Austerity, Keynes and debt

The term ‘austerity’ features prominently in recent debates, whether we’re discussing Greece, Osborne’s spending cuts, or the Labour leadership election. But the term itself is rarely defined. Yet what we mean by ‘austerity’, and the circumstances in which various forms of it apply, are both crucial.

For some, austerity has the precise meaning of ‘public expenditure cuts which focus on welfare and social benefits’. Others use the same word to refer to any kind of deficit reduction, even when this is done by raising taxes or cutting other forms of spending, rather than cutting welfare.

This second, wider definition is usually used in the context of macroeconomic policy. Keynes taught that deliberate deficit spending during an economic downturn does not just alleviate hardship — it helps to turn the recession around. The debt accumulated can be paid off in better times (‘austerity’) — indeed, when an economy is growing, debt can shrink as a proportion of GDP without even needing to run a surplus.

Deficits can also arise for other pressing reasons: war, natural disasters — or having to bail out banks that are systemically “too big to fail”.

So, following the banking crisis, and faced with the biggest economic downturn since the Great Depression of the 1930s, most western countries ran up deficits for these very good reasons. And, to a degree, it worked. A domino effect of failed banks was averted and the fiscal stimulus prevented the recession from being far deeper.

But two different constraints and policy choices have limited the use this instrument.

Political unwillingness

In some countries, governments do not wish to further stimulate their economy by fiscal means, even though they have a margin to do so: either they have low enough debt levels that they could sustain a deficit for longer, or they have a low deficit level that could be raised for a while, or both.

  • The most obvious such case is Germany. There has been constant discussion in the EU and at the G20 about Germany’s potential to do more. Germany has repeatedly refused to do so, arguing that its debt levels, although smaller than others’, were too high in view of its ageing demographic profile. Others have pointed out that Germany’s ability to borrow money at 0% real interest rate was an ideal moment to invest in renewing its crumbling infrastructure, strengthening its future potential while, crucially, stimulating demand in Europe’s economy. Its refusal to do so seemed to be a rigid, doctrinaire position by fiscal hawks. It also put maximum pressure on other countries to take a similar position.
  • In Britain, the debate has centred on the speed of deficit reduction and the way it is being done, with the government cutting back on welfare while simultaneously cutting the highest rate of income tax on the rich. Labour had taken Britain back into growth in 2010, but it stalled (the famous “flatlining”) for three years under Tory-Lib Dem government policies. The UK, which had gone into the 2008 crisis with debt levels even lower than Germany, had a margin that could have been used more extensively.

Similar debates have happened in other countries, inside and outside the EU, and inside and outside the eurozone. But within the eurozone, the systemic importance of Germany as its largest component means that its restrictive policy has reduced aggregate demand at a time when the rest of Europe – and even Germany – could have benefited.

Unmanageable debt

In some other countries, the ability to finance deficits has been constrained by already high — and in some cases unmanageable — debt levels, making it very expensive to borrow money to finance deficits.

The reasons behind these problems are diverse.

  • In some countries, such as Ireland, it’s because of large banking sectors which collapsed and had to be rescued by the taxpayer. It is worth recalling that Ireland and Spain, like the UK, also had even lower debt levels than Germany before the crisis hit.
  • For some others, such as Italy, it’s because of debt levels that accumulated gradually over decades. They practised Keynesianism in a lopsided way: deficits during a slowdown were rarely eliminated during peaks. They were left with no safety margin when the crisis hit.
  • Only Greece is unambiguously the result of gross profligacy in public spending and massive levels of tax evasion, predating the economic crisis. Greece was the only European country to have a debt to GDP ratio of over 100% before the crisis hit. It then rose exponentially. This was not a case of Keynesian stimulus, nor of bailing out banks, nor of borrowing to invest. An annual deficit of 14% of GDP when it already had such a high debt level was a disaster. It is illustrative of what happens if public finances really do get out of control. But the magnitude of Greece’s debt puts it into a different league from the debate elsewhere, such as Britain, and comparisons made by Osborne to the Greek situation are way off the mark.

While on the subject of Greece, it’s worth recalling that it did obtain a write-off of half its debt three years ago, and also the biggest ever loan of its kind in international history (long-term, low-interest) to help it turn the corner. Far from “imposing austerity”, this action by other Eurozone countries and the IMF actually prevented far worse austerity. But the Greek people nonetheless went through one of the most severe downturns in recent economic history, returning to growth only in 2014, and now plunged again into recession as the actions of the Syriza government and the stalemate in the negotiations over its new demands continues.

Greece’s creditors, not just Germany but especially those with a lower standard of living than Greece (Slovakia, Latvia, Lithuania, Estonia), are wary of giving Greece another bailout loan. And part of the problem is Syriza’s erratic negotiating tactics. Not a single other government — whether Conservative, Liberal or Socialist — backed them when they broke off negotiations two weeks ago. But the cost of not reaching an agreement are high – not just for Greece.


What conclusions can we draw from all this for economic policy?

Deficit spending during a downturn must remain a tool of economic policy. But deficits outside a downturn (other than investments producing a monetary return) should be avoided or, at least, kept low (to a percentage of GDP that is lower than the nominal growth rate, thereby enabling the debt-to-GDP ratio to fall), especially if your debts are already high.

After all, the ultimate austerity is when a large chunk of your tax receipts have to be spent on servicing the debt instead of on public services. You don’t need to come anywhere near the Greek scenario for that to be the case.

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