Austerity by Any Other Name

What is austerity? We in Europe hear this term almost every day, yet we do not really know what it means. Some may argue that we now call “austerity” what we used to call “fiscal consolidation.” However, the only thing we can be pretty sure of is that austerity is bad.

Mark Blyth’s Austerity: The History of a Dangerous Idea attempts to demonstrate just how bad it is, and how fiscal consolidation policies are more a product of ideology than of necessity. His polemical targets are economists who maintain that bringing budget deficits down does not necessarily depress demand and, more generally, thinkers who hold that some version of “peace, easy taxes, and a tolerable administration of justice” are the main prerequisites of economic growth.

Professor Blyth argues his case with passion. He considers himself the product of welfare subsidies and governmental intervention, and he sets out to defend the welfare state status quo from what he considers unwarranted attack.

His defense may be palatable, in the current context, in light of his assumption that “the notion of a middle class” is made possible by transfers across income distribution groups. The debate over income inequality is fueled by the well-developed impression that the middle rankings of society are being squeezed into a steadily shrinking space. Blyth’s basic idea that the middle class developed due to governmental support, not efforts in the marketplace, requires serious examination from those who disagree with him, precisely because classical liberals tended to see in the thriving middle classes their natural constituency.

Austerity treats economic and political ideas more than economic and political facts. Consider its author’s definition of the word:

Austerity is a form of voluntary deflation in which the economy adjusts through the reduction of wages, prices, and public spending to restore competitiveness, which is (supposedly) best achieved by cutting the state’s budget, debts, and deficits. Doing so, its advocates believe, will inspire “business confidence” since the government will neither be “crowding-out” the market for investment by sucking up all the available capital through the issuance of debt, nor adding to the nation’s already “too big” debt.

Were we to take this ideas-rich definition of austerity at face value, we would think the so-called “troika” — the group of international lenders that forces austerity upon peripheral European Union member states — traveled with Adam Smith at hand.

Such a definition tends to overlook the fact that the austerity packages imposed by the European Commission, the International Monetary Fund, and the European Central Bank are, shall we say, less than linear from an intellectual standpoint. The case for “expansionary fiscal austerity” developed, actually, in studies that aimed precisely at discriminating between different kind of fiscal consolidation. In the Euro-crisis, austerity measures have been at best a mix of some spending cuts and tax increases. To be sure, Keynes would disapprove of both, but Hayek wouldn’t agree with the latter.

Professor Blyth rails against a more coherent set of ideas, those typically associated with a “classical liberal” (or sometimes “conservative” in the American sense) position. These ideas are “dangerous,” according to him, because they ignore the externalities they generate. That is, spending cuts reduce the disposable income of the middle and lower middle classes.

The book opens with a succinct narrative of the U.S. financial crisis but quickly moves to the migration of that crisis to Europe. Blyth argues that, although European countries typically sit “left of the U.S.” politically, they acted “right of the U.S.” economically, in the crisis, because they built a banking system “too big to bail, which is the real reason why a bunch of putative lefties are squeezing the life out of their welfare states.” The hypothesis that “too big to bail” systems might be the result of mistaken policies, stemming from regulators’ off-kilter assumptions and lack of accurate information, escapes consideration here.

That European governments are “squeezing the life out of their welfare states,” moreover, seems a bit exaggerated. In 2013, public spending as percentage of GDP was on average 49.4 percent in the Eurozone.

Still, the overwhelming fear for the stability of the banking system could well explain the behavior of the European elites in the crisis. Such an explanation would require a cool-headed investigation of the tangle of interests and incentives involved, and a closer look into the European banking system, which is largely, in countries like Italy, Spain, Germany and France, directly or indirectly controlled by politics — and heavily regulated everywhere. Alas, Professor Blyth prefers to immerse himself in the more exciting history of economic and political thought. For him, austerity becomes an all-purpose political explanation of the evils of the world.

He sees “austerity at work” in the 1920s and 1930s all over Europe, and blames on it the emergence of National Socialism. Hitler, he believes, won Germans’ minds and hearts with stimulus policies. “The fact that this turn against austerity took a particularly murderous direction in Germany,” he writes, “does not invalidate the basic point that austerity didn’t work.”

Such a one-dimensional explanation of very complex political phenomena can hardly be taken seriously.

More interestingly, echoing Barry Eichengreen’s work, Blyth sees any monetary “straightjacket” as inherently incompatible with democracy. That democratic polities, in the last century, showed a certain tendency toward fiscal profligacy is a point often made and certainly worth exploring. But I found rather bizarre the idea that this should be seen as a simple natural fact to be accepted, rather than a problem that deserves to be addressed at the level of constitutional design. Pace Blyth, not seeing democracy “as an end in itself” doesn’t necessarily mean considering it “an inflation-causing pathology from which only rules, not discretion, can save us.”

Also, whatever friction may exist between fiscal responsibility and democracy, it is not immediately clear why fiscal profligacy should be a positive catalyst in democratic life. Latin American politics, for example, abound in examples showing exactly the opposite.

For all that he cares about ideas, Blyth surprisingly lacks the precision that one should expect from a student of the history of thought. I will provide just two examples.

He maintains that the Italian classical liberal economist Luigi Einaudi embodied the very essence of the Euro-austere spirit. Indeed, Einaudi argued for a version of European federalism, believed in sound money, and was a champion of fiscal responsibility. He was briefly treasury minister and then governor of the Italian central bank, after World War II, before being elected president of the Republic. His legacy didn’t seem to hold in Italy, at least if you consider the country’s dismal record of fiscal profligacy and inflationism in the second half of the 20th century.

Blyth argues that

Einaudi and his ideas matter because of the school of economics that he founded at the Bocconi University of Milan, which produced two generations of economists reared in these ordo-liberal views.

This is an odd statement. As a matter of fact, Einaudi was evicted from Bocconi as early as 1925 because he dissented from Benito Mussolini’s fascism. Moreover, at the time, Bocconi was far from being a center of dissemination of political ideas. It aimed to be, to put it roughly, an equivalent of the polytechnic school for accountants: a very practical university that eschewed high theory.

Einaudi never thought of leaving the then-more prestigious University of Turin, where he nurtured many students who left their mark in the social sciences (including the certainly not austerity-friendly Piero Sraffa). Also, Einaudi was an empirical economist who wrote in prose. Contemporary Bocconi economists are instead trained in sophisticated, contemporary mathematical economics.

It may well be that two of Blyth’s favorite polemical targets, Alberto Alesina (landed at Harvard) and Francesco Giavazzi (who teaches at Bocconi and MIT), admire Luigi Einaudi. Any Italian of good sense should. But is that enough to argue that Einaudi’s ideas determined their research paths?

Similarly, considerable attention is devoted to the German Ordoliberals, whom the author credits for having inspired the institutional arrangements behind the Eurozone. He considers their liberalism “different” because it “embraces the state and transforms it.” True, Ordoliberals paid considerable attention to the rules of the game and cherished competition. But Blyth doesn’t really explain how Ordoliberals have “modernized liberalism” and ends up noting that their economics “in many ways remain [sic] as classical as Smith and Hume.” In his account of Ordoliberalism Blyth relies exclusively on secondary sources.

The author assumes that the “Ordo” thinkers exterted great influence on how European institutions were shaped but, for all that he values the world of ideas, he is notably unwilling to explain how ideas may translate into politics.

He lambasts public choice for its purported cynicism. He writes that public choice

has become, as Daniel Dennett said about evolution in Darwin’s Dangerous Idea, that “universal acid” that eats away everything it touches by turning everything into a principal-agent/rent-seeking problem. Think that countries in a currency union might actually come to each other’s aide out of a sense of solidarity? Don’t be so naive. Moral hazard is ever present.

Like it or not, though, public choice provides a way to understand politics. Dreary as its tenets might look, they can explain political behavior in a way that probes beneath politicians’ words.

Ideas have consequences — but books, papers and conferences do not shape the world on their own. Blyth is, at best, ambiguous on the point. He cites as damning evidence, for example, Harvard economist Alberto Alesina delivering an updated version of his paper “Tales of Fiscal Adjustment” to an ECOFIN (the group that brings together EU members’ economic and finance ministers) meeting in Madrid in April 2010.

Let me confess that I would gladly enroll in Alberto Alesina’s fan club, but even I seriously doubt that Alesina’s eloquence was enough to convince these officials, by definition among the toughest political players in their respective countries, to adopt his desired policy strategy irrespective of any political calculations. The ideas of economists and political philosophers are indeed more powerful than is commonly understood — but perhaps, not quite this much.

Of course, pointing to Alesina as the power behind the throne is key to blaming, as Blyth does, “austerity in practice” on the set of ideas that he identifies with “austerity in theory.” The latter is associated with the empirically based work of economists such as Alesina, his coauthors Silvia Ardagna and Roberto Perotti, and also Francesco Giavazzi and Marco Pagano, who introduced the idea of an “expansionary fiscal contraction” in a 1990 paper precisely to discriminate between different kinds of fiscal consolidation.

This book criticizes the evidence they provide. It mentions competing evidence, and also points out that smaller economies such as Denmark or, more recently the REBLL economies (Romania, Estonia, Bulgaria, Latvia, Lithuania) can’t taken as role models. Yet inconsistently, Blyth considers the Eurozone to be an extraordinary experiment from which sounder conclusions can be drawn.

That “austerity” in some European countries has mostly been made of tax increases, with scant reliance on “expansionary” spending cuts, is something he seems stubbornly determined to overlook. I’m not sure higher taxes will get us out of recession and debt, either, but this does not justify only defining austerity that way.

When it comes to spending cuts, moreover, Blyth tends to assume that all of them are created equal — but they are not. Government spending can be cut by privatization; by the outsourcing of once-untouchable public services; by reducing waste and political intermediation; by cutting entitlements and freezing the wages of government employees, among other means. Be it noted, too, that most species of spending cuts could be better described as “slower increases in public spending” rather than outright cuts that “squeeze the life out of welfare states.”

On top of that, measures to allow for the “voluntary deflation” that Blyth equates with austerity may have a different origin than spending cuts. For example, European labor markets tend to be rather rigid, and thus some kind of liberalization would typically be needed to restore the proper functioning of the price mechanism.

Blyth shows some sympathy for the Austrian business cycle theory. He writes that “the broad sweep of an asset bubble’s inflation and deflation is well described by the basic Austrian model.” This is why “the Austrians came back in” at the beginning of the crisis: “Their writings from the 1930s seemed to describe the 2008 financial crisis perfectly.” He sees, therefore, what kind of demand a revival in Austrian theory may have answered.

However, he strongly disagrees with Austrian prescriptions. His intellectual bête noire is the idea of economic self-healing, which he associates with “liquidationism.” In his perspective, there is no use in enduring some pain, as it will not cure wounds.

We may do well here to remember here an earlier debate. Hayek (and Arnold Plant, Lionel Robbins, and others) and Keynes (and A.C. Pigou and others) had an exchange in the pages of the Times of London in 1932. It is worth mentioning a short passage from Hayek’s letter:

If the Government wish to help revival, the right way for them to proceed is, not to revert to their old habits of lavish expenditure, but to abolish those restrictions on trade and the free movement of capital…which are at present impeding even the beginning of recovery.

Freeing the movement of capital, then or, abolishing measures that hinder the reallocation of factors of production, now, is as much a political program as printing money. The free-market response to financial crises was never “don’t do anything” but always stressed how a fuller recovery could be brought about by removing barriers that hinder the workings of the price system. Such a response might be tremendously expensive, insofar as political consensus is concerned, in any democratic state.

This is what Blyth may argue. “Laissez faire,” he writes, was the policy of the Belle Epoque (in itself a statement that could be questioned) because the Belle Epoque was “not all that democratic.” But indeed, if something is too unpopular to be attempted, it is difficult to blame it for the consequences of the measures that were actually enacted.

The austerity that “has been applied with exceptional rigor during the ongoing European financial crisis” was not a homogeneous political approach — and in some countries very little was accomplished, especially when it came to the reduction of public spending that so terrifies Professor Blyth.

Unsurprisingly, then, he omits the case of Italy, which may be the best example of stagnant austerity he could hope for. The country is mired in a never-ending recession. And yet Italy provides no illustration of the evils of what were once called structural reforms and now go by the name of austerity. Italy enjoyed consistent primary surpluses for years, and in the crisis succeeded in cutting pension entitlements. At the same time, virtually no supply-side reforms have been undertaken since the crisis erupted. Italy continues to suffer from negative growth rates and appears unable to achieve fiscal consolidation. Whatever the cause of this situation, it is not certainly the reforms that never happened. Expansionary austerity hasn’t been tried here. Instead, a patchwork strategy of tax increases and closing fiscal loopholes was put in place. Once again Keynes would not have approved, and neither would Hayek.

In contrast, if we look at the latest data from the IMF, we may see that countries like Portugal, Ireland and even Greece have eventually reached positive growth again. Ireland’s GDP increased by 3.6 percent in 2014 and is forecast to increase by 3 percent in 2015. Greece grew by 0.6 percent in 2014 and is forecast to grow by 2.8 percent in 2015. Portugal grew by 0.9 percent this year, and Spain by 1.3 percent.

To be sure, none of these feeble signs of hope proves conclusively that austerity works. But they should alert us to the fact that austerity was not a uniform set of policies, nor a coherent set of ideas all of which “have been tried and failed.”

I won’t argue that austerity deserves a do-over. The point is rather that discussion of the history of ideas, and of public policy, must be precise to be useful. The very word “austerity” is used to drive precision and clarity away, as Professor Blyth unintentionally demonstrates in his book.

Alberto Mingardi is the Director General of the Italian free-market think tank, Istituto Bruno Leoni. He is also an Adjunct Fellow at the Cato Institute and a guest blogger at EconLog.