Thoughts on Austerity
Yesterday, Paul Krugman wrote:
Portugal’s government has just fallen in a dispute over austerity proposals. Irish bond yields have topped 10 percent for the first time. And the British government has just marked its economic forecast down and its deficit forecast up.
What do these events have in common? They’re all evidence that slashing spending in the face of high unemployment is a mistake. Austerity advocates predicted that spending cuts would bring quick dividends in the form of rising confidence, and that there would be few, if any, adverse effects on growth and jobs; but they were wrong.
Here’s my take:
[T]here are two sides to every financial transaction. You can’t look at fiscal austerity in a vacuum. A downward shift in the government’s net fiscal deficit means a downward shift in the private sector’s net fiscal surplus – totally doable except for this little thing called debt in places like Spain, the US, Ireland or the UK.
Moreover, the savings rate is already incredibly low in countries like the U.S. and the U.K. If the government tries to pare its fiscal deficit, the result will not be less private sector savings to meet the lower public sector deficit, but rather lower aggregate demand and a larger deficit – that’s the paradox of thrift. See Ireland as exhibit A.
–James Montier does MMT, July 2010
In the medium-term, austerity leads to larger deficits because it causes a recession. Most people really don’t get this bit at all. The way the media and politicians go about talking about this debate goes more to the sustainability of deficit spending and national bankruptcy. Question: where has austerity led for Britain and Ireland and Latvia before it? In each case, it has led to lower aggregate demand and recession. That’s the reality of austerity.
Full-bore austerity is reckless, especially if government doesn’t understand how it would contribute to a debt deflationary outcome. Governments and private sectors across the developed economies cannot all deleverage simultaneously without a severe fall in output and Depression.
What this implies is this (diagram from Paul Krugman’s post with the unfortunate title “Deficits saved the world”):
To make the graph easier to follow we start with sector balances at zero i.e. where sector surplus/deficit equals zero for both the private sector including the current account deficit and for the government sector. And just to be clear, points above the line show private sector savings or public sector deficit.
- We start where the red circle is.
- When an economic shock hits which precipitates a massive deleveraging, the entire demand curve shifts to the left to a new lower GDP level, everything else being equal. Thus, deleveraging equals recession. And we now see the private sector curve hitting the public sector curve where the blue circle is. The private sector is now saving and the public sector is in deficit. That is where we are today.
- However, to bring things back to neutral i.e. where sector surplus/deficit equals zero for both sectors, one could cut government spending dramatically. That shifts the entire government curve to the red line on the left, leaving us where the green circle is: in a deep, deep depression. Krugman calls this the Great Depression outcome.
As I said a couple of weeks ago:
You should view people arguing for cuts in deficit spending who do not also point to this identity in a dubious light. Assume they don’t even realize the identity exists. How are they going to be able to have an enlightened view about deficits if they don’t understand that government deficits are the mirror image of non-government surpluses?
What about the long-term? I think this is the pertinent question. Let’s look at the outcomes from the previous chart. Over the medium term, the Irish, British and Latvian outcomes are the green circle, recession or depression. This is also what Greece and Spain are enduring as a pre-condition of their bailouts.
What one hopes for is the red circle. But is that really possible? I would say it is if we focus on both the loss in employment and the structural adjustments that are needed in the economy. Before the crisis, we had many more people servicing the mortgage, housing and finance sectors in the U.S. the UK, Spain and Ireland. And we had extreme levels of household sector leverage. It will be impossible to simultaneously put millions to work, reduce household leverage, reallocate human and investment capital, restructure the financial sector and reduce the deficit. That isn’t going to happen for the reasons I gave above.
However, there are three distinct outcomes that are possible. If government runs a deficit, it is possible to put millions to work, reduce household leverage, reallocate human and investment capital and restructure the financial sector. If stimulus is geared to propping up the sectors where the crisis began and where capital was misallocated to begin with, over the long-term you will be back to square one. That’s the Japanese solution. On the other hand, a reduction in government deficits would bring about a deep recession and debt deflation. There is a lot of uncertainty of the Knightian variety in that scenario – the unknown unknowns of that scenario are much greater in number. The potential for a long period of stagnation and armed conflict is great, especially given the already difficult economic and geopolitical environment from the Middle East to Japan.
Here’s the case I make. The three outcomes are as follows:
- The Glide Path Solution. increasing aggregate demand by maintaining government spending while trying to liquidate zombie companies and malinvestment. This would allow the private sector to decrease debt burdens significantly over time through increased savings. It also has the benefit of reducing dependency on foreign sources of capital. The downside is a major increase in government debt, the spectre of big government and a long muddle through.
- The Hoover Status Quo. decreasing aggregate demand and precipitating a double dip recession in order to reduce government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain dependency on foreign sources of capital – all without ending the spectre of big government.
- The Liquidation Scenario. decreasing aggregate demand and precipitating a major depression in order to liquidate zombie companies and malinvestment. This would cause a massive wave of defaults and decrease debt burdens significantly through bankruptcy and debt repudiation.
I have advocated path number one. Politically, I would say that is surely not going to happen. In late 2009, the Obama Administration was arguing for path number two. In actual fact, they did not decrease government spending. And when the economy experienced a soft patch last summer, the Fed stepped in with QE. So the contractionary effects of austerity have yet to be felt. Tea Party advocates are looking for path number three.
I have advocated the glide path solution. But I see the liquidation scenario as much better than the present path – especially since, with the present course, we are witnessing crony capitalism on a massive scale. The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.
The Herbert Hoover solution we are now using leads to a Japanese outcome at best or a Great Depression outcome at worst.
The reason path two leads to path three is that people get fed up with cronyism and bailouts. Bailout fatigue leads inexorably from path two to path three.