This is the final draft section of the new chapter of my Zombie Economics book, on Expansionary Austerity.
As before comments are welcome. That includes everything from typos and suggestions for better phrasing to substantive critiques of the argument. If I can get organized, I will try to post the edited version of the entire chapter and invite another round of comments.
As an aside, I just got an email link to the Journal of Economic Literature (behind a login screen), which contains Stephen Williamson’s review of my book, including his claims that both the Efficient Markets Hypothesis and DSGE macro are devoid of any implications. I bet that if I had submitted an article to any publication of the American Economic Association making such claims, it would have been shot down in flames by the referees. But, now it’s been published – anyone keen on a radical critique of mainstream economics can now cite the JEL to the effect that the whole enterprise (at least as applied to finance and macroeconomics) is irrelevant to reality.
Expansionary Austerity – After the Zombies
failure of expansionary austerity is already evident. Predictions that, once the state got out of the way, the private sector would come roaring back, have proved laughably false. After more than a year of austerity in the US and Europe, there is no sign of any recovery. Rather, the risk of another crash looms larger than ever.
Expansionary austerity is not simply a zombie economic idea. It forms the basis of a political strategy of class war, undertaken by the financial and political elite (the “1 per cent”) to hold on to the wealth and power they accumulated during the decades of market liberalism, and to shift the costs of their own failure on to the rest of the population. An effective response must similarly combine an economic analysis with a policy program and a political movement to mobilise resistance to the push for austerity.
In economic terms, the primary need is to relearn the basic lessons of Keynesian economics. Government intervention can help to stabilise aggregate demand and, when monetary policy is ineffectual because of a liquidity trap, expansionary fiscal policy is the optimal choice.
This lesson has been reinforced in both positive and negative ways since the beginning of the crisis. Fiscal stimulus was successful, most clearly in countries like Australia and China, where governments had advance warning of an externally-generated shock. But even in the US and Europe, notably including Germany, fiscal policy softened the impact of the crisis.
That lesson, sadly, was not learned. Instead, we are receiving a much harsher lesson that goes the other way. Just as expansionary fiscal policy works to stimulate economic activity, contractionary fiscal policy (that is, austerity) works to depress it.
Experience has discredited the zombie idea of expansionary austerity, but the lessons of the slump go much further. According to the claims of classical economics (new old) and of Real Business Cycle theory, a long slump like the one that has been going on since 2008 should not happen, except as a result of a failure in labor markets. Although there have been some (fairly desperate) attempts to find such a failure [such as Casey Mulligan’s theory, discussed in Chapter 3, that it was all caused by fear of Obama] none of them can explain a simultaneous slump in the US, Europe and the UK, countries with radically different labor market institutions.
In policy terms, the required response is reasonably clear. Instead of fiscal austerity, what is needed is a return to expansionary fiscal policy to promote economic growth. Only then can the vicious cycle of debt and deflation be broken.
Both for political and economic reasons, it is important to emphasise both sides of the Keynesian policy prescription: stimulatory budget deficits in recessions, matched by stabilising budget surpluses under normal, and especially boom, conditions. This means that expansionary fiscal measures should be temporary, and accompanied by longer term policies to improve fiscal sustainability.
If the EU agreement signed in December 2011 were interpreted in the light of a sound Keynesian analysis, it would in fact be consistent with this approach. The agreement calls on EU governments to limit the ‘structural’ deficit to 0.5 per cent of GDP. The term ‘structural’ is not well-defined, but is generally taken to refer to the component of the budget that is determined by long-term revenue and expenditure policies rather than by short term macroeconomic fluctuations. If this interpretation is taken to allow for short run fiscal stimulus during recessions, then the structural budget should indeed be required to be in, or near balance.
An expansionary fiscal policy is essential to stimulate demand, but monetary policy must also be remodelled in the light of the crisis. The minimal requirement is a more expansionary policy in which a temporary increase in inflation would be accepted as part of the price of cleaning up the massive debts inherited from the crisis.
But deepter changes are needed. The monetary policy regime of the past two decades, in which central banks were entirely independent of government, and the maintenance of low inflation was the sole (or, at least, pre-eminent) goal of monetary policy, has been a catastrophic failure.
The failed system of inflation targeting should be replaced, in the first instance, by a target that takes explicit account of the need to maintain economic activity at a level consistent with full employment. The most popular candidate here is the proposal to target, instead, the level of nominal gross domestic product (GDP).
The idea would be to combine a target rate of inflation (say 2-3 per cent) with an estimate of the long-term rate of real economic growth required to maintain full employment (again 2-3 per cent is a plausible estimate). The aim would then be to keep the value of GDP, expressed in current dollars, on a growth path consistent with these targets (that is, at an average annual rate somewhere between 4 and 6 per cent).
This change would have several effects. First, it would restore the balance that used to prevail in monetary policy before the 1990s, when central banks were explicitly required to pursue full employment as well as price stability. At a minimum, this would force central banks to admit that their current policies are failing, a key requirement for any progress.
Second, because the target would apply to the level of nominal GDP, its adoption would require central banks to catch up the ground lost over the last few years of depressed growth and generally low inflation. That would permit a temporary increase in inflation, which is necessary if growth is to be restarted against a crushing burden of debt.
Last but not least, a nominal GDP target would create room for fiscal policy as well as monetary policy. What is needed now is the abandonment of counterproductive austerity policies and their replacement with a combination of short-term fiscal stimulus and long-run measures aimed at a sustainable budget balance.
The abandonment of inflation targeting would, of course, be an admission of failure. But central banks have failed, disastrously, and admitting this would be the first step towards a sustainable recovery. A system of nominal GDP targeting would maintain or enhance the transparency associated with a system based on stated targets, while restoring the balance missing from a monetary policy based solely on the goal of price stability.
An effective system of nominal GDP targeting central banks co-operate with pro-growth fiscal policy, instead of seeking to counteract it in the name of inflation targets. This in turn would entail a change in the nature of central bank independence. As in the Keynesian era, central banks would still be independent in the sense that they would not be subject to day-to-day political control of their policy decisions. That is, they would have the same kind of independence as other regulatory bodies put in place to manage aspects of economic policy where direct political control is unhelpful. On the other hand, they would no longer be empowered to act as if they were an economic Supreme Court, not merely independent of, but superior to, governments.
Alternative policy programs are all very well, but they are useless in the absence of a political movement capable of resisting the push for austerity, and of demanding a progressive alternative. Until recently, there has been little sign of such a movement. But 2011 has been a year a political ferment throughout the world. The ‘Arab Spring’ arose in a very different context from that of the developed market economies, but the revolts were driven in large measure by the fact that people were no longer willing to accept a system where the benefits of economic progress were creamed off by a tiny elite, leaving the population as a whole to struggle.
The example of the Arab Spring has been inspirational. Resistance to austerity has emerged, first in Europe and then, more surprisingly, in the US, where the ‘Occupy Wall Street’ movement has upended many political preconceptions.
So far, these movements have been notable more for their effects in raising consciousness than for concrete political achievements. But there are promising signs. In the US, the Obama Administration has finally been pushed into taking some positive steps, though it remains to be seen how much of this is mere electoral positioning. Similarly, European social democrats, now in opposition in nearly all countries, are shifting away from their previously uncritical acceptance of market liberalism. The “European Growth and Jobs Pact” tabled by the Socialists and Democrats (the social-democratic grouping in the European Parliament) represents a step in the direction of resistance to austerity, though still a small one.
Meanwhile, even as the parties of the political right push ever harder for pro-rich austerity policies, their incoherence is becoming more evident. Given the state of the US economy, and the failure of the Obama Administration to do much about it, the Republicans ought to be guaranteed of a sweeping victory in the 2012 elections. In reality, the process of nominating an alternative candidate has descended into farce, and the Congressional Republicans have plumbed unheard of depths of (un)popularity. In large measure, this reflects the total separation between ideology and reality now required of Republicans
Meanwhile, in Europe, the dominant rightwing power bloc, consisting of the conservative German and French governments, the European Central Bank and the European Commission, is trying ever more desperate expedients in its attempt to maintain the market liberal order. The imposition of “technocratic” governments in Greece (headed by a former member of the ECB Board) and Italy (headed by a former chairman of the European Commission) represents a substantial abridgement of democracy. It is not clear how this will end, but very hard to see it ending well, at least in the absence of a radical change in policy.
The struggle against the politics of austerity will be a long one, and often dispiriting. As the experience of the 1920s and 1930s showed, the forces pushing for austerity are powerful. Nonetheless, they were defeated in the end, by the New Deal in the US, the Attlee Labour government in the UK, and the success of social democratic movements and policies in Europe.
This time around, we are fighting the idea in a zombie form, already multiply discredited by experience. Keynes’ critique of ‘Treasury view’ has been developed into a coherent alternative to classical economics. While far from being the last word, Keynesian economics has repeatedly demonstrated its capacity to explain a crisis that, according to the views of market liberals, should never have happened at all, and, if it did, should have been followed by a rapid recovery.
The revolts of the past year have shown how the power of ideas, when pushed forward by an active protest movement can be amplified by the power of modern communications technology. There is every reason to hope that the inevitable downfall of the zombie economics of austerity will come sooner rather than later.