Chances are you haven’t missed the ongoing global debate going on about whether austerity or Keynesianism is the better macroeconomic policy in an economic downturn. One of the rewards of looking up “austerity” on Wikipedia is that you discover this little gem of information:
Merriam-Webster's Dictionary named the word "austerity" as its "Word of the Year" for 2010 because of the number of web searches this word generated that year. According to the president and publisher of the dictionary, "austerity had more than 250,000 searches on the dictionary's free online [website] tool."
There are strong arguments for and against both austerity and Keynesianism. However, some recent writings should make us remember to question the terms of the argument itself. While evidence-based economics is important, it can also mislead.
Recapping the debate
On one side, so-called austerians believe that if a country has spent too much, gotten deep in debt and is now in recession, it ought to cut back on spending and pay down its debt.
That sounds reasonable, doesn’t it?
But so does the other side. The Keynesians say this is a fallacy of composition. They say it erroneously analogizes the condition of an entire country to the condition of a household. Yes, if a household is deep in debt and paying big credit card bills, it ought to cut back on spending and pay down its debt (beginning with those credit card balances).
But, the Keynesians say, your spending is my income. If we all cut back on our spending, then all our incomes will get cut back too, and a lot of us will be unemployed. Nobody will be spending, earning or working.
What to do? When too many households are cutting back it’s time, say the Keynesians, for the government to step in, borrow heavily and increase its spending to stimulate the economy, put people to work and shore up incomes. Do that, and the economy will pull itself out of the doldrums. Then, and only then, should the government cut back.
Knock-on effects
But it’s never that simple in economics. Any action – by government or by the private sector – will have knock-on effects. The ultimate outcome depends on the feedback loops into the economy that those knock-on effects produce.
For example, if you don’t believe in Keynesianism, you can argue that if the government spends money – by cutting back taxes, investing in infrastructure projects or just plain handing it out – people will know it’s not going to last.
Because people know the government will cut back later to make up the deficit once it believes it’s gotten the economy rolling again, they won’t spend the money. They’ll save it for the rainy day they know is coming when the government, as it inevitably must, pares back.
This is the “rational expectations” hypothesis. It basically says that whatever the government does, it won’t fool people. They’ll just look ahead to the next government action, which will reverse the current one, and do what they would have done anyway.
But if you’re a Keynesian, you think government spending will get people’s “animal spirits” (Keynes’ term) fired up again. The economy will pick up and then continue on its own.
Economists can debate endlessly about these things. One economist will describe in detail what people will do in the aggregate and what the result will be, and it will sound reasonable – if you can make out what the economist is saying. Then another economist will say, ‘But wait – if that happens, then people will do this and that,’ and that will reverse the first economist’s argument. And it will all turn out very different.
Evidence-based economics
That’s why economists started insisting years ago that economics had to be evidence-based. A logical argument about what the economy and people will do is not enough, no matter how cogent it seems. Economists have to cite empirical data.
That is sensible; but that too runs up on the rocks surprisingly often. Consider the recent debunking of what was probably the most widely distributed economics paper of the 21st century, Growth in a Time of Debt, by Harvard economists Carmen M. Reinhart and Kenneth S. Rogoff.
Reinhart and Rogoff’s research results were based on extensive data and evidence. Their conclusion, widely embraced as an argument for austerity, was that “the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.”
Austerians, pointing out that the government debts of the United States and several major European countries are 90% or higher, cited Reinhart and Rogoff’s conclusion as a reason why those governments needed to cut back.
But then a graduate student at the University of Massachusetts, Thomas Herndon, and two colleagues discovered a variety of errors in Reinhart and Rogoff’s work. The errors invalidated the 90% threshold. The Reinhart-Rogoff-based argument for austerity evaporated.
It’s not the countries
Another widely circulated paper by Alberto F. Alesina and Silvia Ardagna, also of Harvard, claimed to “uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions.” European arguments for austerity have been based in part on the findings of that paper.
In his well-researched polemic, Austerity: The History of a Dangerous Idea, Brown University political science professor Mark Blyth recounted the history of experiments with austerity and their outcomes in laborious detail – laborious, at least, for the non-economic historian.
Blyth described how Alesina and Ardagna’s empirical evidence was found to be faulty. Empirical evidence in economics, it would appear, is just as vulnerable to debate and rebuttal as theoretical arguments.
Blyth’s main point in his book is that except in the case of Greece, the financial crisis-related debt of European countries was accrued by banks, not governments. The countries got into debt by bailing out their banks. In 2007, Blyth noted, Ireland’s net debt-to-GDP ratio was only 12%, and Spain’s was 26%. By contrast, Germany’s at the time was 50%. But since bailing out banks, Ireland’s debt-to-GDP ratio shot up to over 100% and Spain’s to about 90%. The countries weren’t profligate, their banks were – and yet, as Blyth emphasized, the impression has spread that the countries themselves overspent. It was eye opening for me to be reminded that the ratio of European banks’ assets to country GDP is much greater than in the U.S. Those banks are not just too big to fail. They are “too big to bail.”
Blyth devoted many pages to recounting numerous episodes of austerity in the past, almost all of them ending badly. For example, Japan practiced austerity in the 1920s. As Blyth explained, the practice “created the worst depression in Japanese history, provoked an assassination campaign against bankers and empowered ‘the wonderful folks that brought you Pearl Harbor.’”
France was austere in the 1930s. As a result, its defense spending between 1934 and 1938 was one-tenth that of Germany, making it unable to defend itself against the Nazis.
What are the social and political implications?
What are the social and political implications of austerity and stimulus? The Austrian school of economics would not have had governments bail out banks during the financial crisis. A leading Austrian school adherent, Joseph Schumpeter, believed such crises were part of the process of “creative destruction.” Economists of the Austrian school would believe bailing out the banks creates moral hazard – as it has – and would only lead to worse instabilities later.
In this, they may well be right.
But the U.S. government and most other governments were unwilling to let that process of creative destruction play out in the financial crisis of 2007-2009. Why? Most likely, because the Great Depression of the 1930s led to the worst war ever seen and caused upheaval around the world. Did the Great Depression cause World War II? Would the war have occurred if Keynesian fiscal policies had kept the Depression in check? We cannot know.
Blyth quoted the economist Joan Robinson, a disciple of Keynes: “Hitler had already found how to cure unemployment before Keynes had finished explaining why it occurred.”
So while France practiced austerity, Germany deployed massive stimulus. This is why the German economy recovered rapidly in the 1930s. Its “defense” spending outstripped that of France, and the German people regarded Hitler as a savior.
Does the German experience under Hitler chalk one up for stimulus? Perhaps, but that stimulus program launched World War II.
It’s all about the timing
The austerity-stimulus debate is more about timing than about policy. In a January 2010 op-ed in the Financial Times, for example, Reinhart and Rogoff wrote, “rapid withdrawal of stimulus could easily tilt the economy back into recession. Yet, the sooner politicians reconcile themselves to accepting adjustment, the lower the risks of truly paralysing debt problems down the road.”
They were trying to gauge the time when the stimulus should be cut back – as even hard-line Keynesians believe it must be eventually.
How seriously should we take economics?
At the end of a recent article about the Reinhart-Rogoff affair, New Yorker writer John Cassidy wrote, “Economics is a science – it proceeds via hypothesis and empirical testing – but it’s a soft and squishy one, and any argument to the contrary should be treated with great suspicion. Especially in macroeconomics, hard-and-fast laws are hard to find. So are stable parameters and reliable empirical studies. Often, about the best we can do is isolate general tendencies, and then look carefully to see whether they apply in the case under consideration.”
Why is there so much debate about whether and when austerity or stimulus should be applied? The arguments on both sides are debatable, and nothing seems to be provable with any certainty.
The answer is obvious: Something must be done. A decision must be made about what will be done, even if the basis for making that decision is weak. Macroeconomic policy decisions at the national level are like individual investment decisions at the household level. In each case, the decision-maker cannot really know what to do. But any decision leads to such great consequences that the decision-maker must stew over the decision, even without any reason to believe the result of the decision can be known in advance.
Is all of economics a fallacy of misplaced concreteness?
In my early undergraduate years I was blessed with the opportunity to take a yearlong course in philosophy and religion from the mesmerizing Huston Smith. One day he brought Buddhist philosopher Alan Watts as a guest speaker. Later I read an interview with Watts (OK, it was in an issue of Playboy ) in which he made an observation I have never forgotten. Here’s how I remember it:
Watts wondered – I’ll paraphrase – “How can it be said that we just don’t have enough money for some extremely important social project? I thought money was just a measure, like inches. Now, suppose I were a construction worker and I go to work one day, but the boss says, ‘I’m sorry, there’s no work today because we don’t have enough inches. Oh, we have enough lumber, and we even have a tape measure, but we just don’t have enough inches.’ Isn’t that the same thing as saying we don’t have enough money?”
Perhaps that is where economics goes wrong: by abstracting from the real world of goods and services and reducing everything to monetary measures. It might be easier to understand and analyze economic problems if they weren’t so rapidly, and often confusingly, reduced to questions of monetary aggregates like GDP.
Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, environment and sustainable development fields. He is a senior research fellow with the Centre for Systems Informatics Engineering at City University of Hong Kong and a project consultant at the Fung Global Institute, as well as a partner and chief investment officer of Denver-based Fair Advisors. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler.
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