Blogging the Zombies: Expansionary Austerity – Death

Another section of the new chapter for the paperback edition of Zombie Economics. Comments much appreciated

Expansionary Austerity – Death

As we saw in Chapter I, the experience of World War II, and the contrast with the Depression that preceded (and produced) it, marked the death of the classical case for expansionary austerity

This quote from Australia’s White Paper on Full Employment, published in 1945 is worth restating:

Despite the need for more houses, food, equipment and every other type of product, before the war not all those available for work were able to find employment or to feel a sense of security in their future. On the average during the twenty years between 1919 and 1939 more than one-­tenth of the men and women desiring work were unemployed. In the worst period of the depression well over 25 per cent were left in unproductive idleness. By contrast, during the war no financial or other obstacles have been allowed to prevent the need for extra production being satisfied to the limit of our resources. (Commonwealth of Australia 1945, 1)

In sharp contrast with previous wars, the full employment of the war years was maintained after the return of peace. In 1919, the British government of Lloyd George had promised ‘a land fit for heroes’, and had delivered instead the grinding misery of the 1920s. By contrast, under conditions that were far more challenging, the Attlee Labour government elected in 1945 transformed Britain into a modern social democratic nation.

The example of the Attlee government shows the force of Keynes’ observation that ‘the boom, not the slump, is the time for austerity’.  The war had destroyed much of Britain’s overseas wealth as well as a substantial portion of the housing stock and left the country heavily indebted to the United States.  It was therefore, necessary to adopt tight fiscal policies.  Nevertheless, Attlee’s years in office saw the restoration of full employment, strong economic growth and rising living standards. At the same time, inflation was constrained.

Similar outcomes were achieved in other developed countries. All adopted the basic Keynesian premise that governments were responsible for maintaining economic activity at a level consistent with full employment and price stability. 

On the Keynesian view, where resources are under-employed, an increase in public consumption or in investment expenditure constitutes a direct addition to aggregate demand. The same is true the additional private demand arising from a reduction in taxation or an increase in transfer payments. Conversely, reductions in public expenditure, or increases in taxes reduce demand.

It follows that austerity is a contractionary policy, appropriate in boom periods when demand threatens to outrun the productivity capacity of the economy, leading either to inflation or to unsustainable trade deficits.  In the Keynesian view, Expansionary austerity’ is a contradiction in terms.

The Keynesian analysis dominant during the decades after 1945 did not exclude from consideration the indirect effects on which the Treasury View had relied.  However, Keynesians argued that the direct effects of fiscal expansion or contraction would be more important than any second-round effects. Equally importantly, some second-round effects would reinforce the initial impacts of fiscal policy. In particular, in an economy with high unemployment, an initial increase in demand would be amplified as the beneficiaries of public expenditure used their increased income to demand more goods and services.

The key issues here may be understood in terms of the Keynesian concept of the multiplier and the anti-Keynesian idea of ‘crowding out’.  These concepts have been around since the 1930s, and play a central role in the debate over fiscal policy. In the academic literature on macroeconomic theory, however, they have been obscured by the elaborate sophistication of DSGE models. So, it’s worth taking a little time to see how they work

 The idea of the multiplier is simple, though some elementary mathematics is required to get the full picture.  Suppose that, in a depressed economy, the government cuts taxes or makes once-off cash payments to households, spending, say $100 per household. Some of this money will be saved, and some spent. To simplify the illustration, suppose that households spend two-thirds and save one-third.  These proportions are called the (marginal) propensity to consumer and the (marginal) propensity to save.

The money spent by households will create additional demand for goods and services, leading businesses to rehire unemployed workers and bring idle capital back into production. The newly hired workers, in turn, will spend some of their additional income. If they have the same propensity to save as other households, they will spend two-thirds of their additional income, or four-ninths of the additional stimulus.   This second round effect will further increase demand, and so on, giving rise to an infinite series

Using high-school algebra, it’s not hard to work out that this series is a geometric progression and that the total increase in income is equal to the initial increase divided by the propensity to save. In this case, the propensity to save is one third, so the final multiplier is three. 

The most important counter to the Keynesian analysis of fiscal policy was the idea of ‘crowding out’ which was at the core of the ‘Treasury view’ discussed in the previous section. The central idea of crowding out is that expansionary fiscal policy will require the government to issue additional debt. In the absence of accommodating changes in monetary policy, increased sales of debt will lead to higher interest rates, and therefore to lower private borrowing both for consumption and, more importantly, for investment. The result is that higher government spending ‘crowds out’ private investment that is presumed to be more effective.

Keynes’ colleague John Hicks developed an analysis which combined the Keynesian theory of the fiscal multiplier with the possibility of crowding out. Hicks’ approach was represented in the famous ‘IS-LM’ diagram which has given pain, but also enlightenment, to generations of students in introductory macroeconomics courses.

This book is not the place to recapitulate the IS-LM model  ( textbook cite needed). What mattered was that the model formalized Keynes’ basic insight that policies of fiscal expansion would work well when demand was weak and particularly in the ‘liquidity trap’ situation where interest rates are close to zero. By contrast, in a boom, fiscal austerity would reduce interest rates, exactly as in the Treasury view of the world.

It’s also important to remember that the IS-LM model captured only part of Keynes theory, the part sometimes referred to derisively as ‘hydraulic’. Keynes ideas about uncertainty, which inspired post-Keynesian economists like Minsky did not fit into the formulation and were omitted.

During the Keynesian period, critics such as Milton Friedman did not, in general, argue against the basic Keynesian proposition that fiscal policy could stimulate the economy in times of recession. Rather, Friedman argued that, for a variety of reasons, the multiplier effect was unlikely to be as large as was suggested by Keynesians, and that fiscal policy would take effect with long and variable lags. Hence, Friedman argued, macroeconomic stabilization was best pursued through adherence to rules, such as a fixed growth rate for the money supply, 

Partly reflecting the impact of arguments like Friedman’s governments varied in the extent to which they adopted policies of Keynesian demand management. Some adopted active fiscal policy measures to stabilize the economy, Others primarily relied on the ‘automatic stabilizers’ that are a feature of the social democratic welfare state. When the economy contracts, tax revenues fall and governments must pay more in unemployment and welfare benefits. These changes produce an automatic fiscal stimulus. Conversely, in a boom, government revenue increases and expenditure falls.

For nearly three decades, Keynesian macroeconomic management was highly successful. Full employment was maintained through automatic stabilizers and fiscal stimulus. On the other hand, incipient inflationary outbursts, such as that during the Korean War, were brought under control through the appropriate use of contractionary policy, that is, austerity.

Even after the monetarist counter-revolution of the 1970s, the Treasury View of expansionary austerity,  was not revived. From the mid-1970s, to the early 1990s, the main policy objective was to reduce inflation. As a result, economic policymakers generally favored contractionary monetary policies.  Fiscal policy was also generally contractionary, at least in its objectives. Having gone deeply into deficit during the crises of the 1970s, governments mostly sought (with mixed success) to restore budget balance.

As long as reducing inflation was accepted as the primary goal of policy, few economists bothered to deny that the contractionary policies needed to achieve this goal would produce painfully low growth and high unemployment. The only exception came at the high point of faith in rational expectations and New Classical Economics when it was argued that a sufficiently credible commitment to reduce the growth of the money supply could produce an immediate, and costless, reduction in inflation. The experience of the Thatcher government, which followed this prescription and generated a huge increase in unemployment, led to the abandonment of this theory, at least in serious public policy discussions.

As late as the 1990s, then, expansionary austerity was a dead idea.