Post credit bubble fiscal austerity leads to depression

In the video at the end of this post I speak to RT Television about fiscal austerity in the UK and the likelihood of fiscal austerity in the US.

A few thoughts here:

Barack Obama says:

Government has to start living within its means, just like families do. We have to cut the spending we can’t afford so we can put the economy on sounder footing, and give our businesses the confidence they need to grow and create jobs.

Wrong on every single count. This is why the US is probably headed for a repeat of 1938. The President knows better, but he’s saying this stuff anyway. If you have the President spouting this nonsense, you know the Republicans will use it to force cuts that will weaken the economy.

The key here is that it does no good for the Republicans politically to compromise with President Obama. His policies are rightfully seen as failed. The right thing to do politically (but not morally) is to try and strike as much contrast to the President as you can, especially if it makes him look more failed. So that means favouring gridlock and pushing deficit reduction, looking for spending cuts and so on – even if it leads to a government shutdown stare-down as it did under Clinton. Is this the right thing to do?  I don’t think so, if only because it reduces the number of potential positive economic outcomes. But I am speaking now more from a forecasting perspective than one of advocacy.

A few comments about Tuesday’s election’s impact on the economy, Nov 2010

The cuts are coming. The President has assured as much through his misguided rhetoric. We’ll just have to see whether the economy in the US is weak enough that they cause a double dip.

On the UK:

the US has resisted austerity while the UK has embraced it. In my mind, this is the best real-time economic experiment we can have on what does and doesn’t happen as a result of government spending.

The UK is noticeably weaker than the US.  They have failed. Expansionary fiscal consolidation is nonsense. It didn’t work in Ireland, Greece or Spain. And it won’t work in the US or the UK either.

Continuing where I left off from the previous quote, the problem is this:

Personally, I think the budget deficits in the U.S. are unsustainable [see here for why]…Nevertheless, I recognize that the large majority of the deficit in the U.S. has been driven by an output gap due to massive un- and under-employment.

My criticism of the Obama Administration has more to do with its lack of fight in creating jobs. And to the chagrin of my Keynesian readers, I am not talking about artificial boosts to aggregate demand. I don’t buy into the ‘aggregate demand is the only problem’ propaganda. The U.S. and the UK were on an unsustainable course with the FIRE sector (financial services, insurance, and real estate) sucking up an excessive amount of real resources that did not add to the longer-term capital formation. It certainly made a lot of people rich for a period of time. But for the societies as a whole, this misallocation of capital has been destructive, much more so than the telecom and technology misallocation which preceded the housing bubble.

If you want fiscal consolidation because you believe the government is propping up zombies in the FIRE economy, knowing that consolidation leads to economic weakness in the short –term, fine. That’s a risky strategy but it is one point of view. However, the concept that fiscal contraction boosts growth is voodoo economics and this what the governments in Britain and now the US are arguing.

My hope is that, despite slowing in Europe and China, the global economy will have enough pop to get the US through its experiment with expansionary fiscal contraction. But this is just a hope.

Video below.

  1. Dave Holden says

    Steve Keen points to a “Modest proposal” as a European approach.

  2. Stevie b. says

    “They [the UK] have failed. Expansionary fiscal consolidation is nonsense”

    Cor! Ruddy hell! That’s a bit strong isn’t it, Ed? Rome was not built in a day etc. You think we can get out of this mess without some sort of real pain over a real period of time? And long-term global economic wage- convergence & levelling means there sure as hell will be pain. I dunno what the answer is, but surely for the UK better pain now (and they’re not being that brave really – the stated deficit will still be massive, never mind the unstated deficit) than terminal illness tomorrow via artificial job creation by civil servants (or politicians via tax-cuts or whatever) who by definition don’t know how to create real jobs cos they themselves don’t have them (although they do have real pensions sure enough)

    1. Dave Holden says

      As I understand it here in the UK there are no “cuts” as such but no *increases* in spending – which will definitely feel like cuts.

      Here’s an interesting take from an Austrian point of view

      “If you want fiscal consolidation because you believe the government is propping up zombies in the FIRE economy, knowing that consolidation leads to economic weakness in the short –term, fine. That’s a risky strategy but it is one point of view.”

      After years of crony capitalism and malinvestment there are no risk free strategies in my opinion – although of the two polar options of austerity and stimulus the former will almost certainly bring on a *lot* of short term pain.

      Personally I’m torn on the issue mainly I think because this isn’t a normal recession. I wonder what a “moderate proposal” would be for the US.

      1. David Lazarus says

        The UK has only just started its cuts. The cuts are also deep up to 25% or more, depending on department. The government expect the 1.4 million public sector jobs lost to be replaced by more than 2 million private sector jobs by the next election. This is what has been called expansionary fiscal contraction. It is based on the misguided belief that exports will take up the slack. Austerity will bring a lot of pain and it will be permanent as it will shrink the economy so much that the debt burden becomes unsustainable. If Ireland had not socialised the bank losses it would be in a much better state even with the decimation to its finances. Austerity has put the country on the path to ruin. Look at the Baltic’s whose economies have shrunk substantially and now much of the population have left for opportunities else where. Most will never return, that is happening to Ireland as well. That debt will take decades for Ireland to clear. Those that have left will be unable to return because the economy will not be strong enough to accept them as pensioners.

        I would not consider myself an Austrian follower but I do accept that business cycles will inevitably lead to a recession. Trying to mitigate that cycle has lead to too much bad investment out there. Evan as a Keynesian I think that recessions should not be stopped, which is why the Fed should lose that requirement to maintain full employment, and should concentrate on price stability. Congress needs to accept its responsibility.

        I do find fault with the getting to break even analysis. What has happened is that all the strains of the cost cutting has occurred on the variable side and not on the fixed costs side. That has meant that the economy has been permanently weakened because labour does not have the buying power. It was only sustained by ultra low interest rates, which also inflated fixed costs like rent or mortgage liability even if the interest rates were a fraction above zero. In the real world the fixed cost have risen as part of a bubble yet the austrian analysis does not look at that.

  3. David Lazarus says

    “If you want fiscal consolidation because you believe the government is propping up zombies in the FIRE economy, knowing that consolidation leads to economic weakness in the short –term, fine. That’s a risky strategy but it is one point of view” That is what we should have done three years ago. I am in the shrink the FIRE sector to one that is not a risk to society in general.

    We should not protect any banks that have any overseas exposure. It is a way to backstop their gambling. Make it clear to depositors that such banks have no FDIC protection.

    The problem is that the economy and treasuries became dependant on the tax revenues from the FIRE sector and not just as a government. Look at the corrupting influence it has had on politics. It has corrupted attitudes to regulations. As for it being risky. It is a lot less risky long term, as banks do not endanger the economy again.

    I agree that austerity now is the worst thing that can be done. Though voters get the government that they deserve. Long term I think that we should do nothing to boost the economy until the bad investments are cleared out. Allow the automatic stabilisers to do their job. Though the US really needs to improve theirs. Get the central banks to raise interest rates to normal levels and ban them from lowering them to such low levels. Remove personal if necessary including Bernanke. Allow assets to fall to stimulate demand from new businesses. Raise taxes on capital and equalise it at higher levels. Do not worry about reducing the deficit too fast because it will be used to have a works program with as high a level of labour content as possible. Home insulation grants have a high labour content. Then as the economy is growing, very slowly as fewer unemployed start getting proper jobs then transfer the funds to paying down the government debt, or provide additional capital to small solvent banks on favourable terms to boost lending in small communities. Make it about the community and not about big business.

  4. Edward Harrison says

    For ideological reasons, one might believe that reducing government is better. However, it does not follow that doing so is a painless exercise.

    If one does want to see government expenditure reduced for ideological reasons, the question is when and how to do so. Clearly doing so in an abrupt way after a credit bubble is going to be the wrong way. I believe both Obama and Cameron understand this and are trying to make cuts (or reduce the pace of growth) in a way that doesn’t lead to the outcomes we saw in Ireland, Latvia, or Greece. It remains to be seen whether they will be successful.

    Still, we have to be clear what is happening here: we are making cuts that suck money out of the economy – and there is no confidence fairy like Obama points to in the opening quote that causes businesses or households to compensate for that adjustment.

    Ostensibly this is because the debts and the waste are just too great. But we know that cuts dealing with discretionary spending and not medicare or defense are chicken feed. As I said, the budget would be balanced at full employment. Social security and Medicare are longer-term issues.

    Moreover, households are currency users. Government creates the currency.

    The household analogy, while effective for people who don’t understand this, is flawed.

    Obama is simply using voodoo economics to justify something that will weaken the economy. Not only is it foolhardy to do so because it plays into his opponents’ hands, it is simply bad economics.

    I may write up how to put this in the right terms that has the economics right.

  5. Richard says

    Er, sorry, Edward, when you are asked if Americans would do exactly the same thing as the peaceful Brits in the video, you are GRAVELY mistaken when you say they would. Americans would lose it completely. They’d be rioting, breaking windows, throwing things, yelling and screaming, fighting each other. It would be total chaos. See, that’s “America”…

    1. David Lazarus says

      The Brits have not accepted this peacefully. The students have already rioted over the student tuition fees increase. The Tory party headquarters were targeted as a result.

      Politicians do not fear communism any longer which was the motivation for the New Deal. Without some fear motivating the politicians the end result for the country could be anarchy, as they dither.

  6. MB says

    UK spending is increasing by £44bn~ over the budget to 2014 (680bn – 724bn). Spending is rising every year. Why not bother to actually read it?

    Departmental spending budgets are being cut because of the interest bill on £1trn debt is rising every year.

    The UK has actually performed strongly from a labour market pov. 500k private sector jobs have been created in the last 12 months (net employment change of 400k~)

    Government borrowing was £3-4bn under target FY 2010/11 and is on track this year so far.

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