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Austere Illusions: Robert Skidelsky

1) The document criticizes austerity policies and advocates for Keynesian economics. It argues that simply cutting government spending to reduce deficits will not lead to economic growth and may prolong recessions. 2) Research claiming austerity can boost growth through "confidence effects" is flawed, confusing correlation with causation. In reality, fiscal contraction is contractionary and does not offset falling demand. 3) Austerity policies have failed to significantly reduce deficits or boost growth in Europe and the UK over the past few years. Prolonged unemployment also erodes long-term economic potential.

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29 views

Austere Illusions: Robert Skidelsky

1) The document criticizes austerity policies and advocates for Keynesian economics. It argues that simply cutting government spending to reduce deficits will not lead to economic growth and may prolong recessions. 2) Research claiming austerity can boost growth through "confidence effects" is flawed, confusing correlation with causation. In reality, fiscal contraction is contractionary and does not offset falling demand. 3) Austerity policies have failed to significantly reduce deficits or boost growth in Europe and the UK over the past few years. Prolonged unemployment also erodes long-term economic potential.

Uploaded by

OBRE
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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1

Robert Skidelsky
Robert Skidelsky, Professor Emeritus of Political Economy at Warwick University and a
fellow of the British Academy in history and economics, is a member of the British House of
Lords.

Austere Illusions
LONDON – The doctrine of imposing present pain for future benefit has a long history –
stretching all the way back to Adam Smith and his praise of “parsimony.” It is particularly
vociferous in “hard times.” In 1930, US President Herbert Hoover was advised by his
treasury secretary, Andrew Mellon: “Liquidate labour, liquidate stocks, liquidate the farmers,
liquidate real estate. It will purge the rottenness out of the system...People will...live a more
moral life...and enterprising people will pick up the wrecks from less competent people.”

Illustration by Chris Van Es

To “liquidationists” of Mellon’s ilk, the pre-2008 economy was full of cancerous growths –
in banking, in housing, in equities – which need to be cut out before health can be restored.
Their position is clear: the state is a parasite, sucking the lifeblood of free enterprise.
Economies gravitate naturally to a full-employment equilibrium, and, after a shock, do so
fairly quickly if not impeded by misguided government action. This is why they are fierce
opponents of Keynesian interventionism.

Keynes’s heresy was to deny that there are any such natural forces, at least in the short term.
This was the point of his famous remark, “In the long run we are all dead.” Economies,
Keynes believed, can become stuck in prolonged periods of “under-employment
equilibrium”; in such cases, an external stimulus of some kind is needed to jolt them back to
higher employment.

Simply put, Keynes believed that we cannot all cut our way to growth at the same time. To
believe otherwise is to commit the “fallacy of composition.” What is true of the parts is not
true of the whole. If all of Europe is cutting, the United Kingdom cannot grow; if the entire
world is cutting, global growth will stop.

In these circumstances, austerity is exactly the opposite of what is needed. A government


cannot liquidate its deficit if the source of its revenues, the national income, is diminishing. It
is deficit reduction, not debt, that is profligate, because it implies wastage of available human
and physical capital, quite apart from the resulting misery.
2

Austerity’s advocates rely on one – and only one – argument: If fiscal contraction is part of a
credible “consolidation” program aimed at permanently reducing the share of government in
GDP, business expectations will be so encouraged by the prospect of lower taxes and higher
profits that the resulting economic expansion will more than offset the contraction in demand
caused by cuts in public spending. The economist Paul Krugman calls this the “confidence
fairy.”

The pro-austerity argument is pure assertion, but it is meant to be a testable assertion, so


econometricians have been busy trying to prove that the less the government spends, the
faster the economy will grow. Indeed, just a year or two ago, “expansionary fiscal
contraction” was all the rage, and a massive research effort went into proving its existence.

Economists arrived at some striking correlations. For example, “an increase in government
size by ten percentage points is associated with a 0.5-1% lower annual growth rate.” In April
2010, the leader of this school, Harvard University’s Alberto Alesina, assured European
finance ministers that “even sharp reductions of budget deficits have been accompanied and
immediately followed by sustained growth rather than recessions even in the very short run.”

But two fallacies vitiated the “proofs” offered by Alesina and others. First, because the cuts
had to be “credible” – that is, large and decisive – the continuing absence of growth could be
blamed on the insufficiency of the cuts. Thus, Europe’s failure to recover “immediately” has
been due to a lack of austerity, even though public-sector retrenchment has been
unprecedented.

Second, the researchers committed the arch-statistical mistake of confusing correlation with
causation. If you find a correlation between deficit reduction and growth, the reduction could
be causing the growth or vice versa. (Or both the deficit reduction and the growth could be
due to something else – devaluation or higher exports, for example.)

An International Monetary Fund paper in 2012 brought Alesina’s hour of glory to an end.
Going through the same material as Alesina had, its authors pointed out that “while it is
plausible to conjecture that confidence effects have been at play in our sample of
consolidations, during downturns they do not seem to have ever been strong enough to make
the consolidations expansionary.” Fiscal contraction is contractionary, period.

An even more spectacular example of a statistical error and sleight of hand is the widely cited
claim of Harvard economists Carmen Reinhart and Kenneth Rogoff that countries’ growth
slows sharply if their debt/GDP ratio exceeds 90%. This finding reflected the massive
overweighting of one country in their sample, and there was the same confusion between
correlation and causation seen in Alesina’s work: high debt levels may cause a lack of
growth, or a lack of growth may cause high debt levels.

On this foundation of zombie economics and slipshod research rests the case for austerity. In
fact, the austerity boosters in the UK and Europe frequently cited the Alesina and
Reinhart/Rogoff findings.

The results of austerity have been what any Keynesian would have expected: hardly any
growth in the UK and the eurozone in the last two and a half years, and huge declines in some
countries; little reduction in public deficits, despite large spending cuts; and higher national
debts.
3

Two other consequences of austerity are less appreciated. First, prolonged unemployment
destroys not just current but also potential output by eroding the “human capital” of the
unemployed. Second, austerity policies have hit those at the bottom of the income
distribution far more severely than those at the top, simply because those at the top rely much
less on government services.

So we will remain in a state of “under-employment equilibrium” until policy in the UK and


the eurozone is changed (and assuming that policy in the US does not become worse). In the
face of clamour from the right to cut even more savagely, statesmen who are too timid to
increase public spending would be wise to ignore their advice.

Read more at http://www.project-syndicate.org/commentary/the-predictable-failure-of-fiscal-


austerity-by-robert-skidelsky#vl9mJ7goaMbIMSIE.99

QUESTIONS:

1. Keynesian economists argue that governments should increase their budget deficits in times
of recession. Explain the theory behind this claim.
2. Neo-classical economists (like Alesina and others, page 2) assert that reducing government
deficits (known as ‘fiscal contraction’) will produce economic growth. Explain this argument.
3. There are a number of reasons why this neo-classical argument is incorrect, according to
Skidelsky. Explain.

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