Blogging the Zombies: Expansionary Austerity – Reanimation
<h3>Expansionary Austerity – Reanimation</h3>
The idea of expansionary austerity first emerged in the early 1990s, in the context of the formation of the eurozone. The creation of a monetary union between countries with no capacity to undertake a co-ordinated fiscal policy was seen as requiring convergence on a more conservative fiscal stance than had been possible during the chaos of the 1970s and 1980s. The agreements made at Maastricht in 1992 , and later formalised at the Growth and Stability pact required countries wishing to join the eurozone to hold deficits below 3 per cent of GDP and public debt below 60 per cent Check
With unemployment still high in many European countries, there was some reluctance to implement the austerity measures required by the Maastricht criteria. So, there was a lot of interest in analyses claiming to show that austerity could, in fact, be expansionary. A series of such analyses were produced by Albert Alesina and a series of co-authors, most notably Silvia Ardagna.
Some of these papers provided econometric analyses, which tried to show that reducing government expenditure and budget deficits would lead to stronger economic growth. Statistical analysis is rarely as convincing as a good story, however, and the most influential work in this literature was a series of stories about individual countries, entitled ‘Tales of Fiscal Adjustment’ by Alesina and Ardagna.
Although this work had only a modest impact at the time it appeared, it but it become part of the thinking of many anti-Keynesians, particularly in Europe So, when European governments found themselves struggling with apparently unsustainable levels of public debt in the aftermath of the global financial crisis, advocates of austerity measures could argue that the policies they proposed would accelerate economic recovery.
This claim led to a re-examination of the econometric work undertaken by the advocates of expansionary austerity. Some of the most important work was done by the IMF and by one of Alesina’s former co-authors, Roberto Perotti. The conclusions reinforced the common-sense Keynesian view that contractionary fiscal policy (that is, austerity) is contractionary in macroeconomic terms.
The IMF critiques convinced most professional economists, at least those open to empirical evidence. But what about the success stories told by Alesina and Ardagna. Such stories can’t be refuted by statistical analysis. Rather it’s necessary to examine the historical accuracy of the account that is offered. I decided to look at the story told by Alesina and Ardagna about my own country Australia. I expected to find points of disagreement, but I was surprised to find much more. The section on Australia is full of glaring factual errors, even though Alesina had spent time there as a guest of the central bank.
To mention just a few of the most glaring errors
* Alesina and Ardagna attribute the policy of austerity to a leftwing government elected in 1985. In fact, the government was elected in early 1983 at the depths of a severe recession. It implemented an expansionary policy. The recovery was well under way when the government took measures, beginning in 1984 to wind back the budget deficit
* Alesina and Ardagna assert that the main budget savings came from “cuts in transfer programmes .. mainly concentrated on unemployment insurance.” Spending on unemployment benefits fell, but not because of cuts. The unemployment rate was falling and expenditure fell as a result. This is the standard Keynesian “automatic stabilisers” at work
* Most strikingly of all the write ‘Australia is a clear case of an‘expansionary fiscal contraction’. GDP grew faster during and in the aftermath of the adjustment, both in absolute terms and relative to the G7 countries. A private investment boom was associated with profits and easier access to credit following the financial deregulation process that took place in 1985–6.”
This is like the story of the man who jumps off a tall building and says, as he passes the 25th floor “All good so far”. Writing in 1998, Alesina and Ardagna must surely have been aware that, almost immediately after their story ends, Australia entered the worst recession in its postwar history.
Australia’s recession was triggered by contractionary monetary policy, but its severity was largely due to the collapse of the investment boom, which was dominated by speculative investment projects undertaken by so-called ‘entrepreneurs’ who took advantage of financial deregulation to build conglomerate empires that failed in the crisis, almost taking down the banking system with them. The Australian experience of the 1980s was a preview of what would happen in the US and Europe in the 2000s.
To sum up, the tale told by Alesina and Ardagna bears zero relation to the actual history of Australia in the 1980s. The most revealing point about their account is their eagerness to shift the burden of adjustment to a crisis onto its most vulnerable victims – the unemployed. The 1990s literature on expansionary austerity was a warning of what was to come after the global financial crisis.
The crisis and its aftermath
For a brief period after the eruption of the crisis in 2008, it seemed that everyone was a Keynesian. With interest rates already at or near zero in most countries, the fear of disaster led governments of all political persuasions to engage in large-scale fiscal stimulus
The only exceptions to this trend were countries such as Iceland and Ireland where the financial crisis had resulted in the rapid collapse of an over-expanded financial sector. Decisions to guarantee the debts of failing institutions, while perhaps inevitable, were disastrous for the fiscal position of the governments concerned. Public debt increased massively and suddenly, leaving governments with with no room to stimulate the real economy through higher public expenditure and lower taxes.
Unsurprisingly, the combination of financial collapse and enforced fiscal austerity produced severe recessions, made more dramatic by the fact that the countries most affected were precisely those which had enjoyed unprecedented prosperity as a result of the financial sector boom. Conversely, Australia, where the domestic banking system remained stable, and a large-scale fiscal stimulus was introduced before the effects of the global crisis were felt, avoided recession altogether.
The experience of the crisis was entirely in line with the Keynesian analysis. Nonetheless, with the immediate danger of global economic collapse in the past, there was a substantial push to restore the status quo ante, in which fiscal policy played a marginal role. The key players here were central banks, for whom the era of inflation targeting had meant an immense increase in power and prestige. Despite having presided over the near-collapse of the financial system they were supposed to manage, and despite continuing double-digit inflation, central banks were keen to treat the crisis as a temporary aberration, with no lessons for the future.
Emblematic of this view is the widely-publicised statement of outgoing ECB President Jean-Claude Trichet at a press conference in September 2011
1I will say the following: first, we were called to deliver price stability! We were called on by all the democracies of Europe to deliver price stability and, in particular, of course by the 17 democracies that asked us to issue the currency in their 17 countries. We have delivered price stability over the first 12-13 years of the euro! Impeccably! Impeccably! I would like very much to hear some congratulations for this institution, which has delivered price stability in Germany over almost 13 years at approximately 1.55% – as the yearly average of inflation – we will recalculate the figure to the second decimal. This figure is better than any ever obtained in this country over a period of 13 years in the past 50 years. So, my first remark is this: we have a mandate and we deliver on our mandate! And we deliver in a way that is not only numerically convincing, but which is better than anything achieved in the past.
Bad as the return to inflation targeting was, it did not imply a resurrection of the austerity policies that had failed so disastrously in the Great Depression. Although proposals for further discretionary stimulus met with increasing resistance, governments initially maintained a neutral or expansionary policy
All of that changed in early 2010 with the emergence of the Greek sovereign debt crisis. In … the major ratings agencies downgraded Greek government debt, beginning a downward spiral so steep that default became virtually inevitable. As of October 2011, the market prices of Greek bonds and credit default swaps implied a default probability close to 100 per cent, with likely losses of 60 per cent.
For many years, Greek governments had used a wide range of expedients to increase borrowing while appearing to remain within, or close enough to, the limits on debt and deficits set by the ‘Stability and Growth’ Pact under which the eurozone was established. A notable , and well-publicized, instance was a bogus currency swap set up with the assistance of Goldman Sachs.
The real story however, involved the big French and German banks. Under the Basel II system of financial regulation, they had been freed from prescriptive controls on the assets they were required to hold. Instead, they were required to maintain a low-risk portfolio, where risk was assessed by credit ratings agencies.
This system encouraged banks to hold AAA-rated assets, since these were considered as virtually riskless. Unfortunately, low risk usually means low return and banks were hungry for profits. So, there was a massive potential gain to anyone who could find a way of making risk invisible, producing a AAA-rated asset with the high return that risky borrowers were willing to pay.It was for this reason that European banks piled into the subprime derivatives created on a massive scale in the US, often raising the money to do so on the US wholesale market.
Within Europe, the creation of the euro provided another way of adding risk while staying within the Basel II guidelines. Bonds issued by eurozone countries with high public debt, such as Greece and Italy, carried a small but significant risk premium. On the other hand, for regulatory purposes, such debt was effectively treated as risk-free.
The role of the banks, and of the Basel II system was not immediately apparent (even now, the idea that European investments in subprime assets reflected ‘dumb bankers in Dusselsorp’ has a fair bit of currency. Instead, attention was focused almost entirely on the profligacy of Greek governments, … in the civil service and rampant tax evasion.
The real problems came when this analysis was extended to the rest of the heavily indebted periphery – commonly referred to in such accounts as the PIGS (Portugal, Italy, Greece and Spain) group, sometimes with Ireland thrown in as a second ‘I’. This was unfair and inaccurate, particularly as regards Spain and Ireland, which had been running budget surpluses in the years leading up to the crisis. Even Italy was reducing its ratio of debt to GDP, and adopting measures aimed at a gradual return to fiscal sustainability.
The fiscal crisis in these countries was driven by the need to bail out the financial sector, and by the collapse in revenues that resulted from the bursting of financial bubbles. In Ireland, for example, under pressure from the ECB, the government agreed to guarantee all the debts of the major banks, pledging as collateral $20 billion euros from the National Pension Reserve Fund (the equivalent of the Social Security Trust Fund in the US). Most of this money, and tens of billions more from other sources, appears to have been lost.
The injustice of making hospital workers, policy and old age pensioners pay for the crisis, while the bankers who caused it are receiving even bigger bonuses than before, is glaringly obvious. So, just as with trickle down economics, it was necessary to claim that everyone would be better off in the long run.
It was here that the zombie idea of expansionary austerity emerged from the grave. Alesina and Ardagna, citing their dubious work from the 1990s, argued … They attracted the support of central bankers, ratings agencies and financial markets, all of whom wanted to disclaim responsibility for the crisis they had created and get back to a system where they ruled the roost, and profited handsomely as a result.
The shift to austerity was politically convenient for market liberals. Despite the fact that it was their own policies of financial deregulation that had produced the crisis, they used the pretext of austerity to push these policies even further. The Conservative government of David Cameron in the UK [formally a coalition with the Liberal Democrats led by Nick Clegg, but Clegg has proved utterly ineffectual in all respects].
Although the term ‘expansionary austerity’ was not much used in the US, the swing to austerity policies began even earlier than in the US and Europe. After introducing a substantial, but still inadequate fiscal stimulus early in 2009, the Obama Administration withdrew from the economic policy debate, preferring to focus on health policy and wait for the economy to recover.
Meanwhile the Republican party, and particularly the Tea Party faction that emerged in 2009, embraced the idea, though not the terminology, of expansionary austerity and in particular the claim that reducing government spending is the way to prosperity. In the absence of any effective pushback from the Obama Administration, the Tea Party was successful in discrediting Keynesian economic ideas.2
Following Republican victories in the 2010 Congressional elections, the Administration accepted the case for austerity and sought a ‘grand bargain’ with the Republicans. It was only after the Republicans brought the US to the brink of default on its debt in mid-2011 that Obama returned to the economic debate with his proposed American Jobs Act. While rhetorically effective, Obama’s proposals were, predictably, rejected by the Republicans in Congress.
At the state and local government level, austerity policies were in force from the beginning of the crisis. Since they are subject to balanced-budget requirements, state and local governments were forced to respond to declining tax revenues with cuts in expenditure. Initially, they received some support from the stimulus package but, as this source of funding ran out, they were forced to make cuts across the board, including scaling back vital services such as police, schools and social welfare.
The theory of expansionary austerity has faced the test of experience, and failed. Wherever austerity policies have been applied, recovery from the crisis has been halted. At the end of 2012, the unemployment rate was above 8 per cent in the US, the UK and the eurozone. In the UK, where the switch from stimulus to austerity began with the election of the Conservative-Liberal Democratic coalition government in 2010, unemployment rose rapidly to its highest rate in 17 years. In Europe, the risk of a new recession, or worse, remains severe at the time of writing (December 2011).
Although the US economy shows some superficial signs of recovery, the underlying reality is arguably even worse than in Europe. Although unemployment rates have fallen somewhat, this mainly reflects the fact that millions of workers have given up the search for work altogether. The most important measure of labor market performance, the employment-population ratio (that is, the proportion of the adult population who have jobs) fell sharply at the beginning of the crisis and has never recovered (Graphs to come here).
The reanimation of expansionary austerity represents zombie economics at its worst. Having failed utterly to deliver the promised benefits, the financial and political elite, raised to power by market liberalism has pushed ahead with even greater intensity. In the wake of a crisis caused entirely by financial markets and the central banks and regulators that were supposed to control them, the burden of fixing the problem has been placed on ordinary workers, public services, the old, and the sick.
With their main theoretical claims, such as the Efficient Markets Hypothesis and Real Business Cycle in ruins, the advocates of market liberalism have fallen back on long-exploded claims, backed by shoddy research. Yet, in the absence of a coherent alternative, their policy program is being implemented, with disastrous results.
1 The question referred to German concerns about the limited ‘quantitative easing’ undertaken by the ECB. It is striking that, three years into the deepest recession since the 1930s, Trichet is most concerned to defend himself against charges that he is not hawkish enough!
2 It’s worth observing that, although the Tea Party now claims to have been motivated by anger at the bailout of the banks, which took place under the Bush Administration, it did not begin to organize until after the inauguaration of Barack Obama. The precipitating event was a widely publicised rant by a Chicago commodities trader, Rick Santelli. Mr Santelli whose job would have disappeared if the financial system had not been bailed out was not, of course, complaining about the trillions of dollars spent to rescue Wall Street and its offshoots in Chicago and elsewhere. Rather, he was objecting to the much more modest help given to families who had taken out mortgages they could no longer afford to buy houses that had collapsed in value.