“Growth in a Time of Debt,” the much-touted paper by economists Carmen Reinhardt and Kenneth Rogoff, that suggested economic growth stalls once a nation’s debt hits 90 percent of its gross domestic product, has been debunked. But the austerity policies that this research helped undergird are still alive and well. Despite the on-going austerity-driven economic meltdown in Europe, and despite the International Monetary Fund’s recanting of the supposedly positive benefits of cuts, austerity continues, as John Maynard Keynes once put it, “to dominate the economic thought, both practical and theoretical, of the governing and academic classes of this generation.” Why is it so hard to shuck this notion that governments should cut spending and/or raise taxes in times of economic slack?
Two answers present themselves to us.
The first is politics. Few of the Republicans who fret so much about today’s allegedly crushing debt burden did so in 2006, at the height of the boom, when the U.S. debt to GDP ratio was steadily climbing above 60 percent and the deficit was at then-all-time high – and when a Republican was in the White House.
The second answer is more historic, and rests on austerity’s enduring attractiveness in how we view government debt as both a problem and a solution. And its roots lie in Edinburgh, Scotland, rather than in Washington, D.C.
Back in the 1700s two giants of the Scottish Enlightenment, David Hume and Adam Smith, framed how we view government debt, as they grappled with a problem: how can capitalists pay for the state they need, but that they can neither trust nor properly finance. Hume and Smith wrote in the aftermath of a long period of upheaval that saw the transformation of the British state from a near permanent standoff between the king and parliament to one where parliament controlled taxes and a central bank owned by the creditor class managed the finances. The unacknowledged problem involved in building this new capitalist world was that to create markets you had to be in charge of the state. Creating wage labor, enforcing property rights, and policing the skewed distributions of reward that markets produce requires a strong state that protects and promotes the capitalist interest. As Smith put it bluntly, civil government, “in so far as it is instituted for the security of property, is in reality instituted for the defense of the rich against the poor.”
But too strong a state might confiscate a rich person’s wealth, and building a state strong enough to defend against the poor costs a fair bit of cash, which means taxes that you don’t want to pay. So how do you pay for the state that you need without giving up more and more of your cash in taxes to that state? Government debt emerged as the answer. After all, if you can loan the government the money that it needs to keep you safe, and get paid interest for the privilege, why would you ever need to pay taxes? It’s what modern bankers call a ‘free option,’ a contract with an unlimited upside and zero downside. Hume and Smith, of course, disagreed: they pointed out why the option isn’t free. In doing so they gave us same arguments for austerity that we hear today.
Hume noted that government debt is easy to levy while its costs are hidden. And because “it is very tempting to a minister to employ such an expedient…the practice will…be abused, in every government.” Given such abuse, the public will eventually refuse to buy more debt, and the government will turn to foreigners, who will end up possessing “a great share of our national funds [which will] render the public…tributary to them.” Therefore, far from protecting capitalism, the government will have “mortgaged all its revenues [and will] sink into a state of languor, inactivity and impotence.”
Smith built upon his friend Hume’s arguments, adding that by offered investors terms better than those available through regular channels of investment, the ‘easy money’ of debt interest undermines capitalists’ incentive to save and invest. The result: more and more debt is built up while the economy shrinks. Because of this inflationary financing, creditors’ fortunes, and hence their ability to invest, will be destroyed. Inevitably then, “the idle and profuse debtor [will earn] at the expense of the frugal creditor…transporting capital…to those which are likely to…destroy it.”
Both Hume and Smith had good reason to fear debt, both public and private. British national debt grew from 5 percent of GDP in 1700 to 25 percent of GDP in 1761, rising to 34 percent of GDP in 1814 at the height of the Napoleonic wars. Hume’s opinion was sharpened by the bankruptcy of the Bank of France (thanks to the paper money scheme of fellow-Scot John Law), while Smith’s faith even in private credit was shaken by the bankruptcy of the Ayr Bank a few years before the publication of The Wealth of Nations.
However, both Hume and Smith were quite wrong about debt. Hume predicted the collapse of the British economy through debt financing by the late 1700s – just as the U.K. was about to go through a century of expansion and growth. Smith similarly predicted the growth of “enormous debts which at present oppress, and will in the long-run probably ruin, all the great states of Europe.” But the U.K. paid back its debts after 1815, with public debt falling to 6.6 percent of GDP by 1866 and remaining low until the next great war of 1914. In 1945, government spending amounted to 70 percent of the U.K.’s economy. But the debt fell once again as the economy grew and the debt was retired after the Second World War.
But these ancient Scottish diagnoses resonate loudly today. David Hume did not live to see China’s trillion-dollar pile of T-Bills, but we can be sure he would not be surprised by its appearance. Similarly, echoes of Smith’s inflation panic fueled an investment-diverting gold bubble across the globe after 2008. Meanwhile, the German concerns over a transfer union vis-à-vis Southern Europe are little more than modern-day echoes of Smith’s worry over the ‘transport of capital to the idle debtor’ by another name.
Keynes once famously noted that economic policy is oftentimes little more than the product of “some academic scribbler of a few years back.” While Keynes may have changed our view of debt for a while, and more recently economists like Paul Krugman and Joseph Stiglitz have all railed against austerity with eloquence and evidence, the voices of Smith and Hume that still act as the siren call to most economists today. That’s in part because the logic of government crowding-out private investment both pointed to seems to make sense (so long as we assume perfectly efficient markets and positive interest rates). And it’s in part because economists’ inherent distrust of the state and all its works persists. But it may also be because Smith and Hume do have a point, one that Keynes would agree with.
Keynes famously said that ‘the boom, not the slump, is the time for austerity.’ Yet in the boom, when money is plentiful, there is no incentive for a minister, as Hume had it, to raise taxes and pay back the debt. Rather, we hope that growth will do the job for us, or we delegate the task out to the central bank, which as Smith reminds us, is owned by the same merchant interest. So we never do austerity in the boom. We give ourselves another round of tax cuts instead such that the bias towards debt that our Scots forebears noted continues, even in the good times.
Perhaps then it is this factor, more than politics or the language of panic, that motivates contemporary economists to embrace austerity and develop all sorts of arguments about 90 percent thresholds, ‘expansionary contraction,’ and other dubious devices to scare us into costs. The Scottish ghosts of debt –panics past still haunt the minds of some very important, and very living, economists.