The case against austerity
Simon Wren-Lewis, professor of economics at Merton College, Oxford University, introduces his latest paper, The case against austerity today, which is published today by the think tank IPPR.
The argument for austerity relies heavily on the examples of Greece, Ireland and other eurozone countries. It is said that this is the fate we would suffer without immediate cuts. But interest rates on government debt outside the eurozone are very low. In the rest of the world the markets appear to be saying borrow more, not borrow less.
There is a straightforward explanation for this puzzle. Individual eurozone countries, because they cannot print their own currency, are uniquely vulnerable to self-fulfilling debt crises. High interest rates on debt in countries like Spain and Italy are telling us that there is a basic design flaw in the eurozone. They are not a call for the rest of the world to undertake immediate austerity.
Elsewhere, low interest rates reflect the fact that consumers around the world are saving more, and that raises the demand for government debt. This is the standard Keynesian story of a recession, and with monetary policy largely spent, it requires the Keynesian remedy of fiscal stimulus.
This is not to dispute that there is a long run problem of excessive government debt in most countries, including the UK. However this has not been caused by governments spending too much or taxing too little in recessions. It stems from excessive deficits in the good times. Immediate austerity risks repeating the mistakes of the 1930s, and Japan in the 1990s. Both Keynesian macroeconomics as taught to first-year undergraduates and the state-of-the-art Keynesian macroeconomics used by central banks tell us that the optimal response to the twin problems of deficient demand in the short run and excessive debt in the long run is a fiscal stimulus today followed by spending restraint or tax increases when the recovery is assured.
Debt sustainability is essentially a long-term problem. This is why the Office for Budget Responsibility in the UK and the Congressional Budget Office in the US feel the need to undertake the heroic task of making macroeconomic projections 50 years ahead to assess fiscal sustainability. The establishment of the OBR is an important and useful innovation in this respect. On the other hand, fiscal expansion to boost a recovery is a short-term device. Indeed, it is plausible to argue that additional government spending must be temporary to be effective in stimulating the economy. And finally – but critically – the amount of extra debt generated by a short-term stimulus is likely to be relatively small compared to existing levels, so it does not significantly worsen the long-term problem of debt sustainability. In the case of the US, for example, the fiscal expansion undertaken after the recession contributes little to that country’s long-term fiscal difficulties.
The counter argument is political. Promises of austerity tomorrow would not be credible, so we have to start right away. But who exactly is demanding this show of self-flagellation? Outside the eurozone, the markets are not, even for a country like the US that appears to be in a state of gridlock when it comes to dealing with their long run deficit problem. In the UK, do cuts today prove that the government will continue with austerity in five or ten years time, or are they a way of making room for tax cuts before the next election? To use an analogy, if someone was overweight, what would you be more impressed by: a person who analyses why they are overweight, and embarks on a long term plan to correct the problem, or someone who goes on a crash diet?
This is why it is important to see that the eurozone is a special case. Of course austerity suits the ideological agenda of some. However I think many people have felt that the problems that began with Greece indicated that governments around the world had gone as far as they could with fiscal stimulus. Yet the faltering recovery in 2011, and low interest rates on debt outside the eurozone, suggest this is not the case. The shift in the global consensus to austerity that occurred in 2010 looks like a serious misreading of events, and the unemployed are having to pay the price for this mistake.
- Download The case against austerity today, published by IPPR.
Simon Wren-Lewis is professor of economics at Merton College, Oxford University.
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