With world leaders continuing to argue the mantra of austerity, Graeme O’Mara debunks the myth that austerity will lead us to economic recovery


As with most universities in Ireland, the dark cloud that is austerity is butting its ugly head, bringing huge cutbacks in funding available for campus facilities. Of most concern are those to the library facilities in the form of shorter opening hours, fewer textbooks per course and less borrowing privileges, i.e. the rationing of resources so that they can be shared amongst everyone. We’re looking at fewer tutorial hours and fewer lab hours, or at the very least, lesser lab facilities. Put in perspective, these funding shrinkages are hardly traumatic. Of concern, however, is the macroeconomic implication of austerity.

The current Irish debt to GDP ratio, as of the summer, is 108.5%, which is the fourth highest in the Eurozone. Under fiscal overhaul programmes prompted by Europe and ushered on by the IMF, the government is making strong efforts to tackle this deficit, although it is still expected to continue rising until 2015. These efforts embody cutbacks in public expenditure across the board and reductions and cessation of various state services. What is so absurd is that the very idea of austerity amidst recession simply doesn’t make sense: spending less in slumpish times can only serve to contract economic activity even further.

The argument that austerity is counter-productive has its origins in Keynes’ ‘Paradox of Thrift’: as people try to spend less and save more during a recession, aggregate demand falls and this in turn actually lowers savings because of falling incomes and unemployment. It complies with the fallacy of composition in that while individual thrift is beneficial, (it saves money for a ‘rainy day’ and provides funds for borrowers), it is detrimental for the economy as a whole. As the economy saves more, firms are put out of business, causing downsizing and unemployment, and eventually savings will either remain the same or become depleted.

Economists dub this process a ‘deviation amplifying feedback loop.’ Indeed, economist Hyman Minsky referred to the ‘Paradox of Deleveraging’ saying: “A process of balance sheet deleveraging has spread to nearly every corner of the economy. Consumers are pulling back on purchases, especially on durable goods, to build their savings. Businesses are cancelling planned investments and laying off workers to preserve cash. And, financial institutions are shrinking assets to bolster capital and improve their chances of weathering the current storm.”

He spoke of the paradox of deleveraging, in which precautions that may be smart for individuals and firms, magnify the distress of the economy as a whole. It is easy to see then why thriftiness at the exchequer level is adding fuel to an already smoking fire. Reduced fiscal expenditure and increased taxation is inducing a tighter squeeze on the economy; by slashing state services and jobs, the state is simply increasing the burden of unemployment and diminishing growth prospects. Nearly 14,000 additional jobs were lost between April and June of this year and the only reason the unemployment rate has remained below 15% is because of net outward migration.

At the core of the Keynesian argument is that in times of feeble demand, government should step in to pick up the shortfall that the private sector has failed to provide. Too often, as we have seen of late, quantitative easing and expansionary monetary policy, while creating ample circumstances for investment and entrepreneurship, cannot physically induce investors and entrepreneurs to set up shop because it is amidst the backdrop of an ailing economy, causing expectations of profitability to crowd out this amply suitable environment. Likewise; once-bitten, twice-shy banks are not lending enough exacerbating the credit crunch. In these circumstances, an expansionary fiscal policy (increase expenditures, cut taxes) can often be the call of the day.

In his latest book, Nobel Prize winner and Keynesian scholar Paul Krugman argues exactly that. He calls for a large scale, once and for all, fiscal stimuli to get people back to work and provide jobs for graduates; once unemployment is cured, the complex engine that is the economy will gain acceleration again and over time (certainly not overnight) increase aggregate demand and improve the exchequer finances. Coupled with a loose monetary policy that would cut interest rates near the zero lower bound, this should in turn give investors and entrepreneurs the kick they did to set up shop. By fiscal expansion, we are referring to large scale capital projects such as construction of schools, roads, bridges, hospitals, etc. that require mass labour and will enhance the productive capacity of the economy once recovery does take shape.

Krugman himself has said: “Consider the case of Ireland, which has been a good soldier in this crisis, imposing ever-harsher austerity in an attempt to win back the favour of the bond markets. According to the prevailing orthodoxy, this should work. In fact, the will to believe is so strong that members of Europe’s policy elite keep proclaiming that Irish austerity has indeed worked, that the Irish economy has begun to recover. But it hasn’t. And although you’d never know it from much of the press coverage, Irish borrowing costs remain much higher than those of Spain or Italy, let alone Germany. It’s an argument for much more expansionary policies elsewhere and in particular for the European Central Bank to drop its obsession with inflation and focus on growth.”

The independent Irish Fiscal Advisory Council, headed by Harvard PhD John McHale of NUI Galway recently put the dampers on the government’s plan for a €2.25 billion stimulus plan announced with great aplomb during the summer. “We have not seen the cost-benefit analysis,” he said. “We don’t see the argument for relaxing the fiscal stance to pursue a spending plan.” Additional austerity would put Ireland’s public finances on a sustainable footing and provide “an insurance policy” for future years should the recovery be slower than expected.’ Similarly, the ESRI reported in its latest quarterly commentary the need for further spending cuts.

Surely the boom years were the time to implement the likes of An Bord Snip Nua and minimize state services, when the money was rolling? This was not the philosophy of those in charge of budgetary arithmetic, as one TD’s legacy is the quote ‘When I have it, I spend it and when I don’t, I don’t.’ The boom years would have been the right climate to hike taxes, particularly on property related purchases, and bring down public expenditures, including social welfare benefits and public sector pay, given that the unemployment rate of around 4% was mainly structural. These measures may have generated large budget surpluses and helped to shift resources within the economy. Just as austerity is making things worse now, loose spending policies only served to make the party even louder then. But how could you sell that to the electorate?

Krugman’s solution is three pronged: a yearly fiscal stimulus, a higher central bank inflation target which would see prices escalate, eroding away the real value of debt and encouraging spending, and assistance to households burdened with high interest payments by allowing them to refinance at today’s lower rates. A preponderance of studies show that, when interest rates are stuck at zero (presently at 0.75% in Europe), government spending has a large effect on the economy. This makes redundant the argument of fiscal expansion pushing up interest rates and crowding out investment. And while many critics point to the failure of the Obama stimulus plan, Krugman argues that this was not undertaken on a large enough scale.

Is this the way forward? Given that Krugman’s multiplier effect can be generated by an economy with a GDP of $15 trillion (2011), it is hard to see how this prescription can be extended to a small open economy like Ireland. In addition, there is minimal fear at this point in time of more spending pushing the US toward a debt crisis. Given that the Irish economy is essentially broke, monetary policy lies in the hands of inflation obsessed Europe and the government has had a tough time forcing banks to pass on interest rate cuts, it is hard to envision Krugman’s remedy curing the Irish economy.

The way forward then, may be to redistribute savings from austerity into fiscal stimulus initiatives, i.e. spend savings from cutbacks in one area of the economy on job creation in another. It is also of tantamount importance that efforts be taken to force banks to lend out: the ESRI notes that, even where funding is provided through bailed-out banks, a lending rate of 6.3% applies, compared to 3.6% in Germany. An alternative and extremist solution then, as a respected academic at this university advocated, is simply to walk away from the bailout, although I think it is a bit late in the day for that.

Sound economic judgement is flawed by the fact that economic policies are inherently political and it is that political influence which dictates the trajectory of policy; the current election in the US exemplifies this beautifully. Also, politicians tend to have only a feeble knowledge of basic economic principles, with shallow advice coming from their advisers. This may be why such few economists worked in the civil service during the Celtic Tiger years; for fear that they would ‘talk down the economy.’