The end of the line

Review by Lawrence Summers

Those who make the case for austerity are right that government spending cannot be limitless. But cutting in the face of a deep recession has failed time and again

As the old joke about economics examinations has it, the questions do not change – only the answers do. Students in the late 1960s and early 1970s got top marks by grasping that it was a sacred calling of their discipline to guide the economy in ways that avoided the huge costs associated with recessions and high unemployment. This was best done through the aggressive application of strong policies, especially government deficits, to assure adequate demand.

A generation later, matters were very different. By the 1990s, even at the so-called “saltwater” institutions on the US coasts where Keynesians were ascendant, students now learnt that business cycles were not a hugely important matter. Any output lost during troughs would be made up during booms and, in any case, the “great moderation” that began in the mid-1980s meant that such fluctuations as took place were not very severe. Credibility and transparency took precedence over the mitigation of recessions; above all, policy makers sought to ensure that they themselves were not sources of inflation or economic instability. And it became fashionable to suppose that the route to accelerated growth was likely to involve paying down debt, as practised by the Clinton administration in the US and a number of European countries, rather than fiscal expansion.

Now, in the wake of the financial crisis, macroeconomics is in crisis or, at least, high flux. Respected professional economists can be found who advocate as the antidote to our current woes every possible combination of more and less expansionary fiscal and monetary policy. Indeed, there are very few positions that the Group of Seven and Group of 20 leading economies have not at least gestured towards in their communiqués over the nearly six years since the onset of the crisis.

Mark Blyth’s important polemic Austerity: The History of a Dangerous Idea seeks to put much of this in perspective. Blyth, a professor at Brown University, is no two-handed economist. He pulls no punches in making the case against austerity. His idiom is not that of modern macroeconomics – no theoretical equations, econometrics, stylised models, or even data tables. Rather, Blyth writes in the tradition of Keynes, slashing away at orthodoxy and the orthodox, emphasising the power of ideas as well as interests in shaping outcomes, ranging widely over the history of economic and political thought, expressing deep scepticism about financial actors, and rejecting the curtailment of spending as the solution to a period of excess.

Much of what he says is valid and compelling. On many previous occasions – notably efforts to return to the gold standard during the interwar period – austerity has proven to be a disastrous policy. Contrary to widespread belief, the historical record suggests it is more plausible to blame the rise of Hitler on the depression under way as he rose to power than on the previous hyperinflation. Although Blyth does not dwell on the point, Franklin D. Roosevelt’s most serious error through 12 years in the White House was the lurch to austerity in 1937 that threw the American economy back into severe recession. In many cases, the idea of expansionary fiscal contraction is not just oxymoronic but plain moronic as well.

Blyth’s views on the current situation are also cogent. As he argues, the accumulation of debt by the public sector throughout the industrial world has far more to do with the direct and indirect effects of financial distress than it does with government profligacy. Indeed, countries such as Ireland and Spain had more favourable records of government debt accumulation than even Germany before the crisis.

The author makes a strong case that at times such as the present, austerity can actually be self-defeating in that its adverse effects on growth exceed any direct benefits from reduced borrowing. This is nowhere better illustrated than in the UK, where extraordinary austerity has been coupled with a rapid rise in the debt-to-GDP ratio. And Blyth may well be right in linking the preference for austerity in many quarters to a desire to shrink the state and to protect comfortable lifestyles in the financial sector. Correct also is his observation that the G20, after opting for a major expansionary bias in policy at its summit in London in 2009, lurched much too quickly back to contraction in 2010 in Toronto.

All of this is instructive and well argued. But like most good polemicists, Blyth goes too far with his argument – in two respects. First, it is one thing to say that containing spending is the wrong thing now, in a global recession where most major countries are in some kind of liquidity trap. It is a very different thing to oppose belt-tightening anywhere and everywhere. It is simply wrong to assert that austerity is never the right policy. Take, for example, the decisions of the US and Canada in the 1990s to sharply reduce budget deficits. The possibilities of offsetting reduced government demand with growing exports crowded in investment, and greater confidence made fiscal consolidation an appropriate strategy. And there is a more general point. Blyth often seems to forget that in a world where the present value of what a government spends must ultimately be constrained by the present value of the revenue it collects, issuing debt is not an alternative to cutting spending or raising taxes but only a way of deferring these painful steps.

The issue here is a broad one. Keynes could have more accurately titled his landmark work. Instead of being a “General” theory it is, in fact, quite specific, explaining how demand-constrained economies in or near liquidity traps operate. Such a distinction would have avoided the misguided application of Keynesian policies that led to the stagflation of the 1970s and discredited Keynesian economics. By highlighting the special conditions that exist today, it would also have sharpened arguments for expansionary rather than austere policies in the present moment.

Second, in his antipathy towards excessive austerity and towards some of the wealthy propounders of orthodoxy, Blyth goes so far as to approach the absurd. It is entirely legitimate to question whether the Icelandic approach to financial crisis, in which banks were allowed to fail, provides a reasonable model for Cyprus. It is not reasonable to ask whether it would have been availing for the US in 2008 or for Spain today. Instead, as the aftermath of Lehman’s collapse should have demonstrated, cascading failures put at risk the functioning of not just the whole financial sector, but major non-financial companies and a huge range of small and medium-sized businesses. To suggest firm commitment to the non-bailout of major institutions in Europe today is to court calamity.

It is true, as Blyth and many others have pointed out, that bailouts have unjustified beneficiaries. Yes. The fact that wars have unintended innocent victims is not usually taken as an argument against all wars. Equally, any judgment about bailouts must turn on a comparison of costs and benefits. If by bailing out an undeserving few, it is possible to limit a calamity that would otherwise engulf many, it is the right thing to do.

As I have often said, the central irony of financial crisis is that while it is caused by too much confidence, too much lending and too much spending, it can only be resolved with more confidence, more lending and more spending. This is exactly what is denied by austerity doctrines, and it is precisely the case that Austerity makes with more wide-ranging depth than any other study I have encountered. This makes it an important if flawed book. Keynes, after all, was the one who said: “Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.”

Lawrence Summers is Charles W. Eliot university professor at Harvard and a former US Treasury secretary

Copyright The Financial Times Limited 2013.