Social Europe

politics, economy and employment & labour

  • Themes
    • Strategic autonomy
    • War in Ukraine
    • 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 The Great Recession has brought back not only austerity, but also a renewed opposition to Keynesian ideas, considered outdated.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.

Sign up here

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

Screen Shot 2018 05 24 at 11.34.34
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

fraccaroli fig 02

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).

You are here: Home / Economy / Austerity: A Cyclical Tale

Most Popular Posts

Visentini,ITUC,Qatar,Fight Impunity,50,000 Visentini, ‘Fight Impunity’, the ITUC and QatarFrank Hoffer
Russian soldiers' mothers,war,Ukraine The Ukraine war and Russian soldiers’ mothersJennifer Mathers and Natasha Danilova
IGU,documents,International Gas Union,lobby,lobbying,sustainable finance taxonomy,green gas,EU,COP ‘Gaslighting’ Europe on fossil fuelsFaye Holder
Schengen,Fortress Europe,Romania,Bulgaria Romania and Bulgaria stuck in EU’s second tierMagdalena Ulceluse
income inequality,inequality,Gini,1 per cent,elephant chart,elephant Global income inequality: time to revise the elephantBranko Milanovic

Most Recent Posts

Pakistan,flooding,floods Flooded Pakistan, symbol of climate injusticeZareen Zahid Qureshi
reality check,EU foreign policy,Russia Russia’s invasion of Ukraine: a reality check for the EUHeidi Mauer, Richard Whitman and Nicholas Wright
permanent EU investment fund,Recovery and Resilience Facility,public investment,RRF Towards a permanent EU investment fundPhilipp Heimberger and Andreas Lichtenberger
sustainability,SDGs,Finland Embedding sustainability in a government programmeJohanna Juselius
social dialogue,social partners Social dialogue must be at the heart of Europe’s futureClaes-Mikael Ståhl

Other Social Europe Publications

front cover scaled Towards a social-democratic century?
Cover e1655225066994 National recovery and resilience plans
Untitled design The transatlantic relationship
Women Corona e1631700896969 500 Women and the coronavirus crisis
sere12 1 RE No. 12: Why No Economic Democracy in Sweden?

ILO advertisement

Global Wage Report 2022-23: The impact of inflation and COVID-19 on wages and purchasing power

The International Labour Organization's Global Wage Report is a key reference on wages and wage inequality for the academic community and policy-makers around the world.

This eighth edition of the report, The Impact of inflation and COVID-19 on wages and purchasing power, examines the evolution of real wages, giving a unique picture of wage trends globally and by region. The report includes evidence on how wages have evolved through the COVID-19 crisis as well as how the current inflationary context is biting into real wage growth in most regions of the world. The report shows that for the first time in the 21st century real wage growth has fallen to negative values while, at the same time, the gap between real productivity growth and real wage growth continues to widen.

The report analysis the evolution of the real total wage bill from 2019 to 2022 to show how its different components—employment, nominal wages and inflation—have changed during the COVID-19 crisis and, more recently, during the cost-of-living crisis. The decomposition of the total wage bill, and its evolution, is shown for all wage employees and distinguishes between women and men. The report also looks at changes in wage inequality and the gender pay gap to reveal how COVID-19 may have contributed to increasing income inequality in different regions of the world. Together, the empirical evidence in the report becomes the backbone of a policy discussion that could play a key role in a human-centred recovery from the different ongoing crises.


DOWNLOAD HERE

ETUI advertisement

The EU recovery strategy: a blueprint for a more Social Europe or a house of cards?

This new ETUI paper explores the European Union recovery strategy, with a focus on its potentially transformative aspects vis-à-vis European integration and its implications for the social dimension of the EU’s socio-economic governance. In particular, it reflects on whether the agreed measures provide sufficient safeguards against the spectre of austerity and whether these constitute steps away from treating social and labour policies as mere ‘variables’ of economic growth.


DOWNLOAD HERE

Eurofound advertisement

Eurofound webinar: Making telework work for everyone

Since 2020 more European workers and managers have enjoyed greater flexibility and autonomy in work and are reporting their preference for hybrid working. Also driven by technological developments and structural changes in employment, organisations are now integrating telework more permanently into their workplace.

To reflect on these shifts, on 6 December Eurofound researchers Oscar Vargas and John Hurley explored the challenges and opportunities of the surge in telework, as well as the overall growth of telework and teleworkable jobs in the EU and what this means for workers, managers, companies and policymakers.


WATCH THE WEBINAR HERE

Foundation for European Progressive Studies Advertisement

The winter issue of the Progressive Post magazine from FEPS is out!

The sequence of recent catastrophes has thrust new words into our vocabulary—'polycrisis', for example, even 'permacrisis'. These challenges have multiple origins, reinforce each other and cannot be tackled individually. But could they also be opportunities for the EU?

This issue offers compelling analyses on the European health union, multilateralism and international co-operation, the state of the union, political alternatives to the narrative imposed by the right and much more!


DOWNLOAD HERE

Hans Böckler Stiftung Advertisement

The macroeconomic effects of re-applying the EU fiscal rules

Against the background of the European Commission's reform plans for the Stability and Growth Pact (SGP), this policy brief uses the macroeconometric multi-country model NiGEM to simulate the macroeconomic implications of the most relevant reform options from 2024 onwards. Next to a return to the existing and unreformed rules, the most prominent options include an expenditure rule linked to a debt anchor.

Our results for the euro area and its four biggest economies—France, Italy, Germany and Spain—indicate that returning to the rules of the SGP would lead to severe cuts in public spending, particularly if the SGP rules were interpreted as in the past. A more flexible interpretation would only somewhat ease the fiscal-adjustment burden. An expenditure rule along the lines of the European Fiscal Board would, however, not necessarily alleviate that burden in and of itself.

Our simulations show great care must be taken to specify the expenditure rule, such that fiscal consolidation is achieved in a growth-friendly way. Raising the debt ceiling to 90 per cent of gross domestic product and applying less demanding fiscal adjustments, as proposed by the IMK, would go a long way.


DOWNLOAD 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

RSS Feed

Follow us on Facebook

Follow us on Twitter

Follow us on LinkedIn

Follow us on YouTube