The Myth of Austerity

An anti-austerity protest in Italy

"The Myth of Austerity" is the article I wrote for my Freshmen Research Paper in the 2013-2014 academic year, whilst I was in the ninth grade. 

Below is the full version of the paper, including citations. 

Many thanks to my Freshmen Humanities teacher, Dr. Marty Schmidt, for all his support regarding this paper. Enjoy!

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Yashvardhan M. Bardoloi

Dr. Marty Schmidt

Humanities I in Action

18 February 2014

The Myth of Austerity

         In September 2008, investment bank Lehman Brothers unexpectedly declared bankruptcy (“Case Study”). Its failure sent shockwaves across a globalized economy and “almost brought down the. . .financial system” (“Crash Course”). Fragile “credit markets seized up,” bringing business to a halt (Ferguson 271). The United States entered a two year recession (Business Cycle), and unemployment reached levels unseen since the Great Depression (Krugman, “End This” 4).

         Amidst this carnage emerged two radically divergent schools of thought. There were those favoring austerity: government spending cuts to alleviate burgeoning debt (“Austerity”).  Then there were supporters of the late economist John Maynard Keynes, notably Nobel laureate Paul Krugman, who asserted that the “boom, not the slump, is the right time for austerity” (Keynes, “The Collected Writings” 284). He argued that government spending is necessary during slowdowns (Blinder).  In consideration of these views, this paper argues that during economic crises, governments should avoid harmful austerity and instead bolster the economy through stimulus measures. This paper will begin by investigating the cause of economic crises. It will then examine inadequate responses before moving to the advantages of stimulus. Finally, it will present and then deconstruct the fallacious premises upon which stimulus is opposed.

What Causes Economic Crises?

“Irrational Exuberance”

At a speech delivered during the dot-com bubble of the 1990s, former Federal Reserve Chairman Alan Greenspan spoke of “irrational exuberance” in the market (Greenspan). He was referring to “unsustainable investor enthusiasm that drives asset prices up to levels that aren't supported by fundamentals” (“Irrational”). It is this “irrational exuberance” that feeds asset bubbles, which upon bursting, as they always do, lead to economic crises (“5 steps”). The current financial crisis was caused by irrational exuberance in real estate prices, which, after rising astronomically, plummeted with as much force (Crotty). The Great Depression was similarly preceded by a rapid expansion of credit that led to an unsustainable stock market rally and ultimately panic selling (Romer).

A Lack of Demand

To remedy economic maladies, one must first determine their cause. Here, too, economists cannot reach consensus. Classical economists reckon the problem lies in deficient supply, claiming that “products are paid for with products.” (Say 153) This statement is often reworded as “supply creates its own demand” (“Jean”). Keynesians, on the other hand, contend that the demand side is the cause for concern (“Sovereign Doubts”). They theorize that too little spending causes lessened demand in an economy, thereby depressing incomes, as “your spending is my income, and my spending is your income” (Krugman, “The Austerity Agenda”). Studies conducted in the aftermath of the 2007 crisis suggest that the Keynesian approach, while perhaps counterintuitive, is the correct angle through which to view economic crises.

Examining an Inadequate Response

Now that it is known what causes economic crises, it is necessary to analyze inadequate responses, namely those which involve austerity measures or insufficient stimulus.

The Great Depression

At the onset of the Great Depression Keynes famously wrote that the economy had “magneto [alternator] trouble” (Keynes, “Essays”). What he meant was that the “economic engine was as powerful as ever” but a crucial part needed a small fix; in other words, government intervention through stimulus was required (Krugman, “Magneto”). The stock market crash of October 1929 was the particular trouble, but it didn’t warrant the ten years of Depression that ensued (“Depression”). Rather, “[President] Hoover’s fiscal policy accelerated the decline” (Smiley), because despite the exhortations of prominent economists like Keynes and Fisher, Hoover “was adamant that economic stimulus was wrongheaded” and that “drastically cutting spending” was what the economy needed (Barlett). His misguided austerity measures led to the protracted contraction during which unemployment rose as high as 33% (“Great Depression”).

The American Great Recession

Fast forward eighty years to the American Great Recession and another interesting case study is presented. Hoping to avoid the errors of the Great Depression, the American government embarked on an unprecedented and largely effective stimulus program, the $787 billion American Recovery and Reinvestment Act (“Estimated Impact”). Due to the stimulus, unemployment peaked at a relatively low 10 percent (“Recession”). But much to the laments of economists like Krugman and Joseph Stiglitz, stimulus was cut back “too soon” whilst the economy was still “not back to normal” (Stiglitz, “World”). The result of this early reduction was that although Fed Chairman Bernanke claimed he saw “green shoots” in the economy in 2009 (Bernanke), the “promised growth never came” (Krugman, “End This” 6). Clearly, some stimulus is better than none, but stimulus should also be sustained until the economy can stand firmly on its own feet.

The Greek Crisis

Across the Atlantic, the European crisis, exemplified by Greece, was dealt with in quite another fashion. Under strict bailout terms imposed by the International Monetary Fund in 2010, the Greek government acquiesced in large public spending cuts—up to 40% in some sectors—and “budget-balancing” (Weisbrot). These cuts were ostensibly to build “confidence [and therefore]. . .economic recovery” (Trichet). What transpired instead was an economic contraction of 17% versus the expected 5.5%, and Great Depression-rivaling unemployment rates of 27% (Elliot, Inman and Smith). Stiglitz later weighed in on the issue, pointing out that “there is no instance of a large economy getting to growth through austerity” (Stiglitz, “Bloomberg”). Further research was also conducted showing that in 107 cases spending cuts worked in only one (Jayadev and Konczal). The IMF was forced to apologize for its faulty recommendations, and subsequently acknowledged that austerity led to a “lost year” in Greece (Schneider).

The Compelling Case for Stimulus

A response incommensurate to the issue at hand is unfavorable, as was discovered in the previous section. But what is a suitable response? This paper will now expound upon the theories and methods behind stimulus and why it works.

Asset Purchases and Forward Guidance

Central bankers have a wide variety of tools in their financial arsenals. As the crisis unfolded, two unconventional policy tools came of particular use: asset purchases and forward guidance (“Q & A”). Asset purchases, widely known as Quantitative Easing, are when the central bank prints money to buy assets, “[mainly] government bonds, [but also] equities, houses, [and] corporate bonds” (“Quantitative Easing”). These purchases increase demand for government bonds, therefore decreasing the interest rates charged upon them as well as on general money-lending by banks (Amadeo). Lesser borrowing costs also increase expectations of future inflation, and when combined these effects “prod businesses and households to invest” before their money devalues (“Controlling Interest”). This increased investment and demand resolves the previously covered lack-of-demand issue that causes economic crises.

Forward guidance also has the same ultimate goal of increasing aggregate demand in an economy, but it works in a slightly different manner by trying to calm the market (“Forward Guidance”). The U.S. Federal Reserve, for example, stated to the press that it would not raise interest rates as long as unemployment “remain[ed] above 6.5%” and inflation is “projected to be no more than. . .the Committee's [2.5%] longer-run goal” (“FRB”). By giving the market a degree of certainty about interest rates, the Fed boosts confidence and spending, thereby lifting aggregate demand in the economy and subsequently the incomes of people (“The Economist Explains”).

The Multiplier Effect

The multiplier effect, first formulated in 1931 by Keynes’ student Richard Kahn, explains how the effects of government spending are “multiplied” by the economy, as the “injection of extra income leads to more spending, which creates more income” (“Multiplier Effect”). When the economy is at maximum potential, the fiscal multiplier is zero. “Since there are no spare resources. . .government demand would just replace spending elsewhere.” But when an economy is depressed, the initial stimulus can “trigger a cascade of expenditure among consumers and businesses” and increase incomes all around (“Much Ado”). This is the essence of the multiplier effect; a small amount of stimulus spending by the government can cause a significant increase in economic output.

Flawed Arguments Against Stimulus

Regardless of the logic behind an argument, there will always be those who refute it. This economic debate is no different. A litany of counterarguments against stimulus have been proposed. This paper will present, and then highlight the flaws of, the most popular amongst them.

What About Government Debt and Inflation?

Stimulus is based on government spending, so it makes sense that many who oppose stimulus argue that it increases government debt and risks creating hyperinflation (Randazzo). One oft-cited argument comes from a research paper written by two Harvard professors, Carmen Reinhart and Kenneth Rogoff. They found “median growth rates for countries with public debt over roughly 90 percent of GDP are about one percent lower than otherwise,” an incredibly significant sum in the realm of macroeconomics (Reinhart and Rogoff). Subsequently though, when Reinhart and Rogoff’s work was reviewed by economists at University of Massachusetts, it was found that “coding errors and selective exclusion of available data” meant that Reinhart and Rogoff’s results were markedly inaccurate, and that even when debt-to-GDP was above 90%, economies grew at 2.2% (Herndon, Ash and Pollin). Another common argument is that the Fed’s money printing Quantitative Easing measures will lead to damagingly high levels of inflation (Melloan). In reality though, inflation across U.S. and other developed economies is at around 1%, an amount that is “dangerously low” because it “discourages borrowing and spending” and “makes it harder to pay down debt” (Krugman, “Not Enough”).

Is Stimulus Crowding Out Private Investment?

Others argue that stimulus only serves to “crowd out” private investment, implying that stimulus has no multiplier effect and comes “at the expense of private spending” because financing the stimulus purportedly requires either higher tax rates or higher general interest rates caused by government borrowing (Reuss). Referring to the section on the multiplier effect, one can see that this argument is fallacious. When an economy is operating below full capacity, government spending serves not to crowd out, but to “crowd in” by picking up slack and spurring a recovery (Krugman, “Crowding”). As Keynes semi-jokingly wrote, when resources are underemployed in an economy, it would be helpful even if the government “were to fill old bottles with banknotes, bury them at suitable depths” and let private enterprise dig it back up, thereby leading to “no more unemployment” and raising “real income [in] the community” (Keynes, “Book III”). What he intended to demonstrate was that a small push for stimulus by the government, however useless it may seem, serves to induce private investment. Crowding in, not crowding out, is the result of stimulus.

Conclusion

Winston Churchill famously remarked, “Those who do not learn from history are doomed to repeat it” (Churchill). As global economies tentatively emerge from the throes of recession, Churchill’s words of wisdom are worth taking to heart. As evidenced by the Great Depression, Great Recession, and Greek crisis, austerity in the face of crisis only serves to aggravate underlying issues. Furthermore, this paper has established that stimulus is a logical and tenable method by which to bolster an economy. These lessons derived from the current crisis and crises of the past are vital to remember if future crises are to be effectively managed.

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