Will 'austerity' lead to a new recession?

The sudden policy shift in developed countries from 'fiscal stimulus' to 'austerity budgets' is causing concern that this will stem the economic recovery and lead to a new global recession.

Martin Khor

A DEBATE is raging among economists and policy makers as to whether the recent sharp shift in economic policy from 'fiscal stimulus' to 'fiscal austerity' will help the global recovery or cause a new recession.

It is more than an academic debate.  Depending on what the answer is, there could be a continuation of the recovery or a slip into a 'double-dip recession' or even a depression.

European turnaround

The rush to austerity started in Europe, when the near-debt default in Greece quickly created fears of contagion of sovereign debt crises to Portugal, Italy and Spain.

These countries quickly announced severe cuts in government spending and new taxes. Other countries that are thought to be safe from crisis followed, including France and Britain. 

This was a big about-turn from the policy consensus that the threat of depression must be fought by the Keynesian policies of increased government spending through higher budget deficits, and low interest rates.

It is widely acknowledged that the rediscovery and implementation of Keynesian policies in the past few years saved the world from a prolonged recession or even a Great Depression.

But the Greek crisis has struck fear into governments that if their budget deficits are too large, they may not be able to borrow enough at a reasonable rate of interest, and may be forced to default or seek a humiliating bailout from the International Monetary Fund (IMF).

Actually, most governments also have the options of borrowing from their own central banks (or to 'print money') and devaluing their currency (so as to expand their exports by making them cheaper).

But countries in the eurozone such as Greece don't have these options as they cannot lend to themselves and don't have their own currency to devalue.  Thus Greece had to rely on the market to lend to it.  When the market demanded interest that was too high, Greece had to be bailed out by loans from Europe and the IMF.

In June, Britain was the latest country to go for austerity.  The new Tory-Liberal government cut spending by 83 billion pounds and raised taxes by 29 billion pounds.  As Britain is not in the eurozone, it has more options to continue with fiscal stimulus, but the government chose to opt instead for an austerity budget.

Well-known economists and media commentators like Robert Skidelsky, Martin Wolf and Will Hutton have been critical. Skidelsky, the biographer of John Maynard Keynes, criticised the 'conversion to austerity' for being caused by the need to restore 'confidence in the markets'.

'If markets have come to the view that deficits are harmful, they must be appeased, even if they are wrong,' he wrote about the change in policy.

He pointed out that in a parallel situation in 1931, a British government committee recommended a drastic cut in government spending in order to balance the budget, and this was supported by almost all politicians and the business sector.

Keynes was one of the very few who opposed it.  He commented that deficits are 'nature's remedy for preventing business losses from being ... so great as to bring production altogether to a standstill'.

The austerity policies were adopted in 1931, contributing to a long recession, and Skidelsky noted that there was never a complete recovery until the war.

Commenting on the present situation, Skidelsky wrote: 'We are about to embark on a momentous experiment to discover which of the two stories about the economy is true. If, in fact, fiscal consolidation proves to be the royal road to recovery and fast growth then we might as well bury Keynes once and for all.

'If however, the financial markets and their political fuglemen turn out to be as "super-asinine" as Keynes thought they were, then the challenge that financial power poses to good government has to be squarely faced.'

There was a public uproar in late June when the Guardian reported on leaked Treasury documents showing the British austerity budget could cause 1.3 million job losses by 2015-16: 600,000 of the jobs lost would be from the public sector and another 700,000 jobs from firms losing government contracts.

The government responded that 2 million new private sector jobs would be created which would more than offset the 600,000 lost in the public sector.  But this prediction has been met with scepticism.

Germany, whose finances and economy are in strong shape, has been criticised by the United States and those who advocate expansionary policies for insisting that Greece and other countries take on austere policies to qualify for bailout loans, and for itself cutting its deficit.

Its finance minister Wolfgang Schauble replied to the critcisms by saying that Germany is attempting an exit strategy from the present large fiscal stimulus aimed at laying the foundations for future growth.

But the investment guru, George Soros, strongly attacked Germany for insisting on pro-cyclical policies and on strict fiscal discipline for weaker eurozone countries.  He said this is in conflict with the lessons of the 1930s Depression and is liable to push Europe into prolonged stagnation or worse.

Opposition to stimulus

In the United States, although the federal administration is in favour of further fiscal stimulus, it is facing opposition from the Republicans and some Democrats in Congress, and a bill to assist state governments and the unemployed has been stalled.

Most of the states are in deep deficit and since they face problems getting loans, they are now cutting their spending.  This will affect jobs and demand, and more than offset the expansion in federal spending.

The economist Paul Krugman has written scathing columns attacking the new emerging consensus in policy circles favouring immediate fiscal austerity.  He argues that there is no evidence for the belief that fiscal contraction is actually expansionary because it improves confidence. 

For example, Ireland has implemented savage spending cuts; its reward is a depression-level slump, and financial markets continue to treat it as a serious default risk.

The Financial Times, in its editorial on 3 July, warned that the balance of risk has shifted towards a renewed recession. Noting that the world economy is heading for a period of tightening fiscal policy, it reports on estimates that the big advanced economies will tighten their government budgets by 1.9% of their output this year, and that the US will cut its deficit by 2.7% of national output next year.  Europe is estimated to be tightening budgets by 1% of its GDP.

If the Keynesian economists and media commentators are right, the contraction in public spending will have an adverse effect on the private sector and there will be an overall economic slowdown or a new period of recession.

The developing countries will be affected through the trade channel as their exports slow down due to the cuts in spending and the rise in unemployment.

These countries are also following the debate on fiscal stimulus versus austerity budget, as they also face the same policy dilemmas.        

*Third World Resurgence No. 237, May 2010, pp 11-12