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The Austerity Debate: Making the Same Mistake Again?

Making the Same Mistake Again? – Cambridge Journal of Economics special issue on the Austerity Debate

In the Fall of 2008, as the systemic nature of the global financial crisis became increasingly apparent, national governments complemented liquidity provision with guarantees that banks’ debt and assets would be protected. The result was a transfer of the liabilities and risk associated with the financial crisis from the private – banking – sector to the public sector. In response to growing international panic, limited stimulus packages and massive bank bailouts created public deficits that increased the level of fiscal risk and now potentially threaten the recovery, giving rise to a lively debate about fiscal consolidation and austerity as the appropriate policy response.

The proponents of austerity argue that high fiscal deficits threaten to crowd out private spending and undermine market confidence. Fiscal consolidation is thus potentially expansionary because it is theorized to increase expectations of declining future tax liabilities, interest rates and currency values and to boost the confidence of bond holders and investors; this in turn should have a positive effect on growth by spurring consumption, investment and exports and by stimulating confidence in the financial markets.

Opposing this view is the basic Keynesian perspective that fiscal retrenchment in a context of recession will only deepen the downturn. Efforts to reduce the deficit should therefore be postponed until the recovery is firmly entrenched because it is only when the economy has started to grow that these efforts are likely to be successful.

The historical comparative record supports this interpretation by revealing that fiscal consolidation has only ever been successful in a context of strong macroeconomic fundamentals and economic growth.  A recent IMF study finds, further, that in the current environment, the negative short-term effects of austerity are likely to be more severe than usual. The historical record also shows that in the aftermath of a financial crisis, fiscal consolidation tends to be significantly less successful. The Japanese experience during the early 1990s demonstrates just how counter-productive pre-mature fiscal consolidation can be. This lends force to the argument that it is important to first repair the financial sector and restore the channel of credit to the rest of the economy.

In the UK, over-reliance on the financial industry largely explains why Britain, which entered the crisis with a relatively low level of fiscal debt, has seen the budget deficit soar to 11 percent of GDP – only slightly worse than that of the US. There is no question that Britain will eventually have to balance its budget. But in the presence of a financial crisis and a bloated financial sector, the timing is highly controversial.

The ideological stakes in the austerity debate are high. The motivation behind austerity is a political attempt to regain the ground that was lost in the immediate aftermath of the global financial crisis when confidence in Neoliberalism was severely shaken. But more important than articulating a persuasive critique of the austerity agenda is the formulation of a credible alternative account of the crisis and of the policies that will lead to a sustainable global economic recovery.

The Cambridge Journal of Economics (forthcoming January 2012)

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