Austerity: The History of a Dangerous Idea, by Mark Blyth

Do austerity policies ever work? Not according to the author of this illuminating new economic history

Austerity: The History of a Dangerous Idea
Austerity: The History of a Dangerous Idea
Author: Mark Blyth
ISBN-13: 978-0199828302
Publisher: Oxford University Press
Guideline Price: Sterling16.99

In October 2011 David Cameron, the British prime minister, was forced to withdraw a comment he made in his speech at the Conservative Party conference. What did he say that was so wrong that the "official history" had to be rewritten? He told Britons that they should all try to cut spending and pay off their credit-card debts.

Cameron was perhaps thinking that he was simply giving good housekeeping advice. But the journalists who were covering the story – and at least the smarter of his advisers – could see a great big hole in his argument. He did not grasp that one person’s spending is another’s income and, therefore, that the demand in the economy would collapse if people heeded his advice and reduced their spending.

Unfortunately, Cameron is not alone in believing that what may be good for an individual must be good for the economy. Many economists still agree with Adam Smith that "what is prudence in the conduct of every private family can scarce be folly in that of a great kingdom". German politicians talk as if all nations could have trade surpluses if only they tried hard enough, despite the fact that it is impossible for all countries to have a trade surplus, unless we start trading with Mars.

People have struggled for centuries to grasp that the whole is not its parts writ large. Explaining why this has been the case is the central theme of Mark Blyth's brilliant book Austerity: The History of a Dangerous Idea.

Blyth starts his discussion by documenting how a financial crisis originating in the private sector has been turned into a crisis of public finance in what he calls the “greatest bait-and-switch in modern history”. Once this switch was made, Blyth argues, a morality tale was trotted out in which the euro zone’s banking crisis was rebranded as a sovereign-debt crisis and blamed on the profligate governments in the European periphery countries, despite the fact that none of them, with the exception of Greece, had serious budget deficits before the crisis. (Ireland and Spain had surpluses.)

The discussion involves a lot of quite technical issues, but Blyth conducts it in a very user-friendly way. This alone is an important service. For people to know how they have been duped in the bait-and-switch, they need to be told how the trick works. And Blyth does just that.

Blyth then goes on to examine the "intellectual history" of austerity. He shows how early thinkers such as John Locke, David Hume and Adam Smith created an intellectual system whereby governments should do no more than protect private property and be constrained so that they cannot run large public debts. On this foundation the austerity argument proper emerged in the 1920s in the form of American "liquidationism" and the "treasury view" in Britain.

These early austerity arguments were almost totally discredited by the Great Depression. However, Blyth documents how their surviving remnants – ordoliberalism in Germany and Austrian economics in the US – entered the intellectual mainstream again in the 1980s, with the rise of neoliberalism.

According to Blyth, the current version of the austerity argument was created by a group of Italian economists, originating from Bocconi University, in Milan. Blyth very critically examines a series of economic models that these economists have developed, in which it is argued that government debts are inevitable products of democracy and that the best way to cure those debts is to cut spending rather than to raise taxes.

These Italian economists have even invented the supremely Orwellian term “expansionary fiscal contraction”, which is used to argue that cutting spending can increase growth, even at the depth of an economic downturn. (The logic involved is rather bizarre to noneconomists, so I won’t go into that here. Blyth explains it very well.)

In the “natural history” of austerity that follows, Blyth examines with a fine-tooth comb dozens of austerity experiences over the past century.

First he examines the disasters of the interwar period, with austerity in the US, Britain, Sweden, Germany, Japan and France, all of which resulted in economic destruction and political implosion, subsequently discrediting the austerity approach for half a century.

Then he moves the focus to a series of austerity experiences in the 1980s and 1990s, which are presented as success stories by the “austerians” today. Of these, Blyth dismisses Denmark and Sweden on the grounds that they were not success stories at all. He admits that Ireland succeeded in cutting government spending and growing, but argues that it could do so only because of unique conditions that cannot be replicated elsewhere, even in today’s Ireland.

When Ireland cut its public spending in the mid 1980s the international economy was expanding rapidly and Ireland still had its own currency, which it could devalue to take advantage of such a condition. The new membership of the European Union meant not only a freer access to the country’s most important markets but also inflow of a substantial amount of “cohesion funds”, which upgraded infrastructure and helped the country attract foreign direct investments. And, in huge contrast to today’s austerity programmes, wages rose, boosting government revenue and private consumption.

Finally, Blyth demolishes what he wittily names the Rebll alliance, a group of paraperipheral countries in Europe that are flagged as the current success cases of austerity: Romania, Estonia, Bulgaria, Latvia and Lithuania. The prevailing myth is that these plucky little countries are diligently implementing austerity policies that their soft southern European neighbours try to weasel out of and that, as a result, the Reblls are recovering quickly. Blyth shows that these countries have coped with the austerity programme only by increasing their national debts hugely, seeing birth rates plummet and experiencing huge emigration.

Having shown that austerity has never worked, Blyth concludes his book by proposing that we explore the possibility of a new strategy based on some policy taboos of recent years, such as “financial repression”, limiting cross-border capital movements and capping interest rates, and increased taxes for top earners. He also argues that the US government should probably have let its banks go bankrupt – as the Icelandic government did – rather than bail them out.

Although it should be praised for being bold, Blyth's policy package, I believe, goes too far in one sense but not far enough in another. It goes too far in that it is arguing for bankruptcy for failing banks. This cannot be adopted as a rule. However large they were in relation to their national economy, the Icelandic banks were small players in the world economy. Given that the financial system runs on confidence – or shall we say confidence tricks? – the consequence of not bailing out the huge US or UK banks would have been devastating for the rest of the world. After all, the US government had tried the bankruptcy option with Lehman Brothers, only to trigger a panic.

Blyth’s proposal does not go far enough in relation to the treatment of the bankers. The problem with the current bailout scheme is that it saved not only failed banks but also failed bankers, with no substantial punishment and conditions for subsequent behaviour.

Most of the top bank managers have kept their jobs, and their bonus practices have continued in the same manner despite the fact that they are now making profits only because of explicit and implicit supports from government, including payment guarantees and quantitative easing. With no punishment for failures, it is no wonder that bankers are behaving as if nothing has happened.

And, unlike the tougher and tougher conditions that they are imposing on welfare payments to the poor, the subsidies given to those banks have come with no conditions. The UK government’s scheme to give more money to its banks so that they can lend more to small and medium-sized enterprises – the “funding for lending” scheme – has been unsuccessful because there is no condition attached to it. Indeed, the UK government has not even told the bailed-out banks to comply, as it has already openly repudiated its prerogative as their majority shareholder and declared itself to be at “arm’s length” from those banks.

In the US the government went even one step further and deliberately took nonvoting shares when taking over failed banks, so that it can never “interfere” in their management.

Unless we address bankers’ reward (and sanction) systems and conditions of government support, we will never change the financial system, regardless of whether we let banks fail. That Blyth largely overlooks this issue is a shortcoming in this otherwise marvellous book.

All in all, Austerity: The History of a Dangerous Idea is a masterful combination of economic history and intellectual history that puts the current policy debate into a balanced and sophisticated perspective. Anyone who wants to understand what is going on in the world at the moment should read it. Right away.

Ha-Joon Chang teaches economics at the University of Cambridge. He is the author of 23 Things They Don't Tell You About Capitalism.