Everything that helps to increase the confidence of households, firms and investors in the sustainability of public finances is good for the consolidation of growth and job creation. I firmly believe that in the current circumstances confidence-inspiring policies will foster and not hamper economic recovery, because confidence is the key factor today.
—Jean-Claude Trichet, president of the European Central Bank, interviewed in the Italian newspaper La Repubblica, June 2010
In the scary months that followed the fall of Lehman Brothers, just about all major governments agreed that the sudden collapse of private spending had to be offset, and they turned to expansionary fiscal and monetary policy—spending more, taxing less, and printing lots of monetary base—in an effort to limit the damage. In so doing, they were following the advice of standard textbooks; more important, they were following the hard-earned lessons of the Great Depression.
But a funny thing happened in 2010: much of the world’s policy elite—the bankers and financial officials who define conventional wisdom—decided to throw out the textbooks and the lessons of history, and declare that down is up. That is, it quite suddenly became the fashion to call for spending cuts, tax hikes, and even higher interest rates even in the face of mass unemployment.
And I do mean suddenly: the dominance of believers in immediate austerity—“Austerians,” as the financial analyst Rob Parenteau felicitously dubbed them—was already well established by the spring of 2010, when the Organization for Economic Cooperation and Development released its latest report on the economic outlook. The OECD is a Paris-based think tank funded by a club of advanced-country governments, which is why people sometimes refer to the economically advanced world simply as “the OECD,” because membership in the club is more or less synonymous with advanced status. As such, it is of necessity a deeply conventional place, the kind of place where documents are negotiated paragraph by paragraph so as to avoid offending any of the major players.
And what was the advice this bellwether of conventional wisdom gave to America in the spring of 2010, with inflation low, unemployment very high, and the federal government’s borrowing costs near a record low? That the U.S. government should immediately move to slash the budget deficit and that the Federal Reserve should raise short-term interest rates dramatically by the end of the year.
Fortunately, U.S. authorities didn’t follow that advice. There was some “passive” fiscal tightening as the Obama stimulus faded out, but no wholesale shift to austerity. And the Fed not only kept rates low; it embarked on a program of bond purchases in an attempt to provide more oomph to the weak recovery. In Britain, however, an election placed power in the hands of a Conservative–Liberal Democrat coalition that took the OECD’s advice to heart, imposing a program of preemptive spending cuts even though Britain, like America, faced both high unemployment and very low costs of borrowing.
Meanwhile, on the European continent, fiscal austerity became all the rage—and the European Central Bank began raising interest rates in early 2011, despite the deeply depressed state of the euro area economy and the absence of any convincing inflationary threat.
Nor was the OECD alone in demanding monetary and fiscal tightening even in the face of depression. Other international organizations, like the Basel-based Bank for International Settlements (BIS), joined in; so did influential economists like Chicago’s Raghuram Rajan and influential business voices like Pimco’s Bill Gross. Oh, and in America leading Republicans seized on the various arguments being made for austerity as justifications for their own advocacy of spending cuts and tight money. To be sure, some people and organizations bucked the trend—most notably and gratifyingly, the International Monetary Fund continued to be a voice for what I considered policy sanity. But I think it’s fair to say that in 2010–11 what I, following the blogger Duncan Black, often call Very Serious People—people who express opinions that are regarded as sound by the influential and respectable—moved very strongly to the view that it was time to tighten, despite the absence of anything resembling full recovery from the financial crisis and its aftermath.
What was behind this sudden shift in policy fashions?
If you try to parse the arguments of the Austerians, you find yourself chasing an elusive moving target. On interest rates, in particular, I often felt as if the advocates of higher rates were playing Calvinball—the game in the comic strip Calvin and Hobbes in which the players are constantly making up new rules. The OECD, the BIS, and various economists and financial types seemed quite sure that interest rates needed to go up, but their explanations of just why they needed to go up kept changing. This changeability in turn suggested that the real motives for demanding tightening had little to do with an objective assessment of the economics. It also means that I can’t offer a critique of “the” argument for austerity and higher rates; there were various arguments, not necessarily consistent with one another.
Let’s start with the argument that has probably had the most force: fear—specifically, fear that nations that don’t turn their backs on stimulus and move to austerity, even in the face of high unemployment, will find themselves confronting debt crises similar to that of Greece.
The Fear Factor
Austerianism didn’t spring out of nowhere. Even in the months immediately following the fall of Lehman Brothers, some voices denounced the attempts to rescue major economies by engaging in deficit spending and rolling the printing presses. In the heat of the moment, however, these voices were largely drowned out by those calling for urgent expansionary action.
By late 2009, though, both financial markets and the world economy had stabilized, so that the perceived urgency of action had declined. And then came the Greek crisis, which anti-Keynesians everywhere seized upon as an example of what would happen to the rest of us if we didn’t follow the straight and narrow path of fiscal rectitude.
The Greek debt crisis was sui generis even within Europe, that the other debt-crisis countries within the euro area suffered debt crises as a result of the financial crisis, not the other way around. Meanwhile, nations that still have their own currencies have seen no hint of a Greek-style run on their government debt, even when—like the United States, but also Britain and Japan—they too have large debt and deficits.
But none of these observations seemed to matter in the policy debate. As the political scientist Henry Farrell puts it in a study of the rise and fall of Keynesian policies in the crisis, “The collapse of market confidence in Greece was interpreted as a parable of the risks of fiscal profligacy. States which got themselves into serious fiscal difficulties risked collapse in market confidence and perhaps indeed utter ruin.”
Indeed, it became all the fashion for respectable people to issue apocalyptic warnings about imminent disaster if we didn’t move immediately to cut the deficit. Erskine Bowles, the co-chairman—the Democratic co-chairman!—of a panel that was supposed to deliver a plan for long-term deficit reduction, testified to Congress in March 2011, a few months after the panel failed to reach agreement, and warned about a debt crisis any day now:
This problem is going to happen, like the former chairman of the Fed said or Moody’s said, this is a problem we’re going to have to face up to. It may be two years, you know, maybe a little less, maybe a little more, but if our bankers over there in Asia begin to believe that we’re not going to be solid on our debt, that we’re not going to be able to meet our obligations, just stop and think for a minute what happens if they just stop buying our debt.
What happens to interest rates and what happens to the U.S. economy? The markets will absolutely devastate us if we don’t step up to this problem. The problem is real, the solutions are painful and we have to act.
His co-chairman, Alan Simpson, then weighed in with an assertion that it would happen in less than two years. Meanwhile, actual investors seemed not at all worried: interest rates on long-term U.S. bonds were low by historical standards as Bowles and Simpson spoke, and proceeded to fall to record lows over the course of 2011.
Three other points are worth mentioning. First, in early 2011 alarmists had a favorite excuse for the apparent contradiction between their dire warnings of imminent catastrophe and the persistence of low interest rates: the Federal Reserve, they claimed, was keeping rates artificially low by buying debt under its program of “quantitative easing.” Rates would spike, they said, when that program ended in June. They didn’t.
Second, the preachers of imminent debt crisis claimed vindication in August 2011, when Standard & Poor’s, the rating agency, downgraded the U.S. government, taking away its AAA status. There were many pronouncements to the effect that “the market has spoken.” But it wasn’t the market that had spoken; it was just a rating agency—an agency that, like its peers, had given AAA ratings to many financial instruments that eventually turned into toxic waste. And the actual market’s reaction to the S&P downgrade was ... nothing. If anything, U.S. borrowing costs went down. This came as no surprise to those economists who had studied Japan’s experience: both S&P and its competitor Moody’s downgraded Japan in 2002, at a time when the Japanese economy’s situation resembled that of the United States in 2011, and nothing at all happened.
Finally, even if one took warnings about a looming debt crisis seriously, it was far from clear that immediate fiscal austerity—spending cuts and tax hikes when the economy was already deeply depressed—would help ward that crisis off. It’s one thing to cut spending or raise taxes when the economy is fairly close to full employment, and the central bank is raising rates to head off the risk of inflation. In that situation, spending cuts need not depress the economy, because the central bank can offset their depressing effect by cutting, or at least not raising, interest rates. If the economy is deeply depressed, however, and interest rates are already near zero, spending cuts can’t be offset. So they depress the economy further—and this reduces revenues, wiping out at least part of the attempted deficit reduction.
So even if you were worried about a potential loss of confidence, or at any rate worried about the long-term budget picture, economic logic would seem to suggest that austerity should wait—that there should be plans for longer-term cuts in spending and tax hikes, but that these cuts and hikes should not take effect until the economy was stronger.
But the Austerians rejected that logic, insisting that immediate cuts were necessary to restore confidence—and that restored confidence would make those cuts expansionary, not contractionary. This, then, brings us to a second strand of argument: the debate over the output and employment effects of austerity in a depressed economy.
The Confidence Fairy
I opened this essay with remarks by Jean-Claude Trichet, the president of the European Central Bank until the fall of 2011, that encapsulate the remarkably optimistic—and remarkably foolish—doctrine that swept the corridors of power in 2010. This doctrine accepted the idea that the direct effect of slashing government spending is to reduce demand, which would, other things being equal, lead to an economic downturn and higher unemployment. But “confidence,” people like Trichet insisted, would more than make up for this direct effect.
Early on, I took to calling this doctrine belief in the “confidence fairy,” a coinage that seems to have stuck. But what was this all about? Is it possible that cutting government spending can actually increase demand? Yes, it is. In fact, there are a couple of channels through which spending cuts could in principle lead to higher demand: by reducing interest rates and/or by leading people to expect lower future taxes.
Here’s how the interest-rate channel would work: investors, impressed by a government’s effort to reduce its budget deficit, would revise down their expectations about future government borrowing and hence about the future level of interest rates. Because long-term interest rates today reflect expectations about future rates, this expectation of lower future borrowing could lead to lower rates right away. And these lower rates could lead to higher investment spending right away.
Alternatively, austerity now might impress consumers: they could look at the government’s enthusiasm for cutting and conclude that future taxes wouldn’t be as high as they had been expecting. And their belief in a lower tax burden would make them feel richer and spend more, once again right away.
The question, then, wasn’t whether it was possible for austerity to actually expand the economy through these channels; it was whether it was at all plausible to believe that favorable effects through either the interest rate or the expected tax channel would offset the direct depressing effect of lower government spending, particularly under current conditions.
To me, and to many other economists, the answer seemed clear: expansionary austerity was highly implausible in general, and especially given the state of the world as it was in 2010 and remains two years later. To repeat, the key point is that to justify statements like that made by Jean-Claude Trichet to La Repubblica, it’s not enough for these confidence-related effects to exist; they have to be strong enough to more than offset the direct, depressing effects of austerity right now. That was hard to imagine for the interest-rate channel, given that rates were already very low at the beginning of 2010 (and are even lower at the time of this writing). As for the effects via expected future taxes, how many people do you know who decide how much they can afford to spend this year by trying to estimate what current fiscal decisions will mean for their taxes five or 10 years in the future?
The Work of Depressions
The Austerian desire to slash government spending and reduce deficits even in the face of a depressed economy may be wrongheaded; indeed, my view is that it’s deeply destructive. Still, it’s not too hard to understand, since sustained deficits can be a real problem. The urge to raise interest rates is harder to understand. In fact, I was quite shocked when the OECD called for rate hikes in May 2010, and it still seems to me to be a remarkable and strange call.
Why raise rates when the economy is deeply depressed and there seems to be little risk of inflation? The explanations keep shifting.
Back in 2010, when the OECD called for big rate increases, it did an odd thing: it contradicted its own economic forecast. That forecast, based on its models, showed low inflation and high unemployment for years to come. But financial markets, which were more optimistic at the time (they changed their mind later), were implicitly predicting some rise in inflation. The predicted inflation rates were still low by historical standards, but the OECD seized on the rise in predicted inflation to justify a call for tighter money.
By spring 2011, a spike in commodity prices had led to a rise in actual inflation, and the European Central Bank cited that rise as a reason to raise interest rates. That may sound reasonable, except for two things. First, it was quite obvious in the data that this was a temporary event driven by events outside of Europe, that there had been little change in underlying inflation, and that the rise in headline inflation was likely to reverse itself in the near future, as indeed it did. Second, the ECB famously overreacted to a temporary, commodity-driven bump in inflation back in 2008, raising interest rates just as the world economy was plunging into recession. Surely it wouldn’t make exactly the same mistake just a few years later? But it did.
Why did the ECB act with such wrongheaded determination? The answer, I suspect, is that in the world of finance there was a general dislike of low interest rates that had nothing to do with inflation fears; inflation fears were invoked largely to support this preexisting desire to see interest rates rise.
Why would anyone want to raise rates despite high unemployment and low inflation? Well, there were a few attempts to provide a rationale, but they were confusing at best.
For example, Raghuram Rajan of the University of Chicago published an article in the Financial Times under the headline “Bernanke Must End Era of Ultra-low Rates.” In it he warned that low rates might lead to “risk-taking and asset price inflation”—an odd thing to be worried about, given the clear and present problem of mass unemployment. But he also wrongly argued that unemployment was not of a kind that could be solved with higher demand.
The bottom line is that the current jobless recovery suggests the US has to undertake deep structural reforms to improve its supply side. The quality of its financial sector, its physical infrastructure, as well as its human capital, all need serious, and politically difficult, upgrades. If this is our goal, it is unwise to try to revive the patterns of demand before the recession, following the same monetary policies that led to disaster.
The idea that interest rates low enough to promote full employment would somehow be an obstacle to economic adjustment seems odd, but it also sounded familiar to those of us who had looked at the flailing of economists trying to come to grips with the Great Depression. In particular, Rajan’s discussion closely echoed an infamous passage from Joseph Schumpeter, in which he warned against any remedial policies that might prevent the “work of depressions” from being achieved:
In all cases, not only in the two which we have analyzed, recovery came of itself. There is certainly this much of truth in the talk about the recuperative powers of our industrial system. But this is not all: our analysis leads us to believe that recovery is sound only if it does come of itself. For any revival that is merely due to artificial stimulus leaves part of the work of depressions undone and adds, to an undigested remnant of maladjustment, new maladjustment of its own that has to be liquidated in turn, thus threatening business with another crisis ahead. Particularly, our story provides a presumption against remedial measures which work through money and credit. For the trouble is fundamentally not with money and credit, and policies of this class are particularly apt to keep up, and add to, maladjustment, and to produce additional trouble in the future.
When I studied economics, claims like Schumpeter’s were described as characteristic of the “liquidationist” school, which basically asserted that the suffering that takes place in a depression is good and natural, and that nothing should be done to alleviate it. And liquidationism, we were taught, had been decisively refuted by events. Never mind Keynes; Milton Friedman had crusaded against this kind of thinking.
Yet in 2010 liquidationist arguments no different from those of Schumpeter (or Hayek) suddenly regained prominence. Rajan’s writings provide the most explicit statement of the new liquidationism, but I have heard similar arguments from many financial officials. No new evidence or careful reasoning was presented to explain why this doctrine should rise from the dead. Why the sudden appeal?
At this point, I think we have to turn to the question of motivations. Why has Austerian doctrine been so appealing to Very Serious People?
Early in his masterwork, The General Theory of Employment, Interest, and Money, John Maynard Keynes speculated about why the belief that economies could never suffer from inadequate demand, and that it was therefore wrong for governments ever to seek to increase demand—what he referred to as “Ricardian” economics, after the early-19th-century economist David Ricardo—had dominated respectable opinion for so long. His musings are as sharp and forceful now as when they were written:
The completeness of the Ricardian victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.
Indeed; the part about how the economic doctrine that demands austerity also rationalizes social injustice and cruelty more broadly, and how this recommends it to authority, rings especially true.
We might add an insight from another 20th-century economist, Michal Kalecki, who wrote a penetrating 1943 essay on the importance to business leaders of the appeal to “confidence.” As long as there are no routes back to full employment except that of somehow restoring business confidence, he pointed out, business lobbies in effect have veto power over government actions: propose doing anything they dislike, such as raising taxes or enhancing workers’ bargaining power, and they can issue dire warnings that this will reduce confidence and plunge the nation into depression. But let monetary and fiscal policy be deployed to fight unemployment, and suddenly business confidence becomes less necessary, and the need to cater to capitalists’ concerns is much reduced.
Let me add yet another line of explanation. If you look at what Austerians want—fiscal policy that focuses on deficits rather than on job creation, monetary policy that obsessively fights even the hint of inflation and raises interest rates even in the face of mass unemployment—all of it in effect serves the interests of creditors, of those who lend as opposed to those who borrow and/or work for a living. Lenders want governments to make honoring their debts the highest priority, and they oppose any action on the monetary side that either deprives bankers of returns by keeping rates low or erodes the value of claims through inflation.
Finally, there’s the continuing urge to make the economic crisis a morality play, a tale in which a depression is the necessary consequence of prior sins and must not be alleviated. Deficit spending and low interest rates just seem wrong to many people, perhaps especially to central bankers and other financial officials, whose sense of self-worth is bound up with the idea of being the grown-ups who say no.
The trouble is that in the current situation, insisting on perpetuating suffering isn’t the grown-up, mature thing to do. It’s both childish (judging policy by how it feels, not what it does) and destructive.
Reprinted from End This Depression Now! by Paul Krugman. Copyright © 2012 by Paul Krugman. With the permission of the publisher, W.W. Norton & Co.