Social Europe

politics, economy and employment & labour

  • Themes
    • European digital sphere
    • Recovery and resilience
  • Publications
    • Books
    • Dossiers
    • Occasional Papers
    • Research Essays
    • Brexit Paper Series
  • Podcast
  • Videos
  • Newsletter

Austerity: A Cyclical Tale

Nicolò Fraccaroli 29th May 2018

Nicolò Fraccaroli

Nicolò Fraccaroli

Historians are often tempted to think that events of the past return to the present under new clothes in a cyclical way. The Greek historian Thucydides was probably the first to propose this cyclical conception of history. In his narrative of the Peloponnesian War, he looked for those causes that drove people to wars repeatedly through centuries, in order to tackle them and break such cycles. The history of economic thought is not immune to this temptation, especially when it deals with austerity.

In 1989 Peter Hall edited a book to identify the causes that hindered adoption of Keynes’s ideas in the aftermath of the Great Depression in 1929. Depending on the context, ideas, interests or institutions blocked the practical application of Keynes’s theory: to increase public expenditure during a slump. With different timings, however, these obstacles became weaker and Keynesian policies became popular tools to cope with crises in all advanced economies. At least until the recent financial crash, when Thucydides’s vision of history bit back. The Great Recession has brought back not only austerity, but also a renewed opposition to Keynesian ideas, considered outdated. The similarities between the debates of the two crises seem to suggest that Thucydides’s view of history may apply to austerity as well. But was it really the case? Were the economic ideas proposed the same? Or, paraphrasing Reinhart and Rogoff, was this time different?

In our book Austerity vs Stimulus. The Political Future of Economic Recovery (2017, Palgrave Macmillan), Robert Skidelsky and I show how the arguments provided against Keynes in the 1930s were not that different from the ones British and European policy-makers presented in 2010 in support of austerity policies. One element in particular recurred in the narratives of both periods: confidence. Despite being largely overlooked by pre-crisis economists, confidence is both the perpetrator and the victim of austerity’s detective story, as it represents both the reason why fiscal contraction was implemented and why it should not have been.

Keynes vs. the Treasury

Confidence played a crucial role in Keynes’s argument for stimulus. According to Keynes’s paradox of thrift, if confidence is low, as during a crisis, and everyone hence wants to save more, firms will sell less, causing a drop in output. The government should then intervene by borrowing those monies that are piled up in savings and putting them back into circulation with public investment. During the 1929 crisis, this reasoning was opposed by the British Treasury. Its view, backed by a group of LSE economists including Hayek (see here), argued that government spending would crowd out private spending, as the public would engross resources otherwise employed by private firms. Austerity, on the other hand, was supposed to have expansionary effects: if the government reduced its expenditure, firms would invest, bringing back growth.

Although Keynes finally won the battle of ideas against the Treasury in the 1930s, a similar theoretical argument in support of fiscal austerity was proposed in the aftermath of the 2008 crisis. Building on the debate of the 1930s, new austerity supporters incorporated confidence in the rational-expectations framework, proposing a new crowding-out argument against fiscal stimulus. This time the logic was no longer based on a physical crowing out (based on the physical subtraction of resources by the government), but on a psychological crowding out effect. Two schools of thought emerged around this argument.

Our job is keeping you informed!


Subscribe to our free newsletter and stay up to date with the latest Social Europe content.


We will never send you spam and you can unsubscribe anytime.

Thank you!

Please check your inbox and click on the link in the confirmation email to complete your newsletter subscription.

.

Rise and Fall of Expansionary Austerity

The Ricardian school argued that stimulus would fail to revive private spending since forward-looking taxpayers know that a deficit today will turn into higher taxes in the future, and tend therefore to increase their savings in order to pay ‘deferred taxes’. With austerity, instead, they would not fear future taxation and keep consumption and investment high. The New Classical school countered that any increase in the budget deficit would raise interest rates, discouraging private sector investment. Credible austerity policies would hence increase confidence and boost investment and growth. The crowding out argument of the Treasury still applied, but this time as a result of the psychological reaction of firms and consumers based on perfectly rational calculations.

In addition, the expansionary effect of austerity was now supported by new empirical evidence provided by Harvard economist Alberto Alesina and his co-authors (e.g. Alesina and Ardagna 2010). The contribution of these empirical works to the success of austerity should not be underestimated: their influence on British and European policymakers was such that the turn to austerity policy was dubbed as ‘Alesina’s hour’. It was indeed in confidence that George Osborne found the theoretical rationale for his budget-cuts program (Fig. 1). When he presented his Budget to the House of Commons in June 2010, he argued that a deficit would cause:

“higher interest rates, more business failures, sharper rises in unemployment, and potentially even a catastrophic loss of confidence and the end of the recovery. […] This Budget is needed to give confidence to our economy.”

Figure 1: Austerity in the UK

Source: OBR

Both the theoretical arguments and the empirical evidence in support of expansionary austerity proved short-lived. In 2011 Paul De Grauwe debunked the myth that private sector fears are driven by public debt, by showing that the UK, which had a higher debt than Spain, was charged lower interest rates on its bonds when the crisis hit. Spain was in fact perceived as more fragile due to factors such as the fragility of the Eurozone and its limited influence on monetary policy. On the empirical side, a series of papers (Morris and Schuknecht 2007, Guajardo, Leigh and Pescatori 2011, Furceri et al. 2016) highlighted a number of methodological weaknesses in Alesina’s works. Among these, the paper by Jordà and Taylor (2013), which found that, had austerity never been applied in the UK, output would have been 3 percentage points higher (green line) than outturn (blue line) in 2013.

Figure 2


We need your support


Social Europe is an independent publisher and we believe in freely available content. For this model to be sustainable, however, we depend on the solidarity of our readers. Become a Social Europe member for less than 5 Euro per month and help us produce more articles, podcasts and videos. Thank you very much for your support!

Become a Social Europe Member

Source: Jordà and Taylor (2013)

The debate over confidence suggests that the history of economic thought is no exception to Thucydides’s prophecy. New evidence against austerity brought us back to where we were in the 1930s: confidence is moving in the direction Keynesians suggested and policy-makers may turn back to Keynesian fiscal policy, as it belatedly happened in the 1930s (at the moment, though, this shift is very timid). As a result, today’s economists are exploring more deeply the mechanics of confidence. Two examples are the literature on news shocks (Bachmann and Sims 2012), and behavioural macroeconomic models (De Grauwe 2009). Should we then worry about a possible return of austerity in future? The answer depends on the destiny of confidence, a variable that economists can neither observe nor predict, but whose effects are extremely relevant for the economy.

Nicolò Fraccaroli

Nicolò Fraccaroli is a PhD student in Economics at the University of Rome Tor Vergata and a graduate from the London School of Economics in Political Economy of Europe. He published with Robert Skidelsky the book Austerity vs Stimulus: The Political Future of Economic Recovery (Palgrave Macmillan, 2017).

Home ・ Economy ・ Austerity: A Cyclical Tale

Most Popular Posts

schools,Sweden,Swedish,voucher,choice Sweden’s schools: Milton Friedman’s wet dreamLisa Pelling
world order,Russia,China,Europe,United States,US The coming world orderMarc Saxer
south working,remote work ‘South working’: the future of remote workAntonio Aloisi and Luisa Corazza
Russia,Putin,assets,oligarchs Seizing the assets of Russian oligarchsBranko Milanovic
Russians,support,war,Ukraine Why do Russians support the war against Ukraine?Svetlana Erpyleva

Most Recent Posts

biodiversity,COP15,China,climate COP15: negotiations must come out of the shadowsSandrine Maljean-Dubois
reproductive rights,abortion,hungary,eastern europe,united states,us,poland The uneven battlefield of reproductive rightsAndrea Pető
LNG,EIB,liquefied natural gas,European Investment Bank Ukraine is no reason to invest in gasXavier Sol
schools,Sweden,Swedish,voucher,choice Sweden’s schools: Milton Friedman’s wet dreamLisa Pelling
Fit for 55,access to justice,Aarhus convention Access to justice in the ‘Fit for 55’ packageFrederik Hafen

Other Social Europe Publications

The transatlantic relationship
Women and the coronavirus crisis
RE No. 12: Why No Economic Democracy in Sweden?
US election 2020
Corporate taxation in a globalised era

Foundation for European Progressive Studies Advertisement

EU Care Atlas: a new interactive data map showing how care deficits affect the gender earnings gap in the EU

Browse through the EU Care Atlas, a new interactive data map to help uncover what the statistics are often hiding: how care deficits directly feed into the gender earnings gap.

While attention is often focused on the gender pay gap (13%), the EU Care Atlas brings to light the more worrisome and complex picture of women’s economic inequalities. The pay gap is just one of three main elements that explain the overall earnings gap, which is estimated at 36.7%. The EU Care Atlas illustrates the urgent need to look beyond the pay gap and understand the interplay between the overall earnings gap and care imbalances.


BROWSE THROUGH THE MAP

Hans Böckler Stiftung Advertisement

Towards a new Minimum Wage Policy in Germany and Europe: WSI minimum wage report 2022

The past year has seen a much higher political profile for the issue of minimum wages, not only in Germany, which has seen fresh initiatives to tackle low pay, but also in those many other countries in Europe that have embarked on substantial and sustained increases in statutory minimum wages. One key benchmark in determining what should count as an adequate minimum wage is the threshold of 60 per cent of the median wage, a ratio that has also played a role in the European Commission's proposals for an EU-level policy on minimum wages. This year's WSI Minimum Wage Report highlights the feasibility of achieving minimum wages that meet this criterion, given the political will. And with an increase to 12 euro per hour planned for autumn 2022, Germany might now find itself promoted from laggard to minimum-wage trailblazer.


FREE DOWNLOAD

ETUI advertisement

Bilan social / Social policy in the EU: state of play 2021 and perspectives

The new edition of the Bilan social 2021, co-produced by the European Social Observatory (OSE) and the European Trade Union Institute (ETUI), reveals that while EU social policy-making took a blow in 2020, 2021 was guided by the re-emerging social aspirations of the European Commission and the launch of several important initiatives. Against the background of Covid-19, climate change and the debate on the future of Europe, the French presidency of the Council of the EU and the von der Leyen commission must now be closely scrutinised by EU citizens and social stakeholders.


AVAILABLE HERE

Eurofound advertisement

Living and working in Europe 2021

The Covid-19 pandemic continued to be a defining force in 2021, and Eurofound continued its work of examining and recording the many and diverse impacts across the EU. Living and working in Europe 2021 provides a snapshot of the changes to employment, work and living conditions in Europe. It also summarises the agency’s findings on issues such as gender equality in employment, wealth inequality and labour shortages. These will have a significant bearing on recovery from the pandemic, resilience in the face of the war in Ukraine and a successful transition to a green and digital future.


AVAILABLE HERE

About Social Europe

Our Mission

Article Submission

Membership

Advertisements

Legal Disclosure

Privacy Policy

Copyright

Social Europe ISSN 2628-7641

Social Europe Archives

Search Social Europe

Themes Archive

Politics Archive

Economy Archive

Society Archive

Ecology Archive

Follow us on social media

Follow us on Facebook

Follow us on Twitter

Follow us on LinkedIn

Follow us on YouTube