The High Cost of Austerity Peter Gourevitch Professor of Political Science Founding Dean, School of International Relations and Pacific Studies UC San Diego March 2012
We live in economically troubled times: the Euro crisis, unemployment, income inequality, declining social mobility, debt, both personal and national. And in this election year we hear a vigorous debate about what to do in response: should we slash spending, cut taxes, reduce deficits, thus take what is being called the Expansionary austerity approach? Or should we stimulate the economy with more demand through deficit spending, and hope the revived economy will bring in the tax revenues to repay the debt.
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This debate is not new. It reminds me a lot of what I have read about the Great Depression. Back in 1929, when the famous stock market crash occurred in October, the orthodox view on what to do was austerity: cut spending, cut taxes, bring the budgets in balance. That would restore business confidence, induce more investment and thus start a positive spiral up.
So that is what governments did. They also tried to get consumers to buy domestic products by raising tariffs to protect against imports and devaluing their own currencies to make imports more expensive. The result? Disaster. Each country cut spending, which shrank the economy further, which obligated governments to cut taxes even more, which meant cutting spending and thus again reducing demand. Each country sought to protect itself, but the collective behavior made things worse. This was called “beggar thy neighbor policies” – you hope to help yourself at the expense of your neighbor. The most famous presentation of this is called the Kindleberger Spiral, after a noted MIT economic historian.
Here it is: it starts with the level of world trade in 1929, at the moment of the October stock market crash. As we move across each month, world trade contracts more, as each country makes these orthodox policy moves. By 1932/33 we were there at that point, an incredible contraction of world output and world trade. Unemployment in the US and Germany had reached 25 per cent.
At this point, governments collapsed. In democracies, elections brought in new majorities, notably in Scandinavia and the US. With the political shift came a move away from economic orthodoxy. Governments started to spend. They built bridges, dams, electrification, --- including here in the U.S., the Grand Coulee dam, the Triborough Bridge, the Golden Gate Bridge, rural electrification. This stimulated demand through the multiplier. The economy improved. But in 36/37, orthodox thinking said we must now slash all these deficits, so the government cut back on spending, and the result? – A sharp slump in the economy, so the government started to spend again.
John Maynard Keynes theorized all this in his famous work published in 1936. But Keynes’ theory did not cause the policy -- the practical work was already happening. Governments in Sweden and the US were spending because they were responding to popular pressure to fight unemployment. It was not when economic theory figured out what to do that orthodoxy was abandoned, but when political opposition to orthodoxy generated by unemployment got strong enough to force a change of policy.
The issue back then was fiscal prudence vs. fighting unemployment: the disagreement was: “ What was a tolerable risk of inflation in the future” vs. “what was tolerable about joblessness today.” Keynes argued that the loss of production and income was worse over the long run than the cost and risk of inflation. The debt of the deficits could be paid back through rising production by stimulating the economy.
Today in winter of 2012, we have the same debate. As we see big debt in a place like Greece, the argument is made they must pay it back and we impose austerity on them: fire public employees, cut back on pensions, health care, spending on public works. But austerity kills growth. European governments are insisting on an austerity logic that risks repeating the Kindleberger Spiral, a contraction that gets worse, not better.
The same discussion is occurring here. Do we stress paying down the national debt, or fighting unemployment now? I argue that the budget battle is not a technical matter but a value judgment. Unemployment is a terrible thing to families. So what is worse? Unemployment or the risk of future inflation? This is very partisan in the sense of political parties and interest groups, not surprising as it is about value and political choice. It is not solely about spending levels and taxes per se: it is spending on whom and on what. Conservatives have been willing to spend on defense and to cut taxes on the wealthy, and to oppose spending on health care, housing, and education.
Democrats largely fight for the opposite: higher taxes on the wealthy to pay for social spending. So it is a values issue, which has translated into a partisan one. And that it is why it is so hard to reach agreement. I am for fighting unemployment, so I oppose the austerity line. You have to think about your values and decide!! The election in November is one opportunity to do so.
I’m Peter Gourevitch, thanks for listening to me!!