Austerity economics is now completely discredited. It’s time for a Keynesian alternative.

Since around 2009 a consensus has been forming as a response to the economic and “deficit crisis” amongst the leaderships of most of Europe and the USA, as well as most of the media.  The Tea Party in the USA, David Cameron’s “compassionate Conservatives” and the establishment parties and media across Europe are all saying the same thing in response. Government  is the problem. Government spending is too high, Government debts are too high and Government deficits are too high. The solution, to save the economy from the wrath of the bond markets, and to save to Eurozone from catastrophe, must be austerity: dramatic cut backs in government are needed urgently, to eradicate or drastically reduce government deficits within a few years.

In this post, I want to argue that the consensus view in favour of austerity is wrong. The savage cuts in expenditure being implemented across the West are not only causing misery and the destruction of public services. They have ruined the chances for a swift recovery out of the recession and are pushing Western countries into a long, severe depression. The entire West is now almost certain to enter a Japan-style lost decade, or worse. The effects in developing countries like China, India and Indonesia will be worse still, with growth slowing as their key export markets shrink. This is the nature of our globalised economy: decisions made by millionaires in board rooms on Wall Street can lead to devastation for people working in factories for a few dollars a day, on the other side of the world.

First I will outline Keynes’ Theories of the economy and why I think they are still highly relevant, and in particular how they saved the world from total economic meltdown. Second I will outline the origins of the idea of austerity, the current consensus view. Then I want to illustrate the scale of austerity taking place and the effects it is having. In particular, I aim to show that austerity has not been expansionary, that it is damaging the global economy. I will then provide evidence that austerity is making it harder for governments to cut the deficit. Finally, I will advocate a Keynesian-inspired alternative to the austerity programs.

Table of Contents

Keynes’ Brilliant Theories

John Maynard Keynes indisputably stands as one of the greatest economists of all time. In 1936 he published his General Theory of Employment, Interest and Money, which brought about a revolution in economic thinking. Keynes realised that a recession occurs due to reasonably rational actions by thousands of individuals, and yet its overall impact is totally destructive to all of these individuals. If some event causes households or businesses to hold back some of their money, to spend a little less, the rational response of others is to do the same. If less is spent, then potential income or business is taken away from others, businesses will lose profit and be forced to produce less and spend less, in turn forcing others to spend less money also. Unemployment will increase as workers are laid off, wages will fall or stagnate and demand will shrink. The result is a vicious cycle, only ceasing when incomes are so shrunken that the demand for money again equals the available supply. The collective consequence of all of these thousands of rational behaviours leads to the supreme irrationality and waste of a recession of factories lying empty, whilst workers are unemployed, of goods not being produced, demand shrinking as people hoard their money, and the economy’s capacity is wasted.

Keynes also realised that there was an obvious solution to this problem. If a recession is caused by the rational behaviour of thousands of individuals, leading to disastrous results, then through collective, assertive action, it can be overcome. Government and central banks give the ideal mechanism for this collective action: through an expansive monetary policy, by increasing the supply of money, or by fiscal expansion, increasing spending to stimulate growth, government can provide the driving force to bring an economy back into growth, and to avoid recession altogether. Government monetary and fiscal policy should be counter-cyclic: during times of recession it should be expansionary, when growth is strong, government should pull back a little, to stop the economy overheating. As Robert Heilbroner puts it in The Worldly Philosophers: The Lives, Times and Ideas of the Great Economic Thinkers,

The General Theory pointed out that the catastrophe facing America and, indeed, the whole Western world, was only the consequences of a lack of sufficient investment on the part of business. And so the remedy was perfectly logical: if business was not able to expand, the government must take up the slack.

Despite Monetarist objections, Keynesian  economics has been vindicated time after time again. The most famous example is rearmament and the Second World War, bringing the USA and other countries out of the Great Depression of the 1930s. Nobel Prize winning economist Paul Krugman provides another example in his (highly recommended) book Peddling Prosperity: Economic Sense and Nonsense in the Age of Diminished Expectations:

A good example of the Keynesian prescription in practice came in the aftermath of the stock market crash of 1987. During one terrifying week in October 1987, stock prices abruptly plunged, falling 23 percent in five days- slightly worse than the fall following Black Thursday in 1929. The crash was both a reflection of declining investor confidence and a potential cause of a further fall in confidence, and in the face of a passive Federal Reserve this loss of confidence could quite easily have led to a severe economic slump. But the Federal Reserve was not passive. it aggressively expanded the money supply, to such good effect that there was no slump at all: output actually rose faster in the year after the crash than in the year before. (And the stock market itself recovered and soared to new heights.)

There are plenty of other examples of Keynes’ ideas being implemented successfully, but for our purposes the most relevant is the so-called “Keynesian resurgence” of 2008, in response to the financial crisis, and before the deficit-obsessed austerity consensus developed.

Keynesian Stimulus Prevented Global Economic Meltdown

It is a well-known aphorism that there are no atheists in foxholes, and no ideologues in financial crises. In response to the collapse of the banking system in 2007 and 2008, a resurgence of Keynesian thinking quickly emerged among policy makers, politicians and commentators, as the only hope for escaping a financial crisis even more severe than the Great Depression. This led to the largest Keynesian stimulus in history. There is now a wealth of evidence to show that this averted what almost became a complete meltdown of the global economy. It stands as a supreme testament to Keynes’ ideas.

As early as January 2008, IMF managing director Dominique Strauss-Kahn began calling for a global fiscal stimulus. Vince Cable, among others, led calls for the UK government to nationalise Northern Rock in February, and the Labour Government eventually responded. Gordon Brown built support for fiscal stimulus among global leaders at September’s UN General Assembly, even securing agreement from US President George Bush, supposedly a supporter of Monetarist ideas.

In his autobiography, Back from the Brink: 1,000 Days at Number 11 , then UK chancellor Alistair Diary writes how his thinking was “influenced hugely by Keynes’s thinking, indeed, as were most other governments”. In late 2008 and 2009 fiscal stimulus packages were widely launched across the world, with packages in G20 countries averaging at about 2% of GDP, with a ratio of public spending to tax cuts of about 2:1. In the USA, the TARP program originally authorized expenditures of $700 billion and was expected to cost the U.S. taxpayers as much as $300 billion, although it was later reduced to $431 billion. Further stimulus came in the form of the Federal Reserve’s Maiden Lane Transactions and the Federal takeover of Fannie Mae and Freddie Mac. In February 2009, Barack Obama was able to pass a further stimulus package of around $787 billion through Congress. In total, over the past few years, the US government stimulus packages have totalled $700 billion and $917 billion plus a bank bailout of $787 billion. In addition, the Fed has pumped about $1.5 trillion into the economy. Even China launched a fiscal stimulus package, worth $586 billion when the Shanghai Index began to plummet after the collapse of Lehman Brothers. In November 2008, the a European stimulus plan amounting to €200 billion was proposed. In the UK alone, this amounted to around £30billion, involving emergency measures, aid to the real estate sector, a VAT reduction from 17.5 to 15%, and a building program in school, hospitals, green energy designed to create 100,000 jobs. This was in addition to a £500 billion rescue package by the UK government itself, including £50 billion in direct state investment to the banks themselves.

Meanwhile, a number of commentators, academics and economists began to abandon free market monetarism in favour of Keynesian economics. Richard Posner and Martin Feldstein, had previously been associated with anti-Keynesian thinking, yet by 2009 publically converted to Keynesian economics. In March 2008, leading free-market journalist Martin Wolf, chief economics commentator at the Financial Times, announced the death of the dream of global free-market capitalism, and quoted Josef Ackermann, chief executive of Deutsche Bank, as saying “I no longer believe in the market’s self-healing power.” Economist Robert Shiller began advocating robust government intervention to tackle the financial crisis, citing Keynes. Macro economist James K. Galbraith used the 25th Annual Milton Friedman Distinguished Lecture to launch a sweeping attack against the consensus for Monetarist economics and argued that Keynesian economics were far more relevant for tackling the emerging crises.

The evidence seems to point overwhelmingly towards these government interventions being a success. Total economic meltdown was avoided, against the odds. In February 2009 the Financial Times reported that both government officials and private investors were seeing signs of recovery, such as rises in commodity prices, a 13% rise in the Chinese stock market over a period of 10 days, and a big increase in lending – reflecting the government’s success in using state-owned banks to inject liquidity into the real economy. The leak of the planned stimulus had been enough to halt the decline in October 2008. In mid-2009, Paul Krugman wrote, in an important article:

All in all, then, the government has played a crucial stabilizing role in this economic crisis. Ronald Reagan was wrong: sometimes the private sector is the problem, and government is the solution.

Meanwhile, economics professor Arvind Subramanian argued that the global stimulus successfully prevented a global slide into depression, with the fiscal policy stimulus measures taking their “cue from Keynes”. A July 2010 paperby Moody’s chief economist Mark Zandl and former Federal Reserve vice chairman Alan Blinder predicted that the US recession would have been far worse without the government intervention. They calculate that in the absence of both a monetary and fiscal response, unemployment would have peaked at about 16.5% instead of about 10%, the peak to trough GDP decline would have been about 12% instead of 4%.

Such a situation would have threatened the entire global economy, as almost every major bank teetered towards collapse. Only the huge size and scale of stimulus program was able to avert such a crisis. Keynes’ ideas were once again vindicated, in the most dramatic possible way.

The Ideology of Austerity

So how did the global consensus among politicians shift from a Keynesian resurgence to the ideology of austerity so quickly? Right wing monetarists in the media, think tanks and politics had been waiting for some time for an opportunity to launch a sweeping supply-side revolution, permanently altering the economy and society of the Western world. The economic crisis, or rather the amassing debt and deficits caused by the crisis provided just such an opportunity. It’s worth discussing the origins of this ideology and how it came to dominate the politics of so many countries so quickly. Many of the arguments put forward in defence of austerity turn out to be either dangerous or hollow.

By 2009 that the Monetarist right had began to fight back. By definition, the largest Keynesian stimulus of all time had a price, in the form of huge government expenditure. Moreover, despite being large enough to prevent outright economic collapse, it was insufficient to prevent most Western developed countries falling into a severe depression. The combined effect of these was a huge increase in the government debt and deficits in most countries. Before, the stimulus had even had time to work, Conservatives in Europe and the USA were arguing that governments needed to scale back immediately and drastically. To quote Will Hutton:

A consensus stretching from US Republicans through to Angela Merkel’s Christian Democrats via George Osborne’s Treasury continues to claim that the state is the source of economic bad. The state threatens enterprise, invites damaging taxation, and is the root cause of spreading inflation. The state must balance the books just as the private sector must

One visibly manifest form of this was the rise of the “Tea Party” movement in the United States, funded among others by the billionaire Koch family, but in Europe much the same arguments were being made. George Osborne, then Conservative Shadow Chancellor in the UK argued that:

Even a modest dose of Keynesian spending – say increasing it by an additional 1% of GDP – means that in the end taxes will have to rise by the equivalent of almost 4p on income tax. That’s not just a tax bombshell, it’s a cruise missile aimed at the heart of a recovery.

The Neoconservative right, influenced by the success of shock-therapy in drastically and suddenly transforming a country, had long been waiting for just such a crisis. By transforming, in the public mind, one of the greatest crises of free market capitalism into a crisis in big government, a golden opportunity was created to justify the implementation of wide-ranging policies that would be unacceptable under normal circumstances. Indeed, the economic crisis has been used as a justification for the creation of internal markets in education and healthcare, and a tripling of University tuition fees, none of which will contribute to any significant improvement in public finances within this Parliament.

Intellectually, justification was given by supply side economists, advocating expansionary austerity, based on belief that private sector investment must always be more efficient than state investment, and so any state-spending must be “crowding out” the private sector. In principle, they argued, austerity could be expansionary if households and businesses believe that cuts now will lead to tax reductions in the future, and alter their spending habits accordingly.  In particular, they used the examples of Sweden and Canada from the 1990s, who had opted for structural adjustment and spending cuts, experiencing good levels of growth and no increase of unemployment over the considered period. Between 1994 and 1998, Canada reduced its deficit by cutting social expenditure, whilst simultaneously reducing unemployment by 4%, and high levels of GDP growth of above 4%. Sweden began a similar program of fiscal consolidation in 1994, reducing unemployment by 3% and reasonably high growth in GDP. The right argued these could give a model of how austerity could be accompanied by a successful economy: it was the Laffer curve in action.

But a more careful analysis of the evidence reveals that neither case provides a good model for the current wide-scale austerity programs. Whilst Canada was aggressively cutting spending, the implementation of NAFTA increased exports as a proportion of Canadian GDP to 45%, and  household demand grew by 20% in its main trading partner, the USA. Meanwhile, Sweden’s main trading partners in the EU Single Market grew by 3%. In other words, these austerity programs were parasitic, dependent on economic growth taking place in these countries’ export markets, during a period in which the overall economic climate was highly favourable.

They simply don’t offer an adequate model for the current economic climate, in which almost every country is cutting expenditure at the same time.  For example, all of the UK’s main trading partners, accounting for 70% of the UK export markets are simultaneously undertaking similar austerity programs. There is no hope of one country leeching off another’s growing demand. It’s also worth pointing out that both austerity programs led to a huge increase in inequality and household indebtedness. Between 1994 and 2000, the Canadian Gini index rose by 22% and Canadian household net lending/borrowing fell from 7% of GDP to 0%, and kept on decreasing to -4% in 2007. Meanwhile, the Swedish Gini index rose by a staggering 31% between 1994 and 2000. Even under the most favourable circumstances, the so-called expansionary austerity did not benefit the poorest and lower middle classes in these model countries.

The empirical justification for the austerity program is feeble. But this is not of fundamental importance to the pro-austerity lobby. They have been looking for an opportunity to launch a monetarist revolution, inspired by the shock therapy programs across the developing world. The economic crisis provided just such an opportunity and we are now living with the consequences.

Austerity is hitting- hard

In the UK, commentators on the Conservative right are increasingly becoming “austerity deniers”, arguing that real spending cuts are not seriously taking place, or that they are minimal. Examples include Peter Hitchens, Stephen Glover, the Spectator’s Jonathon Jones and above all Fraser Nelson, who described it as “the austerity myth”. Much of the thinking behind this comes from a report from one of the world’s biggest money brokers, Tullett Prebon. Their arguments are simply incorrect, as shown in an excellent article by the IPPR. According to the Office of Budget Responsibility, in the financial year 2011/12 , central government spending rose by spending rose by 2 per cent, from £604.8 billion to £617.0 billion, entirely due to debt interest and net benefit increases due to the recession. Actual spending on public services fell by 0.5%, the first fall in real terms since 1955/6. Meanwhile, public sector employment fell by 410,000 in 2 years, reaching its lowest level since 2003. Moreover, as Nick Pearce of the IPPR states:

As importantly, these figures exclude capital spending on things like housing and public infrastructure. Public net investment (ie after asset sales) fell by 24.9 per cent between 2010/11 and 2011/12 (a cut of £9.5 billion). It is on capital spending that the axe has fallen hardest in the last year – which is why construction output has fallen, taking us back into recession in the first quarter of this year. Capital spending has the highest multiplier effect on output, which is why cutting it has a big impact during periods of recession or weak growth. That cut, by the way, was a decision of the last Labour government which the Coalition inherited – so to register this out is not to make partisan points about the current government’s fiscal stance.

Indeed, taking the rising unemployment levels (now around the 2.6million mark, extraordinarily high, given that it doesn’t include people on incapacity and disability benefits, nor does it take into account the huge increase in part-time work and unpaid internships to compensate), and debt interest into account, the UK government is making unprecedented spending cuts in public services- most departments will be making cuts of around 20% by the end of this Parliament. The UK’s austerity program has also included a rise in VAT to 20%, increased social insurance contributions, cuts in benefits, tax credits and frozen public sector wages. All of these will hit the poorest and middle the hardest. The effects of this have been well-documented by newspapers, for example here and here. The impact of austerity in other countries may be even more severe. For example,  Rajiv Shav, the administrator of the U.S. Agency for International Development testifed before a Congress sub-committesaying:

We estimate, and I believe these are very conservative estimates, that H.R. 1 would lead to 70,000 kids dying. Of that 70,000, 30,000 would come from malaria control programs that would have to be scaled back, specifically. The other 40,000 is broken out as 24,000 who would die because of a lack of support for immunizations and other investments, and 16,000 would be because of the lack of skilled attendants at birth.

Although the depth and scale of the austerity program has varied from country to country, the essential features remain the same: the UK, Estonia, Ireland, Greece, Spain and Portugal, among others, have all implemented rises in VAT, cuts in benefits, public sector pay cuts or freezes, and increased social insurance contributions for employees and the self employed (but rarely for employers). Nonetheless, countries are eager to emphasise that their situation is unique, and not quite as dire as their neighbours:
wide-ranging study, attempting to model the impact of austerity in various countries discovered that in Portugal, Greece and Estonia, the poorest two deciles are contributing a larger proportion of their income to pay cuts and benefit cuts, VAT and tax increases than the richest deciles. The regressive effect is similar but less severe in Spain and the UK.  In Greece the elderly are hit the hardest, and in all countries those with children are suffering more than those without.
Indeed, in Greece, where the austerity program has been most severe, the effects have been particularly savage. The social fabric is unravelling, with increased crime. In the first year of the cuts alone, homelessness increased by 25% and youth unemployment reach 42.5%. Universal healthcare provision has effectively ended, yet the public healthcare system is nonetheless on the verge of total collapse, with many hospitals forced to cancel operations, as illustrated in this short film by Greek documentary maker Aris Chatzistefanou. These are conditions of comparable seriousness to the Great Depression, and it is no surprise that for the first time since the Second World War, an openly Neo-Nazi Party, Golden Dawn, has twice gained almost 7% of the votes.
The yet-to-be-implemented Greek bailout deal involves further austerity measures:
  • Cut 15,000 state sector jobs this year – aiming for 150,000 to be cut by 2015
  • Cut minimum wage by 22%, to about 600 euros a month
  • Pension cut worth 300m euros this year
  • Spending cuts of more than 3bn euros this year
  • Liberalise labour laws to make hiring and firing easier
  • Boost tax collection
  • Carry out privatisations worth 15bn euros by 2015
  • Open up more professions to competition, eg in health, tourism and real estate
  • Greece aims to cut its debt burden to 116% of GDP by 2020
The truly horrific human cost of these austerity programs could perhaps be justified if it could be shown that it would lead back to growth and prosperity. Yet, unfortunately, as I will argue in the next section, the evidence is showing precisely the opposite. Just as Keynes would have predicted in 1935, fiscal retrenchment is pulling the economy back, leaving sustained economic growth unreachable. Worse still, with the unemployment persistently high, and tax revenues not increasing, it is becoming impossible to pay off the deficits, which the political and media establishment tell us makes the austerity programs necessary. We are in a trap, and there is no way out, except by breaking with the fiscal retrenchment regimes, and launching a large-scale Keynesian stimulus.

Austerity has not been expansionary

The pro-austerity lobby argued that austerity would be expansionary- the supply-side revolution would launch a surge in economic activity, as business was freed up to spend and invest, just as they believed (erroneously) happened in Canada and Sweden. Remove the dead weight of government, and private enterprise would flourish. But, as the Keynesians predicted, this has not happened; in fact, the policies of austerity are dragging our economies down. They are weakening our economy.

That the austerity has not been expansionary is self-evident. The figures really do speak for themselves. The UK and Eurozone are now back into recession, after having briefly climbed out. This double-dip recession was predicted by some Keynesian economists and the OECD. Indeed, a letter by fifty two leading economists and Whitehall advisers wrote a letter publicly warning Osborne that publicly the British economy was too fragile to withstand his severe program of cuts.Let’s look at the figures for GDP growth and unemployment (taken from

US GDP Growth

UK GDP Growth

Eurozone GDP Growth

US unemployment

UK Unemployment

Eurozone Unemployment

We see a broadly similar pattern everywhere. In the period immediately after the Keynesian resurgence, in which the stimulus was taking effect, from late 2009 to the end of 2010, economic growth swiftly recovered in the USA, the UK and the Eurozone. Yet, once austerity was implemented from 2011 onwards, the recovery was killed. In the Eurozone and UK, where austerity is most severe, unemployment is once again on the rise, whilst it remains persistently high in the USA.

Average quarterly GDP growth
Keynesian Stimulus Austerity
Q1 2010 – Q4 2010 Q1 2011 – Q2 2012
USA 3.5% 1.7%
UK 0.7% -0.1%
Eurozone 0.4% 0.2%
The evidence, in so far as it exists, really does suggest that austerity is choking off the recovery, and strangling prospects for growth. And this in turn is making it far harder to pay off the deficits government revenues from taxation are inevitably falling, and unemployment benefits must increase. Cutting benefits, public services and public sector wages can do something to redress this balance, but it also pulls the economy back even further. As Martin Wolf writes in the Financial Times:
 Fact one: in the fourth quarter of 2011, UK gross domestic product was 3.8 per cent lower than at the pre-crisis peak in the first quarter of 2008. Fact two: the economy is now stagnant, with output in the last quarter of 2011 a mere 0.3 per cent above its level in the third quarter of 2010. Fact three: as Jonathan Portes of the National Institute of Economic and Social Research notes, the UK “depression”—the period during which output is below its pre-crisis peak—is now longer than the Great Depression, let alone subsequent recessions. Fact four: it could be many years before this slump ends.
Nobel Prize-winning economist Joseph Stiglitz has described this situation as economic suicide. In the US, a number of former opponents of Keynesian thinking are once again concluding that the monetarist policies of fiscal retrenchment were a mistake: Henry Blodget has stated “It’s official- Keynes was right”, whilst David Frum has written an article entitled “It’s Time We Republicans Finally Admitted That Paul Krugman Might Be Right”.
The evidence is now clear: austerity is not only failing to deliver economic growth, it is prolonging the depression.

More Pain, Less Gain

Whilst it’s clear that the austerity programs implemented across most Western nations have killed off growth, they haven’t been implemented to the same degree everywhere. Genuine experiments are rare in economics, but a few countries offer us a glimmer of insight into how a less severe austerity program could help an economy grow. There is a close correlation between the depth of the cuts and the growth and unemployment a country experiences. The evidence all points in the same direction: fewer cuts, and more stimulus helps the economy to pull its way out of recession, by stimulating demand and reducing unemployment.

Belgium: No government is better than any government

One particularly interesting example is that of Belgium, which, due to deep seated divisions between the French and Dutch speaking regions was left without a functioning government for a record-breaking 541 days after the elections in June 2010. Belgium’s caretaker government did not have the power to push through harsh austerity measures and hike taxes in the way other euro zone countries have done: the new government has only begun to implement austerity measures at the very start of this year. Meanwhile, Belgian salaries and pensions were indexed to inflation, automatically rising in line with prices. The results, as reported in the financial times, were stunning: Belgium’s growth rates were consistently close to top of EU growth rates before new government formed, outperforming neighbouring France and Germany, and for some quarters reaching growth rates over 10 times that found in the UK. Almost uniquely, unemployment has nearly recovered to pre-crisis levels.

As Rudi Thomaes, head of the federation of Belgian enterprises said: “Part of the explanation of why the Belgian economy is still strong is that we are late in introducing measures of fiscal consolidation”. It would seem that no government at all is preferable for an economy than a government implementing cuts in the wake of a financial crisis.

Belgium GDP Growth

Belgium Unemployment

Iceland’s “post-crisis miracle”

Since 2001, Iceland’s banks had undergone a programme of massive deregulation, leaving the small country highly exposed to the financial crisis. By the second quarter of 2008, Iceland’s external debt was 9.553 trillion Icelandic krónur (€50 billion),  80% of which was held by the banking sector. This was more than 7 times Iceland’s overall GDP. In late September 2008, all three of Iceland’s main banks were nationalised. The market capitalisation of the Icelandic stock exchange dropped by more than 90%, the krónur tumbled in value, and GDP fell by 10% and unemployment increased seven times over. Under such dire circumstances, Iceland had no hope of implementing standard austerity measures, much more urgent action was needed.

Jóhanna Sigurðardóttir of the Social Democratic Alliance became the new Prime Minister in 2009 after 14 days of protests, and went on to win the April 2009 election. The right-wing Independence Party, which had been in power for eighteen years until January 2009, lost a third of its support and nine seats in the Althing. Her coalition government with the Left-Green Movement devalued Iceland’s currency massively and imposed capital controls and defaulted on Iceland’s debts. Uniquely, the corrupt bankers responsible for the crisis have been put on trial. The IMF has declared its program in Iceland to be a success, and growth is expanding at a respectable 2.5% per year, whilst unemployment slowly falls. Iceland’s recovery is now being studied as a model for other countries to follow. Paul Krugman has declared it to be a “post-crisis miracle“.

Iceland GDP Growth

Iceland Unemployment

Austerity is stopping us cut the deficit

The austerity programs are failing even to fulfil their primary aim: of cutting the deficits. There is now good evidence to suggest that austerity is making it harder, not easier to cut the deficit. This is a damning indictment of the austerity programs. Not only are they fatally weakening the economy, but they are locking countries into a vicious cycle of low growth and spiralling debt, from which they are unable to escape.
Perhaps the clearest example of the effects of austerity comes from a comparison of the cases of the United States and United Kingdom. Both are cutting, but at very different rates, and with very different effects. In the US, the dysfunctional state of politics has prevented cuts as drastic as those being implemented in the UK. Taking into account both state and local government, cumulatively since 2007, the US austerity program has amounted to some 3% of GDP less than that in the UK.

The results are notable: as mentioned above, since Q1 2011, the US has been growing at 1.7%, whilst the UK has been shrinking by an average of 0.1%. US unemployment has fallen by around 2%, whilst unemployment in the UK has risen by about 0.5%, overtaking the US for the first time since the crisis began.

Adam Posen, External Member of the Monetary Policy Committee, Bank of England and Senior Fellow, Peterson Institute for International Economics, recently gave a significant speech on precisely this subject, entitled: Why is their recovery better than ours?.

He concluded:

Corporate investment rebounded much more in the US than the UK because
o there were more non-bank options available to provide financing for investment
o there was less spillover from euro area risks on to the US than the UK banks

Household consumption rebounded much more in the US than the UK because
o there was significantly less net withdrawal of fiscal stimulus in the US than UK All speeches are available online at
o there was a greater rise in energy costs faced by the UK than US consumer

Inflation was higher in the UK than in the US because
o the UK fiscal tightening took in part the form of a Value-Added Tax increase
o Sterling depreciated more and more rapidly than the Dollar did

By examining other possible factors that could be responsible for the discrepancy, he concluded the government austerity program must be the key factor. As he put it, “The shocks were almost the same for both countries, and net trade and automatic stabilizers only add to the gap to be explained.” Meanwhile, monetary policy (as opposed to fiscal policy) is almost the same in both countries. Both central banks cut interest rates rapidly to zero and have engaged in quantitative easing.

  • Equity prices, which should offer some indication of the prospects for future growth in corporate profits, have risen by very similar amounts in the UK and US
  • Net exports, and manufacturing in particular, in the UK and US have both “come back” roughly to the degree that the countries’ respective currency adjustments would have predicted, and thus more so in the UK than in the US, consistent with adaptability;
  • Corporate bankruptcy rates rose by similar amounts (50%) versus their pre-crisis averages in both countries, and were more volatile in the US than in the UK;
  • Corporations in both the UK and US are sitting on historically unprecedented hoards of cash rather than investing that cash (or returning it to shareholders), although a little more so in the UK than in the US; and,
  • The share of private gross fixed capital formation in GDP has been stable in both countries at the same level (around 12% of GDP), so investment rose in the US only proportionately with the growth as it came through, rather than shifting upwards in prospect.

Adam Posen concludes:

Cumulatively, the UK government tightened fiscal policy by 3% more than the US government did – taking local governments and automatic stabilizers into account – and this had a material impact on consumption. This was particularly the case because a large chunk of the fiscal consolidation in 2010 and in 2011 took the form of a VAT increase, which has a high multiplier for households.

Fiscal Retrenchment

Cumulative fiscal retrenchment in the US has amounted to 3% of GDP less than that in the UK

Private Consumption

Private Consumption is recovering in the US, but not the UK

Private Investment Recovery

Private Investment is recovering in the US, but not the UK

In other words, the situation is dire in both the US and the UK, but far worse in the UK. This can only be explained by the even tighter fiscal retrenchment taking place in the UK. As a result, the US economy has already recovered to pre-crisis levels, whereas in the UK it is still 4% smaller.

Yet even more notable has been the effect on the US deficit. Using figures from the IMF, the US budget deficit is due to fall by nearly 5% of GDP between 2009 and 2012, from 13% of national income to 8.1%. This compares to a fall in the UK of just 2.4% of GDP,  from 10.4% to 8%.

To quote BBC economics editor, Stephanie Flanders:

Why? Because the faster pace of deficit reduction in the US does not seem to come from greater government efforts to cut borrowing. Instead it seems to come from, er, faster growth.

This comes through when you look at what has happened to the “cyclically adjusted”, or structural, deficit for each country since 2009. That is a much better (though still deeply imperfect) guide to whether a government is actively taking steps to cut borrowing, because it supposedly strips out the automatic effect that the rate of economic growth will have on spending and revenues.

When you do that, the UK and US positions are exactly reversed.

The IMF thinks that America’s structural deficit has fallen by just 1.6% of GDP since 2009. By contrast, the coalition has been able to cut it from 9% of GDP in 2009 to 5.1% in 2012 – a fall of four percentage points.

So it turns out that the standard view – that America and Britain have been pursuing different paths – is true, after all.

The traditional view also seems to fit the facts in the eurozone, which the IMF reckons to have halved its structural deficit in this period since 2009, to 2% of GDP this year. However, the story for individual countries varies enormously, as you would expect.

Germany has cut its structural borrowing from a piddling 1.3% of GDP in 2009 to an even smaller 0.6% of GDP in 2012. Spain has had to cut its structural deficit from 9.7% of GDP in 2009 to 3.9% of GDP in 2012. So it has had a smaller relative tightening than Germany, but a much more punishing one for the economy.

In other words, Britain’s faster pace of cuts and austerity measures has not only killed off Britain’s prospects for growth, but in so doing has hindered its ability to pay off the deficit. By cutting more slowly, the USA has enabled a faster rate of growth, faster declines in unemployment, increased tax revenues and is consequently cutting the deficit at a faster rate than the UK. Of course, the situation in both countries remains terrible, and both countries are probably cutting the deficit too quickly, but the data really does vindicate the Keynesian approach.

The ideologically motivated cuts being made by right-wing governments across the Western world are proving to be a disaster for the economy, and causing widespread misery. They are choking economic growth and forcing countries into a deep, prolonged depression. They are preventing the deficits from being paid off as quickly as would otherwise be the case. Even the ratings agency, Standard and Poor, has now admitted, “austerity alone is self-defeating.” The austerity programs are trapping countries into low growth and high deficits from which they are unable to escape; as growth slows the deficits increase, causing the pro-austerity lobby to demand even greater cuts. But there is an alternative path we can take.

We need a Keynesian Stimulus Now!

J. Bradford DeLong and Lawrence H. Summers:

We are here to say that, as a matter of arithmetic, in a depressed economy like the present, if a long deep recession casts even a small shadow on future potential output, with interest rates in the range at which the U.S. has been able to borrow, there is a substantial likelihood that expansionary fiscal policy right now would be self-financing, and an overwhelming likelihood that it would pass a benefit-cost test.

Martin Wolf:

In brief, the endlessly repeated “credibility” arguments against a change in fiscal policy are feeble. The UK has fiscal levers at its disposal and should use them …It may be humiliating for the government to offer such a speech now. But there is no reason why the people of the UK should suffer for its mistake, indefinitely.

The cuts are have proved ineffectual, even in their supposed primary aim of reducing the deficits. It turns out that without stable economic growth -and the austerity programs are strangling any chance of this- it is almost impossible to cut a government’s deficit. What we need is precisely the opposite.

There is an alternative. The insights of Keynes have been proved right, time after time again. Those countries worst affected, such as Greece, now have no choice but to default on their debts- they are simply unpayable and the austerity program is dragging these countries down into misery and despair. Countries like the UK, with rock-bottom interest rates have far more flexibility available to them. This is an ideal climate for the government borrow money and invest. Britain urgently needs improvements to its infrastructure. A massive government-driven Keynesian fiscal stimulus, particularly increasing spending in much-needed infrastructure, such as railways and airports, and in constructing affordable housing would boost the economy.

It is time for governments to change course, and launch a program of Keynesian stimulus, the once chance we have avoiding long-term depression.


  1. […] possible: in the Savings and loans crisis of the 1980s, more than 800 bank officials were jailed. Iceland’s socialist government has insisted on prosecuting fraudulent bankers, including Kaupthing Bank’s the former chief […]

  2. […] these aims, but it has now taken its first tentative steps. And, although most of Europe remains locked into severe austerity programs, damaging any hope of economic recovery and locking the continent into depression, this deal surely […]

  3. […] would be for the government to slow down its rate of cuts and to stimulate the economy, as I have argued elsewhere. Clearly, the governments is unwilling to do this. There are, however, other ways to […]

  4. […] the economy in a double dip recession, at least partly of the government’s making, George Osborne has spent much of the week trying to implicate the […]

  5. […] regular readers will know, many economists have already concluded that austerity is strangling the recovery before it has even begun; indeed the economy is weak enough to seriously jeopardise attempts to […]

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  7. Sonat · ·

    I didn’t read your article in full, but right at the beginning you defend Keyne’s idea that when people decide to spend less, the economy enters in a vicious circle of recession.

    This idea is wrong because when people decide not to spend, they don’t hoard their money. They save it in the bank, where it will be used to invest back in the economy.

    The fallacy should be apparent because one corollary of Keyne’s thinking is that saving is a bad thing. If you consider the extreme situation where saving is zero, you realise there’s no money for investment, and thus no economic growth. With an ever expanding population, zero growth means continuous impoverishment.

    Saving = investment. Keynes is wrong.

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