Why austerity is failing

Matthew Rao


July 13th, 2014

Matthew Rao examines the merits of the two main approaches to dealing with global economic stagnation.

In the aftermath of the Global Financial Crisis, economists from all around the world – despite failing to predict the crisis – felt strong enough to offer their advice as to how we could pull ourselves out of the abyss. The conversation was roughly divided between two contrasting views. One group of economists, loosely entitled ‘Keynesians’, recognised government spending as the surest way to rebuild, with unemployment as their main focus. The other group, which we can call ‘Austerians’, proposed the exact opposite, namely cutbacks to government spending and welfare in order to balance the budgets and avoid a full-blown debt crisis.

Although I would love to be able to report that the Keynesians won this battle, as you look around the world, you’re forced to notice that economic history and equitable policy eventually lost out most of the time to wishful thinking and ridiculous assumptions. Even though most countries enacted stimulus measures immediately after the crisis began, austerity was eventually imposed throughout many countries around the world and certainly in the two most important areas, the US and the Eurozone.

One might scoff at the suggestion that the US engaged in austerity considering the Obama administration enacted a 787 billion dollar stimulus package, but when you consider the fact that the US is a 17 trillion dollar economy and that many US states cancelled out much of the positive effects of this spending with cuts of their own, the stimulus looks far less potent.

Across the Atlantic, the imposition of austerity in Europe has been much more pronounced. Although many countries in Europe first responded with stimulus packages, this eventually gave way to austere measures in the following years. Slashing government spending and the social safety net has resulted in long-term pain, as consumers are not spending, meaning businesses are not hiring, leading to even less consumption, causing high unemployment and low growth. And of course, when there is low growth and high unemployment, there is less government revenue and more automatic outlays on welfare programs, meaning government budgets can’t be balanced and debt will accrue. This is as efficiently as I can summarise the impact of austerity, and in doing so, I hope the case against it is self-evident.

In contrast, the few places where Keynesians were listened to, the economy experienced a real rebound. The Rudd stimulus package was the essence of Keynesian economic policy, which is most potent in depression and depression-like situations. The handing out of $950 to just about everyone, as well as RBA action to reduce interest rates to record low levels and keeping them there, was exactly what was needed to ensure the incredibly vital income-spending tap remained running. In doing so, Australia was able to dodge the ‘paradox of thrift’ – a situation that I touched on earlier, in which most consumers are saving their income, leading to less consumption and the entire income share gradually receding. Many may think the mining boom was the be all and end all of our well-publicised avoidance of a recession, but we weren’t the only ones who pulled off this feat. Korea enacted a stimulus very similar to ours around the same time and also avoided a recession. However, unlike Australia, they did not have a mining boom or commodities boom of any kind. Their insistence on long-term investment and social spending, much like Australia, ensured that post-GFC life wouldn’t be too unbearable and unemployment wouldn’t be too acute.

I am being thorough about making this distinction between the Keynesians and the Austerians because there’s every chance that this distinction could become very important in the coming years. Worldwide growth is steadily improving, America’s unemployment rate is gradually falling, the British economy is slowly (very slowly) expanding and the Eurozone is shooting itself in the foot less and less (although the long-term damage has already been done). Regardless, in the coming years and decades, the business cycle will come into play as economies naturally rise from their slump and begrudgingly venture towards prosperity due to the rollback of austerity.

And as this happens, the Austerians will continue to claim these developments as vindications of their policies. If you doubt this, just look at how they have reacted over the most meagre of growth results. George Osbourne, British Chancellor of the Exchequer (equivalent to our treasurer) has been raving on for years that his program of austerity has been successful. It speaks volumes that he spent much of this time fawning over the most pathetic increases in growth, most of the time barely reaching a 1% increase in GDP. As much as this is annoying, it is also dangerous. If the Austerians are allowed to claim this as victory, history is ever more likely to recognise their policies as legitimate and future economists and policy-makers are even more likely to repeat the same mistakes.

And if you think that these results would have been the same or even worse under a more Keynesian approach, I encourage you to survey around the world. The pattern is pretty self-explanatory. As mentioned earlier, in countries such as Australia and Korea where stimulus was imposed, the economy grew. In countries such as America where stimulus was mixed with austerity, the economy experienced a sharp decline before gradually improving. And in countries all throughout Europe where excessive austerity was the order of the day, the economies very nearly imploded.

If present day evidence isn’t sufficient, then how about venturing back to the 1930’s in the years of the Great Depression. The initial reaction from the Federal Reserve was to basically allow the money supply to contract, which exacerbated the crisis to remarkable depths. In the proceeding year’s growth was gradually increasing, until 1937-38, when the government decided that balancing the budget was the primary aim, which lead to an American recession within the depression. Only when one of the largest expenditure programs ever, World War II, began, did the world actually lift itself out of the Great Depression.

Therefore it is crucial that the Keynesians, those who advocated for a replication of what has worked, remain as vocal as possible in asserting the fact that we would have been out of economic peril much sooner, with much less destruction caused, if they had been listened to.

The best way to avoid repeating the mistakes of the past is to remember the lessons learnt. The clear lesson of the Great Depression was to spend money in a crisis to avoid a catastrophe. As clear as this was, we only partially learnt this lesson and its antithesis was still applied too much and too soon. I can only imagine how poorly we will react to a future crisis if the prevailing conventional wisdom of the Global Financial Crisis is that reducing deficits instead of unemployment is the main long-term concern. Therefore, it becomes vitally important for us not to gift the Austerians the privilege of writing this chapter of economic history.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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