Originally published in the Imperial Management Review
Prior to
the Great Depression, economists conceived of their field as something
bordering on a perfect science; capitalism, so it was thought, had proven to be
an economic system devoid of major inefficiencies. This point of view, buffeted
by the bull market of the 1920s, abruptly disintegrated at the end of that
decade, leaving economists aghast at the approaching Great Depression
With traditional monetary policy
ineffective, it took a fresh and invasive look at the capitalist system, most
notably by John Maynard Keynes, to understand the challenges that capitalist
economies faced. In his General Theory of
Employment, Interest and Money, Keynes attributed the depression to a lack
of private sector demand, which could only be made up by increased government
spending. It was the role of the government, said Keynes, to stimulate the
economy. This basic idea comprised the policy prescription taken by America and
Britain during the 1930s and 1940s.
As memories of the Depression
dwindled, economic thinking shifted away from Keynesianism. The efficient
markets hypothesis, which conceives of markets as being rational, gained
traction. After World War II, monetary policy was effective in combating economic
challenges, including soaring inflation of the 1970s. Keynesian fiscal policy
no longer seemed necessary and soon fell out of favor.
The success of economics as a
field was again trumpeted, with major thinkers touting the merits of economic
policy for balancing employment, inflation and growth. The back patting
extended in to 2008, with a number of esteemed economists ardently believing
their profession to have reached a pinnacle. Complex and beautifully crafted
mathematical models conjured up just the right prescriptions to indefinitely
maintain the goals of central banks.
And then the housing bubble burst.
And global credit markets dried up. And unemployment skyrocketed. And
unmanageable sovereign debt engulfed Europe. The Nobel garnished makers of
those mathematical models appeared worryingly close to cosmeticians caking on
layers of make-up to conceal a severely scarred truth. With the Fed lowering
interest rates near the zero-lower bound, monetary policy met its limits. And
thus our story begins.
*****
Austerians, who believe that in a
recession government should cut deficit spending and make room for private
sector investment, faced off against Keynesians, who believe that recessions
represent an absence of private sector demand; the government, according to the
Keynesians, must increase deficit spending to stimulate the economy. Which
policy is the right one is currently at the heart of economic debate.
Although the Austerity v. Stimulus
debate is not a new one, the global economic community has yet to reach a
consensus on which is really most effective. Context often compounds clear-cut
conclusions, and many adherents—in either camp—have a shifty penchant for
exaggerating contextual differences to resuscitate their beleaguered ideology.
If the economic elite were to come
together to organize an experiment wherein two countries of similar context
were to receive two different policy responses during a recession—austerity for
one and stimulus for the other—ethical review boards would be spinning like
tops trying thwart it. Which country you believe would be the dead guinea pig
depends on your perspective. But it’s clear that one of the countries would
suffer unnecessarily.
Sometimes, however, the most
seminal of experiments occur naturally. Despite their differences, the
economies of the United States and the United Kingdom are similar in a number
of important ways, including having and borrowing in their own currencies. While
the relationship is not 1:1, those who would downplay the similarities will
have a fairly conspicuous agenda.
And so the experiment begins. With
the inauguration of the coalition government, the United Kingdom began to
invoke fiscal austerity; they reneged on Labour’s stimulus program, which saw
GDP growth at 2.5% annually, in favor of across the board spending cuts.
George Osborne, Chancellor of the
Exchequer, instituted an aggressive policy of deficit reduction and tax
increases, effectively foisting contractionary policy on an already sclerotic
economy. Government spending, he argued, would crowd out private investment,
thereby thwarting further growth and prolonging recession. The answer was
simple: curtail government spending.
How has this turned out for the
UK? Well, last year its economy shrank .1%, a far cry from the .8% growth it
had projected. The most recent report from the Office of National Statistics
revealed that the UK narrowly avoided consummating its ongoing flirtation with
a triple-dip recession. Despite lowering its growth forecast for 2013 from 2%
to 1.2%, Osborne maintained that “it’s a hard road but we are getting there.
Britain is on the right track. Turning back now would be a disaster.”
Quite at odds with Osborne, the National
Institute for Economic and Social Research has attributed the UK’s sustained
depression and its worsening outlook to austerity. Although most European countries followed a path of
austerity, some of them are now beginning to shy away from it, after years of negative
growth and rising unemployment.
Portugal recently announced a
far-reaching stimulus package. Italy’s new Prime Minister has promised to curb
austerity programs and begin stimulus. Most notably, perhaps, the IMF has had
an about-face with regard to austerity. Christine Lagarde, Managing Director of
the IMF, recently impugned the efficacy of Osborne’s deficit reduction plan,
warning that cuts are likely hampering growth and prolonging recession.
Moreover, IMF Chief Economist Olivier Blanchard stated that
Osborne is “playing
with fire” by remaining on a path of austerity. Blanchard, once a proponent of Britain’s austerity plans,
conducted a review of previous IMF projections. He found that countries that
engaged in austerity notably underperformed IMF projections of growth.
Conversely, countries that took a more Keynesian approach, like the United
States, tended to outperformed IMF projections. After reviewing the findings,
Blanchard has advanced the IMF’s evolving viewpoint on austerity, stating that
raising taxes and cutting spending succeed only is dragging out depression.
*****
Two notable papers serve as the
academic pillars for austerity: Alesina and Ardagna’s Large Changes in Fiscal Policy and Reinhart and Rogoff’s Growth in a Time of Debt. Both have been
championed as a coup de grace to Keynesianism. Both have been ignominiously
refuted.
When we distance ourselves from
the dizzying political discourse and focus on the differential outcomes over
the last five years, it’s clear which side of the Austerity v. Stimulus debate
has triumphed. The United States, with its comparatively more Keynesian
approach, has had a comparatively stronger recovery.
According to critics of the Obama
Administration, the United States was supposed to be Greece by now. Interest
rates were meant to have skyrocketed, deficits to have rapidly expanded, large
capital outflows to have abounded and the dollar to have deteriorated. But none of this transpired. Instead,
GDP growth averaged 2.1% since 2009, compared to .9% in the UK. Unemployment is
trending downward and is projected to reach 6.5% by next year, and the deficit
is expected to shrink to 4% of GDP by 2014.
More than 5 years into the Great
Recession, the verdict is clear. The IMF, the World Bank and the WTO have all
warned that austerity will hamstring growth and exacerbate unemployment. They
were able to look at the data objectively and come to sensible policy
recommendations based on empirical evidence.
Yet Austerians cling to their a
priori judgments and increasingly refuted ideologies. They refuse to
acknowledge the role austerity has played in hindering recovery. We’re hoping
to resuscitate our injured guinea pig, but the wheel of death spins on.
