Monday, April 4, 2011

The economic consequences of our folly

Austerity is a terrible idea and it is probably a wrong one. It has become the mantra of European governments, the word most often quoted in 2010 . Why we should combat austerity policies may seem quite obvious in the light of the enormous consequences of the crisis. The same debate took place in the 30s- and we know how things went.  Yet, mainstream economists continue to deny the evidence. As such, it is a sound idea if we mean 'putting your house in order'* . But this is far from being true. Austerity policies aim to cut deficit due to excess of debt but it also lowers spending and also reduces the amount of benefits and public services provided.

One of the strongest opponents of austerity, P.Krugman, wrote (NYT March 25) "... we have a political climate in which self-styled deficit hawks want to punish the unemployed even as they oppose any action that would address our long-run budget problems. And here's what we know from experience abroad: The confidence fairy won't save us from the consequences of our folly"
 In Portugal, the government resigned due to dispute over an austerity package - the PM, José Socrates argued that he did not want his country to end up like Ireland or Greece. But it is now urged to pass an austerity plan, though this will not suffice to avoid a bailout.  

Ireland is still struggling with a huge deficit due to the bailout of its banks and imposed to its citizens savage cuts in public spending to reassure financial markets.  It does not seem to be enough for them as  yield rates rose up to 10% for the first time since June 2009 and the unemployment rate now stands at 13.5 percent.
In Britain, the government decided an unprecedented austerity policy with savage cuts to civil service (almost half were made redundant), a huge increase of university fees and further cuts to public services.  The economic forecasts are not encouraging -  there is no sign of economic recovery and deficits are set to increase in future. The Labour party leader, Ed Milliband is now regaining popularity among the electorate with a left wing discourse emphasizing the excessive inequality and the fact hat the disadvantaged classes are paying the price for austerity.

The underlying  assumption of austerity policies is that they will restore confidence which will create jobs and growth by the fact that private investment will then crowd in and more than offset the government's spending cuts. In economics, this idea stems from the belief in the existence of a general economic equilibrium which predicts that economic fluctuations revert back to a "normal" state of affairs automatically. 

Austerity policies had the opposite effect with  further depressing growth and engendering deflation which increases the value of debts. This can also cause countries to fall into a liquidity trap causing credit markets to freeze up and unemployment to increase. In some countries such as Ireland and Spain, austerity measures introduced as a response to the financial crisis proved ineffective in combating public indebtedness and placed those countries at risk of default in late 2010. 

On the other hand, fiscal expansion is not always the right thing to do, but in times of recession with high unemployment, it is the only policy measure to restore a situation of equilibrium. Because we are in a crisis situation, we need unorthodox measures, so jobs first then cut the deficit later is the right strategy as tax revenues will increase with the effect of closing the deficit.  Unfortunately, this strategy has been abandoned  in the face of social injustice and unemployment. 

*The term economics comes from the Ancient Greek οἰκονομία(oikonomia, "management of a household, administration") from οἶκος (oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)"(from Wikipedia) 

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