Thoughts on Austerity

Yesterday, Paul Krugman wrote:

Portugal’s government has just fallen in a dispute over austerity proposals. Irish bond yields have topped 10 percent for the first time. And the British government has just marked its economic forecast down and its deficit forecast up.

What do these events have in common? They’re all evidence that slashing spending in the face of high unemployment is a mistake. Austerity advocates predicted that spending cuts would bring quick dividends in the form of rising confidence, and that there would be few, if any, adverse effects on growth and jobs; but they were wrong.

Here’s my take:

[T]here are two sides to every financial transaction. You can’t look at fiscal austerity in a vacuum. A downward shift in the government’s net fiscal deficit means a downward shift in the private sector’s net fiscal surplus – totally doable except for this little thing called debt in places like Spain, the US, Ireland or the UK.

Moreover, the savings rate is already incredibly low in countries like the U.S. and the U.K. If the government tries to pare its fiscal deficit, the result will not be less private sector savings to meet the lower public sector deficit, but rather lower aggregate demand and a larger deficit – that’s the paradox of thrift. See Ireland as exhibit A.

James Montier does MMT, July 2010

In the medium-term, austerity leads to larger deficits because it causes a recession. Most people really don’t get this bit at all. The way the media and politicians go about talking about this debate goes more to the sustainability of deficit spending and national bankruptcy. Question: where has austerity led for Britain and Ireland and Latvia before it?  In each case, it has led to lower aggregate demand and recession. That’s the reality of austerity.

Full-bore austerity is reckless, especially if government doesn’t understand how it would contribute to a debt deflationary outcome. Governments and private sectors across the developed economies cannot all deleverage simultaneously without a severe fall in output  and Depression.

What this implies is this (diagram from Paul Krugman’s post with the unfortunate title “Deficits saved the world”):

KrugmansFinancialBalancesNew

To make the graph easier to follow we start with sector balances at zero i.e. where sector surplus/deficit equals zero for both the private sector including the current account deficit and for the government sector. And just to be clear, points above the line show private sector savings or public sector deficit.

  1. We start where the red circle is.
  2. When an economic shock hits which precipitates a massive deleveraging, the entire demand curve shifts to the left to a new lower GDP level, everything else being equal. Thus, deleveraging equals recession. And we now see the private sector curve hitting the public sector curve where the blue circle is. The private sector is now saving and the public sector is in deficit. That is where we are today.
  3. However, to bring things back to neutral i.e. where sector surplus/deficit equals zero for both sectors, one could cut government spending dramatically.  That shifts the entire government curve to the red line on the left, leaving us where the green circle is: in a deep, deep depression. Krugman calls this the Great Depression outcome.

Minsky: Turning neoclassical economics on its head, Jul 2009

As I said a couple of weeks ago:

You should view people arguing for cuts in deficit spending who do not also point to this identity in a dubious light. Assume they don’t even realize the identity exists. How are they going to be able to have an enlightened view about deficits if they don’t understand that government deficits are the mirror image of non-government surpluses?

More thoughts on out of control deficit spending

What about the long-term? I think this is the pertinent question. Let’s look at the outcomes from the previous chart. Over the medium term, the Irish, British and Latvian outcomes are the green circle, recession or depression. This is also what Greece and Spain are enduring as a pre-condition of their bailouts.

What one hopes for is the red circle. But is that really possible? I would say it is if we focus on both the loss in employment and the structural adjustments that are needed in the economy.  Before the crisis, we had many more people servicing the mortgage, housing and finance sectors in the U.S. the UK, Spain and Ireland. And we had extreme levels of household sector leverage.  It will be impossible to simultaneously put millions to work, reduce household leverage, reallocate human and investment capital, restructure the financial sector and reduce the deficit.  That isn’t going to happen for the reasons I gave above.

However, there are three distinct outcomes that are possible. If government runs a deficit, it is possible to put millions to work, reduce household leverage, reallocate human and  investment capital and restructure the financial sector. If stimulus is geared to propping up the sectors where the crisis began and where capital was misallocated to begin with, over the long-term you will be back to square one. That’s the Japanese solution. On the other hand, a reduction in government deficits would bring about a deep recession and debt deflation. There is a lot of uncertainty of the Knightian variety in that scenario – the unknown unknowns of that scenario are much greater in number. The potential for a long period of stagnation and armed conflict is great, especially given the already difficult economic and geopolitical environment from the Middle East to Japan.

Here’s the case I make. The three outcomes are as follows:

  1. The Glide Path Solution. increasing aggregate demand by maintaining government spending while trying to liquidate zombie companies and malinvestment. This would allow the private sector to decrease debt burdens significantly over time through increased savings. It also has the benefit of reducing dependency on foreign sources of capital. The downside is a major increase in government debt, the spectre of big government and a long muddle through.
  2. The Hoover Status Quo. decreasing aggregate demand and precipitating a double dip recession in order to reduce government deficits. This would cause a wave of defaults and decrease debt burdens through bankruptcy and debt repudiation. Meanwhile they will try to prop up zombie companies and maintain malinvestment. This would simultaneously prevent the private sector from decreasing debt burdens through increased savings and maintain dependency on foreign sources of capital – all without ending the spectre of big government.
  3. The Liquidation Scenario. decreasing aggregate demand and precipitating a major depression in order to liquidate zombie companies and malinvestment. This would cause a massive wave of defaults and decrease debt burdens significantly through bankruptcy and debt repudiation.

I have advocated path number one. Politically, I would say that is surely not going to happen. In late 2009, the Obama Administration was arguing for path number two. In actual fact, they did not decrease government spending. And when the economy experienced a soft patch last summer, the Fed stepped in with QE. So the contractionary effects of austerity have yet to be felt. Tea Party advocates are looking for path number three.

I have advocated the glide path solution. But I see the liquidation scenario as much better than the present path – especially since, with the present course, we are witnessing crony capitalism on a massive scale. The problem with the liquidation scenario is a lower standard of living and the prospect of geopolitical tension, social unrest, poverty, and war.

The Herbert Hoover solution we are now using leads to a Japanese outcome at best or a Great Depression outcome at worst.

Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”

The reason path two leads to path three is that people get fed up with cronyism and bailouts. Bailout fatigue leads inexorably from path two to path three.

10 Comments
  1. ºC says

    Good to see some reasoning out of the mainstream. Let’s hope people notice.

  2. ºC says

    Good to see some reasoning out of the mainstream. Let’s hope people notice.

  3. Kirk Kinder says

    Edward,

    I certainly think your glide path would be the best course of action, but do you really think that we would reduce the malinvestment and liquidate zombie companies. Japan’s private sector has lowered its debt level and increased savings, but Japan never allowed liquidation. Certainly, we have let little companies and banks go under, but we have shown no willingness to allow a big company to do so (and they are the ones who need it the most in many cases).

    Also, how does the glide path end if we see a large scale monetization of debt and even a currency crisis. This has led to international instability in the past as well (notably Germany).

  4. Kirk Kinder says

    Edward,

    I certainly think your glide path would be the best course of action, but do you really think that we would reduce the malinvestment and liquidate zombie companies. Japan’s private sector has lowered its debt level and increased savings, but Japan never allowed liquidation. Certainly, we have let little companies and banks go under, but we have shown no willingness to allow a big company to do so (and they are the ones who need it the most in many cases).

    Also, how does the glide path end if we see a large scale monetization of debt and even a currency crisis. This has led to international instability in the past as well (notably Germany).

  5. Anonymous says

    Nailed it. Thank you.

  6. Anonymous says

    Nailed it. Thank you.

  7. ralph says

    Glide Path is best, but the way it’s set out above is a muddle.

    First, “maintaining government spending” is not needed where the objective is to “increase aggregate demand”. It’s the DEFICIT that maintains AD. Whether government spending is rising or falling is irrelevant, as is the proportion of GDP gabbed by government. (Though of course violent changes in the proportion of GDP taken by govt would tend to raise unemployment while people are re-allocated to different jobs.)

    Second, why do special efforts need to be made to “liquidate zombie companies and malinvestment”? Bankrupt companies are constantly falling by the wayside whether a country is in a boom or a recession. Artificial props for such companies should NEVER, NEVER, NEVER be provided: regardless of whether a country is in a boom or recession. In other words this “zombie” point does not have anything particularly to do with escaping the current recession.

    Third, I don’t agree with the claim that “The downside is a major increase in government debt, the spectre of big government”. A deficit does not, repeat not, necessarily involve increased government debt: the deficit can perfectly well accumulate as an expanded monetary base. Indeed, this is exactly what has happened over the last year or so as a result of QE. Moreover, having a deficit accumulate as increased monetary base rather than increased debt was the policy favoured by Keynes (though he was not very forthright about this). In contrast, Abba Lerner advocated this policy more openly.

    As regards the idea that a deficit necessarily means big government, I dealt with that above.

    Finally, I don’t agree with the claim that “If stimulus is geared to propping up the sectors where the crisis began and where capital was misallocated to begin with, over the long-term you will be back to square one.”. The main area of malinvestment was property: housing in particular. Why encourage MORE of this malinvestment? Unwanted houses can just be left to rot or be bulldozed. End of story. And as regards the surplus of construction workers, I can cite more than one study which shows these people are finding no more difficulty finding work than other groups.

    I.e. there is no need to wait for “the long-term” to solve this problem.

  8. ralph says

    Glide Path is best, but the way it’s set out above is a muddle.

    First, “maintaining government spending” is not needed where the objective is to “increase aggregate demand”. It’s the DEFICIT that maintains AD. Whether government spending is rising or falling is irrelevant, as is the proportion of GDP gabbed by government. (Though of course violent changes in the proportion of GDP taken by govt would tend to raise unemployment while people are re-allocated to different jobs.)

    Second, why do special efforts need to be made to “liquidate zombie companies and malinvestment”? Bankrupt companies are constantly falling by the wayside whether a country is in a boom or a recession. Artificial props for such companies should NEVER, NEVER, NEVER be provided: regardless of whether a country is in a boom or recession. In other words this “zombie” point does not have anything particularly to do with escaping the current recession.

    Third, I don’t agree with the claim that “The downside is a major increase in government debt, the spectre of big government”. A deficit does not, repeat not, necessarily involve increased government debt: the deficit can perfectly well accumulate as an expanded monetary base. Indeed, this is exactly what has happened over the last year or so as a result of QE. Moreover, having a deficit accumulate as increased monetary base rather than increased debt was the policy favoured by Keynes (though he was not very forthright about this). In contrast, Abba Lerner advocated this policy more openly.

    As regards the idea that a deficit necessarily means big government, I dealt with that above.

    Finally, I don’t agree with the claim that “If stimulus is geared to propping up the sectors where the crisis began and where capital was misallocated to begin with, over the long-term you will be back to square one.”. The main area of malinvestment was property: housing in particular. Why encourage MORE of this malinvestment? Unwanted houses can just be left to rot or be bulldozed. End of story. And as regards the surplus of construction workers, I can cite more than one study which shows these people are finding no more difficulty finding work than other groups.

    I.e. there is no need to wait for “the long-term” to solve this problem.

  9. Anonymous says

    Edward, good article, but I think your 3 possible solutions are a little oversimplified. What we have experienced in reality is somewhere between the glide path and Hoover status quo. We have the increased G of glide path along with the malinvestment of Hoover status quo. Not saying we won’t get to step 2 full bore, but for now the comparisons of Obama to Hoover seem a bit overdone.

  10. Anonymous says

    Edward, good article, but I think your 3 possible solutions are a little oversimplified. What we have experienced in reality is somewhere between the glide path and Hoover status quo. We have the increased G of glide path along with the malinvestment of Hoover status quo. Not saying we won’t get to step 2 full bore, but for now the comparisons of Obama to Hoover seem a bit overdone.

  11. DavidLazarusUK says

    I prefer the liquidation route, but with stimulus unlike the Tea Party. This eliminates the mal-investment without them being able to lobby against it. By taking the liquidation route you also clean up politics as it is those that have made bad investment decisions that want them protected through bailouts or legislation. Interest rates should be raised to increase incomes for those that rely on their investment incomes to live. It would also kill off any remaining speculation in real estate, which would be very good long term. It would lower the cost base for businesses as well. It also lowers the entry points for new businesses. High start up costs harm enterprise so stamp on capital gains not earned in a productive business through taxation.

    If housing is no longer an investment option people will actually look at investing in businesses that create jobs.

    If the government had a national energy policy to reduce energy usage through efficiency it could lower the costs for heating families, and business running costs. This would be highly stimulative as it would be labor intensive. Over time these people will be able to find jobs elsewhere.

    It could impose higher energy efficiency standards that would stimulate R&D and use of renewable energy. This could open up parts of the US to an electric economy rather than oil based. It would reduce the US dependance on foreign oil and reduce the trade deficit at the same time.

    By having a stimulus on top of liquidation it maintains employment which can help people build up their savings, as they de-lever which the US consumer still has along way to go to work off that debt. Once that process is complete the government can start eliminating its deficit.

    A key change is to restate the Feds objective of full employment and cap the definition of full employment at 2% unemployed. Any status quo where 5% unemployed was regarded as full employment is ridiculous.

  12. Anonymous says

    I prefer the liquidation route, but with stimulus unlike the Tea Party. This eliminates the mal-investment without them being able to lobby against it. By taking the liquidation route you also clean up politics as it is those that have made bad investment decisions that want them protected through bailouts or legislation. Interest rates should be raised to increase incomes for those that rely on their investment incomes to live. It would also kill off any remaining speculation in real estate, which would be very good long term. It would lower the cost base for businesses as well. It also lowers the entry points for new businesses. High start up costs harm enterprise so stamp on capital gains not earned in a productive business through taxation.

    If housing is no longer an investment option people will actually look at investing in businesses that create jobs.

    If the government had a national energy policy to reduce energy usage through efficiency it could lower the costs for heating families, and business running costs. This would be highly stimulative as it would be labor intensive. Over time these people will be able to find jobs elsewhere.

    It could impose higher energy efficiency standards that would stimulate R&D and use of renewable energy. This could open up parts of the US to an electric economy rather than oil based. It would reduce the US dependance on foreign oil and reduce the trade deficit at the same time.

    By having a stimulus on top of liquidation it maintains employment which can help people build up their savings, as they de-lever which the US consumer still has along way to go to work off that debt. Once that process is complete the government can start eliminating its deficit.

    A key change is to restate the Feds objective of full employment and cap the definition of full employment at 2% unemployed. Any status quo where 5% unemployed was regarded as full employment is ridiculous.

  13. Carry Trader says

    Austerity is counter-productive under the current environment where demand is constrained. But this is difficult to admit based on their narrow ideological vision.

    Regards,
    http://theintrinsicvalue.com

  14. Carry Trader says

    Austerity is counter-productive under the current environment where demand is constrained. But this is difficult to admit based on their narrow ideological vision.

    Regards,
    http://theintrinsicvalue.com

  15. Edward Harrison says

    David,

    My ideas here are very much in tune with what you are saying. The main difference between the glide path and the liquidation scenarios is the maintenance of aggregate demand and employment. The main difference between the Hoover option and the glide path one is the cronyism and malinvestment.

    SouthWabashSoul,

    The Hoover terminology s a holdover from how I described this originally. So given today’s policy debates, it’s not the best moniker. I could see this meme making a comeback later this year, however.

    Ralph,

    the term ‘spectre’ mans risk or possibility in this context. Deficit does not necessarily mean big government. It is the ex post result of an accounting identity when the private sector is net saving and the CA is in deficit. One could have a small government and a deficit. My point is that an increase in government spending to maintain demand always means a risk that temporary and cyclical programs become permanent.

    Kirk,

    Exactly right on Japan. The problem there is two fold. The desire to reduce deficits is a political constraint that is very real. You have to use the initial response period to close the output gap and reach full employment while restructuring or you’ll be back to square one, but with more constraints (lower policy rates, more government debt, higher structural unemployment)

  16. Edward Harrison says

    David,

    My ideas here are very much in tune with what you are saying. The main difference between the glide path and the liquidation scenarios is the maintenance of aggregate demand and employment. The main difference between the Hoover option and the glide path one is the cronyism and malinvestment.

    SouthWabashSoul,

    The Hoover terminology s a holdover from how I described this originally. So given today’s policy debates, it’s not the best moniker. I could see this meme making a comeback later this year, however.

    Ralph,

    the term ‘spectre’ mans risk or possibility in this context. Deficit does not necessarily mean big government. It is the ex post result of an accounting identity when the private sector is net saving and the CA is in deficit. One could have a small government and a deficit. My point is that an increase in government spending to maintain demand always means a risk that temporary and cyclical programs become permanent.

    Kirk,

    Exactly right on Japan. The problem there is two fold. The desire to reduce deficits is a political constraint that is very real. You have to use the initial response period to close the output gap and reach full employment while restructuring or you’ll be back to square one, but with more constraints (lower policy rates, more government debt, higher structural unemployment)

  17. fresnodan says

    The question I have with the first graph is this: what if the demand is all ersatz?
    What if the GDP is the lower number to begin with because the higher GDP was all fake to begin with – it was all fraudulent credit for years?

    Say I take advantage (literally) of your business. I write you some checks, I get a service from you, and much later you find that the checks aren’t worth the paper they are printed on (being a victim of identy theft recently some businesses have experienced this – although I am at a loss (heh heh) to understand why they would cash a check from a closed account – but I digress).
    You went out and bought stuff, money multiplier, we’re all gonna be rich.
    Now the bad checks are discovered (let’s say 1 million – I really like your business or is it really that I don’t like your busniness?).
    Now, in all the graphs and GDP calculations, who is taking the actual loss? In this example, you lost the value of a lot of time, worth ostensibly 1 million bucks. I think the graphs and GDP caluculations may account for the zero income (deleveraging), but are they truly accounting for the loss of real production? In the same vein, a deficit that builds a new sewer is far more worthwhile than a deficit that takes care of the Country wide sewer. Dropping money from helecopters may do some good. Is dropping money into volcanos stimulative?

    I have no problem with the government stimulating in recessions, but one gets the impression from the government stimulas crowd as if there is no negative consequence to malinvestment.

    1. Edward Harrison says

      That is the problem. If you disaggregate aggregate demand you find that it does matter which demand is being stimulated. I have argued that when the output gap is large this is less relevant but clearly it is relevant as we see regarding the stimulus already enacted. The thrust of stimulus was to prop up the housing and financial sectors by getting consumers spending again. Afterwards, perhaps there will be an effort to move away from this, but I doubt it.

      We need to increase aggregate demand by definition. That much is clear from the large number of people out of work. However, the rubber hits the road in terms of policy choices informed by the political environment. Every single country I can think of has used stimulus has a means to prop up ailing sectors that have either made poor investment choices (finance) or that are riddled with overcapacity (autos, finance, housing).

      While I think one needs to fear a debt deflationary spiral, one should also recognize that stimulus is no panacea. It can only go so far since it is used as a means of maintaining a mis-allocation of resources. That’s the political reality we have seen during this crisis.

  18. Anonymous says

    The question I have with the first graph is this: what if the demand is all ersatz?
    What if the GDP is the lower number to begin with because the higher GDP was all fake to begin with – it was all fraudulent credit for years?

    Say I take advantage (literally) of your business. I write you some checks, I get a service from you, and much later you find that the checks aren’t worth the paper they are printed on (being a victim of identy theft recently some businesses have experienced this – although I am at a loss (heh heh) to understand why they would cash a check from a closed account – but I digress).
    You went out and bought stuff, money multiplier, we’re all gonna be rich.
    Now the bad checks are discovered (let’s say 1 million – I really like your business or is it really that I don’t like your busniness?).
    Now, in all the graphs and GDP calculations, who is taking the actual loss? In this example, you lost the value of a lot of time, worth ostensibly 1 million bucks. I think the graphs and GDP caluculations may account for the zero income (deleveraging), but are they truly accounting for the loss of real production? In the same vein, a deficit that builds a new sewer is far more worthwhile than a deficit that takes care of the Country wide sewer. Dropping money from helecopters may do some good. Is dropping money into volcanos stimulative?

    I have no problem with the government stimulating in recessions, but one gets the impression from the government stimulas crowd as if there is no negative consequence to malinvestment.

    1. Edward Harrison says

      That is the problem. If you disaggregate aggregate demand you find that it does matter which demand is being stimulated. I have argued that when the output gap is large this is less relevant but clearly it is relevant as we see regarding the stimulus already enacted. The thrust of stimulus was to prop up the housing and financial sectors by getting consumers spending again. Afterwards, perhaps there will be an effort to move away from this, but I doubt it.

      We need to increase aggregate demand by definition. That much is clear from the large number of people out of work. However, the rubber hits the road in terms of policy choices informed by the political environment. Every single country I can think of has used stimulus has a means to prop up ailing sectors that have either made poor investment choices (finance) or that are riddled with overcapacity (autos, finance, housing).

      While I think one needs to fear a debt deflationary spiral, one should also recognize that stimulus is no panacea. It can only go so far since it is used as a means of maintaining a mis-allocation of resources. That’s the political reality we have seen during this crisis.

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