The Anti-Economist — From the October 2012 issue

The Austerity Myth

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As economic adversity continues to spread, from Athens to Madrid, London to the Beltway, austerity has become a most dangerous idea. What now dominates the world is the popular theory that if countries just tighten their belts, strong growth and lower unemployment will soon follow. It is the opposite of the Keynesian lessons learned from the Great Depression and is supported by neither historical nor empirical evidence. The world’s leading economic commentators, Nobel Laureate Paul Krugman of the New York Times and Martin Wolf of the Financial Times, have regularly railed against austerity, but to little avail.

Advocates of austerity in Western Europe have claimed that it would rapidly reduce budget deficits and calm financial markets. Instead, it has failed in every country in which it has been applied. Imposed on financially shaky European nations by their more robust partners, particularly Germany, it is largely responsible for unemployment rates approaching 25 percent in Spain and Greece, which was the level reached in America during the Great Depression. In Portugal and Ireland, unemployment stands at roughly 15 percent. And in the euro zone, much of which is now in a full-fledged recession, the average rate of joblessness is 11 percent—the highest since the monetary union was created in 1999.

The United States, too, has been attracted to austerity for some time. We are not, it’s true, obliged to slash budgets in order to obtain a bailout from the bureaucrats in Frankfurt am Main. But despite our weak economy, there is no fiscal stimulus coming next year, since both Republican and Democratic lawmakers insist that the federal deficit is the nation’s most urgent problem. In fact, federal as well as state and local spending has been falling for a year or more, and if we go over the “fiscal cliff” of automatic spending cuts mandated by the 2011 budget compromise and the expiration of the Bush tax cuts, government stimulus will shrink much further. Even if Washington softens the blow by postponing or reversing tax and spending changes, government will suck hundreds of billions of dollars out of the economy.


If there is a central idea behind austerity economics, it is the debunked pre-Depression assumption that economies are self-adjusting. As incomes fall and borrowing declines, goes the argument, interest rates also come down, encouraging business to borrow and invest again. And in a recession, of course, prices may also come down, so consumers will start buying again. The financial establishment of the early 1930s, led by Republican treasury secretary Andrew Mellon, was content to sit tight and allow the economy to recover on its own. Mellon feared that a stimulus package and its resulting budget deficits would quickly breed inflation, drive up interest rates, and ruin whatever halting progress had already been made.

Today the heirs to Andrew Mellon imagine inflation to be around every corner. John Maynard Keynes thought he had rid the world of this destructive idea with his classic 1936 study, The General Theory of Employment, Interest and Money. Not so. John Cochrane, an outspoken economist at the University of Chicago who has characterized Keynesian fiscal stimulus as “insane,” proclaimed in early 2009 that the greatest danger to America would be high inflation—unleashed, of course, by such big-spending federal policies as President Obama’s $787 billion stimulus package. The ubiquitous economic historian Niall Ferguson, now of Harvard, forecast a similarly deleterious increase in interest rates. (Even with both inflation and U.S. interest rates at negligible levels today, neither Cochrane nor Ferguson has recanted.) Meanwhile, such Mellonites as the antediluvian Jens Weidmann, the current head of the German central bank, stubbornly repeat the same warnings to European policymakers.

How, you may ask, did we get here? To appreciate the hold austerity has on otherwise intelligent economists, we must understand that it is as much a superstition as an economic theory. Like all superstitions, its roots are deep in human nature. Self-denial, from the Odyssey to the Old Testament, has been a traditional reaction to difficult circumstances. Sacrifice is the rallying cry of war, just as fasting is a central purifying practice of many religions. Self-sacrifice is also, sad to say, deeply attractive as an answer to economic problems. It feels right—a form of penitence and machismo. Perhaps that’s why Spain and Greece have voted in austerity regimes, even at the cost of ruining their economies and civic life, and as vociferous anti-austerity minorities in those countries grow louder and more anguished.

The problem is that although austerity may work for individuals, it seldom works for economies. To the contrary, frequently it makes matters worse. If all individuals tighten their belts, demand for goods and services will fall, workers will be fired, and demand will fall even more. Business won’t invest without growing sales: this was Keynes’s message in a nutshell. He argued that government had to supply the spending for goods and services that would restore incentives to invest, while simultaneously lowering interest rates. Rather than adjusting down, unemployment could stay high indefinitely.

The depression of the 1930s should have disabused economists of the belief in the self-adjusting propensities of free-market economies. Unfortunately, the theory has been resurrected in major American and British universities over the past generation. Not only is stimulus not really necessary, these academics assert; it won’t work. They argue that more government stimulus won’t lead to spending by consumers, who instead will save their money because they realize taxes will eventually be raised to finance the debt. They also argue that an increased federal deficit will crowd out private borrowing and productive investment, and eventually jack up interest rates. In other words, government spending will have little or no bang for its buck.

This theory is mostly baloney, especially during economically weak periods. If Americans are given money now, they will certainly spend it—or at least work down their debt. As for interest rates, they are at record lows today, despite high budget deficits.


Needless to say, austerity economists claim they have the evidence to support their views. Yet their research is shoddy and transparently misleading. Most often cited is a study by Harvard professors Alberto Alesina and Silvia Ardagna, who gathered budget data for major nations over a generation and found that when deficits fell, periods of economic growth often followed. But deficits often fall for reasons that have nothing to do with austerity—a sudden boost in tax revenues from a stock-market boom, for example. Economists from the International Monetary Fund, no hotbed of progressivism, swiftly challenged Alesina’s and Ardagna’s work. Their analysis of the historical data, focusing on occasions when governments made deliberate austerity decisions to cut deficits, found that in almost all such cases, unemployment rose and growth slowed—just as is happening today.

Another popular but dubious finding is that public debt of 90 percent of GDP or more seriously impedes economic growth. This was the argument made by Kenneth Rogoff and Carmen Reinhart, authors of the acclaimed book This Time Is Different. But their analysis is highly distorted by the soaring U.S. deficit during World War II, which they lumped together with other data to prove that such high debt leads to slow growth or to recession. When the war ended, the United States indeed fell into steep recession, but the decline was due to the end of intensive war production, not the high deficit.

Then there is John Taylor, a veteran economist from Stanford and a member of George H. W. Bush’s Council of Economic Advisers, who was among the most vocal critics of the Obama stimulus in 2009. Taylor based his view on a simple paper he had written in which he showed that Bush’s 2008 tax rebate of about $100 billion was not spent by consumers. Flat consumer spending, he argued, means no growth. But Christina Romer, a Berkeley economist and former chair of Obama’s CEA, pointed out that consumption should have fallen at the same time because house prices were collapsing; that it held steady showed the rebate had worked.

The advocates of Keynesian stimulus have built a stronger, more comprehensive empirical case in their favor than have proponents of austerity. The economy had fallen off a cliff when Obama was elected in 2008: Americans were losing jobs by the hundreds of thousands, and GDP was plummeting. But by the third quarter of 2009, a few months after the stimulus began reaching Americans, the free fall had stopped. More detailed analysis backs up this conclusion. For example, measuring the impact of the stimulus on state spending shows local improvements in growth. Reasonable estimates are that the stimulus created 3 million jobs in its first year.

Why, then, didn’t the economy continue to grow rapidly? Austerity advocates have claimed that persistent high unemployment is proof that the stimulus failed. The stimulus, in fact, was too small when measured against the depth of the recession. A second stimulus was necessary, but by then even the Democrats had been seduced by austerity economics and set out to chop away at the deficit.

There is considerably more evidence of the benefits of fiscal stimulus. Researchers have looked state by state at how military spending has affected local growth and found a close correlation between more growth and higher government expenditure. (In a classic example of hypocrisy, Republicans themselves are now demanding that military spending not be cut because it will cost jobs.) Other researchers have shown similar improvements in growth and employment in reaction to higher levels of local Medicaid spending. Still others find that the bang for the buck from fiscal stimulus is especially high when the economy is weak. Finally, the U.S. economy has grown significantly more than Europe’s since early 2009, when the stimulus was launched. According to Romer, such studies are only the beginning, and the “vast majority are coming to a similar conclusion.”

In the end, given so much evidence to the contrary, the popularity of the austerity myth largely owes to the power of a privileged elite. This is a class struggle. Austerity is essentially about smaller government, and a small-government ideology means lower taxes and fewer regulations—a boon to big business, especially the finance industry, and the rich. If less government weren’t such a boon, there would be more advocates for higher taxes among the deficit hawks, who instead shriek over every nickel extracted from the One Percent. Let’s recall that if the Bush tax cuts, including those for the middle class, were completely rescinded, the United States would for the next ten to fifteen years have a deficit considered manageable by any reasonable standard. And after 2025 or so, it is mostly the inefficiency of the health-care system that will drive up federal spending. How many times must one say this for it to sink in?

A strong injection of fiscal stimulus into the economy—perhaps $500 billion—would for now put America back on track. But given the mortgage-debt overhang, it wouldn’t have the muscle needed to ensure longer-term growth. Fiscal stimulus has to be accompanied by significant mortgage relief. Additional spending should also be aimed at building America’s economic foundation, which requires investment in educational quality, especially for the poor, and in infrastructure.

It is hard to be optimistic about the future, though, when a bad idea has such a strong hold. The Germans can’t see beyond their own noses. In Europe, hope rests with leaders like François Hollande, the recently elected president of France, and the sometimes enlightened Mario Draghi, head of the European Central Bank.

In the United States, meanwhile, budget-balancing obsessions will make a strong recovery unlikely. Austerity will become the next American president’s albatross. It may ensure a new recession in 2013 and, at the least, high unemployment rates and ongoing budget deficits for the foreseeable future. Social programs that benefit the middle class and the poor will be cut no matter who occupies the White House. Which is not to say that the election is irrelevant. Mitt Romney will embrace austerity with bright-eyed enthusiasm, and his running mate, Paul Ryan, seems to want to cut every entitlement in sight. Barack Obama is also likely to embrace it to some degree—but perhaps he, and we, will come to our senses. His health-care plan, having recently made it through the Supreme Court, may yet open a door to making government less unpopular. If so—and if he is reelected—Obama will have to walk through that door and proclaim proudly the benefits of government. He will have to stimulate the economy and, sometime later in his term, demand higher taxes to stabilize the debt and finance necessary public investment. Leaner and meaner may feel good to some, especially those at the top who don’t bear the pain, but it will make what ails us much worse.

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is a senior fellow at the Roosevelt Institute and the author, most recently, of Age of Greed.

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