There are a great many subtleties in how a government should attempt to do (1), (2), and (3). There is much to be said about when each is appropriate. There is a lot we need to learn about how attempts to carry out one of the three may interfere with or make impossible attempts to carry out the other branches of policy. But those are not our topics today.

Our topic today is that, somehow, all three are now off the table. There is right now in the North Atlantic no likelihood of reforms of Wall Street and Canary Wharf to accomplish (1) and diminish the likelihood and severity of a financial panic. There is right now in the North Atlantic no likelihood at all of (2): no political pressure to expand or even extend the anemic government-spending stimulus measures that have ben undertaken. And there is right now in the North Atlantic little likelihood of (3): the European Central Bank is actively looking for ways to shrink the supply of the financial assets it provides to the private sector, and the Federal Reserve is under pressure to do the same–both because of a claimed fear that further expansionary asset provision policies run the risk of igniting unwarranted inflation.

But there is no likelihood of unwarranted inflation that can be seen either in the tracks of price indexes or in the tracks of financial market readings of forecast expectations.

Nevertheless, you listen to the speeches of North Atlantic policymakers and you read the reports, and you hear things like:

“Obama said that just as people and companies have had to be cautious about spending, ‘government should have to tighten its belt as well…’”

Now there were—and perhaps there still are—people in the White House who took these lines out of speeches as fast as they could But the speechwriters keep putting them in, and President Obama keeps saying them, in all likelihood because he believes them.

And here we reach the limits of my mental horizons as a neoliberal, as a technocrat, as a mainstream neoclassical economist. Right now the global market economy is suffering a grand mal seizure of high unemployment and slack demand. We know the cures–fiscal stimulus via more government spending, monetary stimulus via provision by central banks of the financial assets the private sector wants to hold, institutional reform to try once gain to curb the bankers’ tendency to indulge in speculative excess under control. Yet we are not doing any of them. Instead, we are calling for “austerity.”

John Maynard Keynes put it better than I can in talking about a similar current of thought back in the 1930s:

It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924-1929] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man’s speculative spirit. It would, they feel, be a victory for the Mammon of Unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy.

We need, they say, what they politely call a ‘prolonged liquidation’ to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

I do not take this view. I find the explanation of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity…

I do not understand it either. But many people do. And I do not understand why such people think as they do.


No do I understand why they think that way.  But I suspect that it has to do with political and rich elites preferring to have a more dominant share of a smaller pie than to rationally wanting to share a larger one.  As one of the commenters to Brad’s post put it:

We’ve been down this road before. “Auterity” is just a euphemism for getting the ignorant and foolish to support their own ruin in the name of wealth transference to the already wealthy by destroying government programs and services that benefit the middle class and needy.



Ireland: “Responsible” Policy Punishes Citizens for Bankers’ Sins

Poor Ireland.  For some unknown reason, the Irish seem doomed to suffer under the misguided rule of others, despite being the source of great music, culture and a brew so good      For centuries, the oppressor was the English.  In this century Ireland has fallen under the boot of the bankers and The Powers That Be (TPTB) who have have fallen under the sway of “responsbile austerity”.  There is a lesson here for America if we would only listen and pay attention.

Earlier in this century, before 2007, Ireland apparently had left it’s history of poverty and oppression to become the poster child for success via globalization. It’s GDP boomed (see graph). It attracted foreign direct investment and many foreign firms, including Google and others. It was called the Celtic tiger. GDP per capita had risen to the second highest in Europe behind Luxembourg. It was following the recommended path towards financial globalization that conservative right-wing economists have been pushing for several decades.  The right-wing Heritage foundation praised it’s financial deregulation, low tax, and nearly non-existent taxes on foreign corporations as the key to success.  And by conventional measures like GDP it appeared to work.

But in 2007, things began to turn down.   Seems Ireland had developed a highly skewed and unequal distribution of income (like the U.S. today). It had become overly dependent on a property and housing boom with 12% of GDP resulting from new construction (kinda like the U.S.).  And much of the apparent GDP increases were illusion – the result of the difference between GDP and GNP – meaning life really wasn’t as good as the GDP numbers suggested.  (See  GDP vs. GNP to learn the difference between GDP and GNP and how it distorts things for Ireland but not the U.S.).  Then the Global Financial Crisis came.  Ireland got hit pretty hard. The housing market tanked. Bank loans started going bad in large numbers.  Now it should be noted that these were all private-market loan decisions.  They were the result of foreign investors making private contracts to take on the risk and make loans to people in Ireland (and outside) to buy Irish property.  But when the loans began to go bad in large numbers, the large (mostly) Euro banks’ who had made the loans had their solvency threatened.  And with that, the profits of Euro investors in those Euro banks were threatened.  The Irish government was urged to be “responsible” by taking the responsibility away from the banks and investors who made the loans.  The Irish government guaranteed the banks’ loans after the fact.  As Paul Krugman recounts:

The Irish story began with a genuine economic miracle. But eventually this gave way to a speculative frenzy driven by runaway banks and real estate developers, all in a cozy relationship with leading politicians. The frenzy was financed with huge borrowing on the part of Irish banks, largely from banks in other European nations.

Then the bubble burst, and those banks faced huge losses. You might have expected those who lent money to the banks to share in the losses. After all, they were consenting adults, and if they failed to understand the risks they were taking that was nobody’s fault but their own. But, no, the Irish government stepped in to guarantee the banks’ debt, turning private losses into public obligations.

Before the bank bust, Ireland had little public debt. But with taxpayers suddenly on the hook for gigantic bank losses, even as revenues plunged, the nation’s creditworthiness was put in doubt. So Ireland tried to reassure the markets with a harsh program of spending cuts.

Step back for a minute and think about that. These debts were incurred, not to pay for public programs, but by private wheeler-dealers seeking nothing but their own profit. Yet ordinary Irish citizens are now bearing the burden of those debts.

When the Irish government took on the bad debts made by private banks in order to save large international investors from the consequences of their bad choices , it naturally led to a large increase in the Irish government debt to GDP ratio. So in return for the good (?) deed of rescuing international investors, banks, and bond buyers from the consequences of their investments, those investors, banks, and bond-buyers have punished the Irish government by driving interest rates on Irish bonds to high levels.  The speculators smell another Greece.  Talk of bailouts began earlier this month. And, finally with interest rates rising and the speculators circling like sharks, the Irish government accepted a “bail-out” earlier this week from the Euro central bank and IMF, the usual TPTB.

I’m not sure that it should really be called a “bail-out” though.  It’s actually a strange deal like something out of  Alice in Wonderland or a George Orwell novel.  In return for the Irish government agreeing to cut spending even more, raise taxes, and punish it’s already suffering people, the Irish government gets a large credit line so it can borrow even more money in the future.  Of course, by cutting spending and raising taxes in the middle of a serious, deep recession and when it has no control over it’s monetary policy (Ireland is in the Eurozone), it will, of course have even larger deficits than is planned or expected and will need to borrow that money.  Which will only kick the can down the road to some point in the future when another “bail-out” is necessary.  God save us all from such “bail-outs”.

What  could the do instead?  Well, first off, long-term policy should be focused on growth by investing in infrastructure and education and research, much like Finland does and not in globalization and chasing multi-national banks and corporations who play shell games.  More directly, the Irish government should consider what Iceland, that other small European island in the North Atlantic did.  As Krugman also observed in the same article:

Part of the answer is that Iceland let foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts. As the International Monetary Fund notes — approvingly! — “private sector bankruptcies have led to a marked decline in external debt.” Meanwhile, Iceland helped avoid a financial panic in part by imposing temporary capital controls — that is, by limiting the ability of residents to pull funds out of the country.

And Iceland has also benefited from the fact that, unlike Ireland, it still has its own currency; devaluation of the krona, which has made Iceland’s exports more competitive, has been an important factor in limiting the depth of Iceland’s slump.

None of these heterodox options are available to Ireland, say the wise heads. Ireland, they say, must continue to inflict pain on its citizens — because to do anything else would fatally undermine confidence.

But Ireland is now in its third year of austerity, and confidence just keeps draining away. And you have to wonder what it will take for serious people to realize that punishing the populace for the bankers’ sins is worse than a crime; it’s a mistake.

But to follow the Iceland example requires two things.  First, Ireland would have to leave the Eurozone and return to issuing and controlling it’s own currency. And, second, it’s politicians would have to the well-being of the Irish people above the claims and self-interest of the banks and large international investors.  I say not gonna happen.