The following article is quite possibly one of the best explanations of Keynesian vs classical economics I’ve ever read.
Why Debunking The Austerity Paper Won’t Kill Austerity — And What Actually Could
By Ruy Teixeira, Guest Blogger on ThinkProgress
Yesterday on TP Ideas Zack Beauchamp covered the release of new research showing that a key paper used to justify austerity in a time of economic crisis is so empirically flawed as to be rendered useless as a guide to policy. That paper, by Carmen Reinhart and Kenneth Rogoff, purported to show that countries that cross a 90 percent debt to GDP ratio sustain a big hit to economic growth. Turns out the data were analyzed incorrectly and the alleged relationship does not exist. Out the window goes one of the main intellectual justifications for the current hysteria about bringing down the national debt.
Zack focused on exposing the foibles of journalists who take as gospel studies like Reinhart-Rogoff based on methodology they don’t understand and data they know nothing about. That is indeed a problem and his post does a service by concentrating on it.
I’ll take a different tack here and focus on the idea of austerity. The theory that slashing deficits can revive slumping economies has been a dominant economic theory since the late 18th century and the rise of classical economics. But its claim to be a policy elixir has never been grounded in strong empirical evidence. That is why, despite this serious hit to the academic case for austerity, we should not expect austerity’s vice grip on policy to weaken very soon or very easily.
The theory behind the austerity idea is as follows. Classical economists believed that the overall economy tended toward a full employment equilibrium where all resources were productively employed. While this equilibrium could be temporarily disturbed by wage and price rigidities, misguided monetary policies and other things that distorted the market, the economy would quickly return to a full employment equilibrium once these distortions were eased. The role for government in responding to recession was therefore to do nothing, letting prices and wages fall to their natural levels or, even better, to do less, since government spending simply crowds out the private spending necessary to get the economy back into equilibrium. That is why, prior to Keynes, the orthodox budgetary approach to recessions was to cut, not increase, government spending so as to create the proper business environment and hasten the arrival of a new equilibrium.
Keynes didn’t buy all this, seeing it as inconsistent with the behavior of real world economies, especially the ones he was observing at the time. In his view, the normal state of capitalist economies was not full employment because total demand in the economy could easily fall short of total supply, creating equilibria with high levels of unemployment — the reverse of the classical precept (Say’s Law) that supply creates its own demand. A shortfall of demand could arise, for example, when consumers and investors start to prefer holding cash to spending and investing.
Another reason for a shortfall of demand, according to Keynes, was the instability of investment, the non-consumption part of demand. Investment was unstable because businesses’ expectations fluctuated depending on their assessments of future possibilities for profit which, in turn, were intrinsically uncertain. Classical economists, in contrast, believed businesses precisely understood their statistical probabilities of success and invested accordingly. Keynes rejected this view and insisted that uncertainty was pervasive.
Given shortfalls in demand, only the “animal spirits” of capitalists — confidence and the lack thereof — allowed capitalists to forge ahead (or not) in poor business conditions and were therefore a huge influence on their investment decisions. And if capitalists lacked confidence in their ability to make profits they would seek to reduce costs by laying off workers, thereby reducing demand in the economy and further eroding business confidence. The process of lowering output, employment and confidence would continue until a new equilibrium was reached — an “under-employment equilibrium” rather than the full employment equilibrium of the classical economists.
Keynes argued that because these equilibria were a natural and recurring tendency of capitalism, there was no natural adjustment process that would lead a market economy back to full employment. Nor could monetary policy mechanisms, like lowering interest rates or increasing the money supply, always be relied upon to jolt businesses back into action and increase employment. Instead, government must frequently step in to make up shortfalls in demand through fiscal policy — in other words, through government spending.
This was a powerful idea and powerfully backed up as well by the empirical record. Its influence spread rapidly. As Mark Blaug, perhaps the leading historian of economic thought, remarks “[N]ever before had the economics profession been won over so rapidly and so massively to a new economic theory, nor has it since. Within the space of about a decade, 1936-46, the vast majority of economists in the Western world were converted to the Keynesian way of thinking.” This “Keynesian consensus” underpinned economic policy-making until the 1970s.
But the austerity idea never really went away as Mark Blyth shows in his excellent new book Austerity: The History of a Dangerous Idea (soon to be the subject of a TP Ideas book symposium!). It came roaring back in the 1970’s when Keynesian economics appeared to falter, dominated economic thinking for the decades leading up to Great Financial Crisis and then, after a very brief resurgence of Keynesian economics in 2008-2010, is back again (see this great paper by Henry Farrell and John Quiggin for a blow by blow of how this happened), suffusing our economic conversation with the “expansionary fiscal austerity” chimera — the idea that the way out of an economic slump is to cut spending which will lead to rising business confidence, more investment and strong growth.
It ain’t working and, truth be told, it’s never worked. As Larry Summers put it a review of Blyth’s book in the Financial Times:
In many cases, the idea of expansionary fiscal contraction is not just oxymoronic but plain moronic as well. Blyth’s views on the current situation are also cogent. As he argues, the accumulation of debt by the public sector throughout the industrial world has far more to do with the direct and indirect effects of financial distress than it does with government profligacy. Indeed, countries such as Ireland and Spain had more favourable records of government debt accumulation than even Germany before the crisis.
The author makes a strong case that at times such as the present, austerity can actually be self-defeating in that its adverse effects on growth exceed any direct benefits from reduced borrowing. This is nowhere better illustrated than in the UK, where extraordinary austerity has been coupled with a rapid rise in the debt-to-GDP ratio.
So how can we defeat a powerful idea like austerity given its remarkable ability to persist across time in spite of abundant empirical evidence that it just doesn’t work? The only answer is another powerful idea; just undermining the austerity idea empirically isn’t going to do the job.
Indeed, the entire history of austerity is a testament to the amazing power of ideas. It is a lesson that progressives, focused as we tend to be on the pragmatic, day-to-day struggle, should take to heart.