Unconventional Economic Wisdom
Taming Finance in an Age of Austerity
Joseph E. Stiglitz
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NEW YORK – It was not long ago that we could say, “We are all Keynesians now.” The financial sector and its free-market ideology had brought the world to the brink of ruin. Markets clearly were not self-correcting. Deregulation had proven to be a dismal failure.
The “innovations” unleashed by modern finance did not lead to higher long-term efficiency, faster growth, or more prosperity for all. Instead, they were designed to circumvent accounting standards and to evade and avoid taxes that are required to finance the public investments in infrastructure and technology – like the Internet – that underlie real growth, not the phantom growth promoted by the financial sector.
The financial sector pontificated not only about how to create a dynamic economy, but also about what to do in the event of a recession (which, according to their ideology, could be caused only by a failure of government, not of markets). Whenever an economy enters recession, revenues fall, and expenditures – say, for unemployment benefits – increase. So deficits grow.
Financial-sector deficit hawks said that governments should focus on eliminating deficits, preferably by cutting back on expenditures. The reduced deficits would restore confidence, which would restore investment – and thus growth. But, as plausible as this line of reasoning may sound, the historical evidence repeatedly refutes it.
When US President Herbert Hoover tried that recipe, it helped transform the 1929 stock-market crash into the Great Depression. When the International Monetary Fund tried the same formula in East Asia in 1997, downturns became recessions, and recessions became depressions.
The reasoning behind such episodes is based on a flawed analogy. A household that owes more money than it can easily repay needs to cut back on spending. But when a government does that, output and incomes decline, unemployment increases, and the ability to repay may actually decrease. What is true for a family is not true for a country.
More sophisticated advocates warn that government spending will drive up interest rates, thus “crowding out” private investment. When the economy is at full employment, this is a legitimate concern. But not now: given extraordinarily low long-term interest rates, no serious economist raises the “crowding out” issue nowadays.
In Europe, especially Germany, and in some quarters in the US, as government deficits and debt grow, so, too, do calls for increased austerity. If heeded, as appears to be the case in many countries, the results will be disastrous, especially given the fragility of the recovery. Growth will slow, with Europe and/or America possibly even slipping back into recession.
Stimulus spending, the deficit hawks’ favorite bogeyman, did not cause most of the increased deficits and debt, which are the result of “automatic stabilizers” – the tax cuts and spending increases that automatically accompany economic fluctuations. So, as austerity undermines growth, debt reduction will be marginal at best.
Keynesian economics worked: if not for stimulus measures and automatic stabilizers, the recession would have been far deeper and longer, and unemployment much higher. This does not mean that we should ignore the level of debt. But what matters is long-term debt.
There is a simple Keynesian recipe: First, shift spending away from unproductive uses – such as wars in Afghanistan and Iraq, or unconditional bank bailouts that do not revive lending – toward high-return investments. Second, encourage spending and promote equity and efficiency by raising taxes on corporations that don’t reinvest, for example, and lowering them on those that do, or by raising taxes on speculative capital gains (say, in real estate) and on carbon- and pollution-intensive energy, while cutting taxes for lower-income payers.
There are other measures that might help. For example, governments should help banks that lend to small- and medium-size enterprises, which are the main source of job creation – or establish new financial institutions that would do so – rather than supporting big banks that make their money from derivatives and abusive credit card practices.
Financial markets have worked hard to create a system that enforces their views: with free and open capital markets, a small country can be flooded with funds one moment, only to be charged high interest rates – or cut off completely – soon thereafter. In such circumstances, small countries seemingly have no choice: financial markets’ diktat on austerity, lest they be punished by withdrawal of financing.
But financial markets are a harsh and fickle taskmaster. The day after Spain announced its austerity package, its bonds were downgraded. The problem was not a lack of confidence that the Spanish government would fulfill its promises, but too much confidence that it would, and that this would reduce growth and increase unemployment from its already intolerable level of 20%. In short, having gotten the world into its current economic mess, financial markets are now saying to countries like Greece and Spain: damned if you don’t cut back on spending, but damned if you do as well.
Finance is a means to an end, not an end in itself. It is supposed to serve the interests of the rest of society, not the other way around. Taming financial markets will not be easy, but it can and must be done, through a combination of taxation and regulation – and, if necessary, government stepping in to fill some of the breaches (as it already does in the case of lending to small- and medium-size enterprises.)
Unsurprisingly, financial markets do not want to be tamed. They like the way things have been working, and why shouldn’t they? In countries with corrupt and imperfect democracies, they have the wherewithal to resist change. Fortunately, citizens in Europe and America have lost patience. The process of tempering and taming has begun. But there is far more yet to do.
Joseph E. Stiglitz is University Professor at Columbia University and a Nobel laureate in Economics. His latest book, Freefall: Free Markets and the Sinking of the Global Economy, is now available in French, German, Japanese, and Spanish.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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HooversGhost 06:03 08 Jul 10
"When US President Herbert Hoover tried that recipe ..."
Hoover didn't try cutting spending--in fact he increased it by 50% during his term. Nor did he maintain a balanced budget--the budget went from a large surplus to a large deficit.
Data from Table 1.1 here: http://www.whitehouse.gov/omb/budget/fy2008/pdf/hist.pdf
"And yet one should read history ..." Indeed you should, sir.
josefski 10:11 08 Jul 10
But when Roosevelt responded to deficit hawks and balanced the budget after the first round of Keynesian investment, the economy tanked again and didn't recover until after WWII. And Hoover did increase spending, but he did it too late.
mgkurilla 02:15 09 Jul 10
The discussion between stimulus spending and austerity is misplaced. The real problem with stimulus spending is not "spending" but rather what the spending is used for. Governments do not have any vision or long term view regarding the economy and thus cannot craft spending plans that take the future into account.
One hears in the media all the time that personal consumption is 70% of our economy, but no one questions whether this is good, bad, or immaterial. As a result, most government spending is directed to simply maintain what is regarded as the status quo. But if the former status quo was unsustainable and partly responsible for the financial crisis in the first place, then it's easy to see how continuation of this allocation of scarce resources will not fix anything and more likely to simply extend and pretend all the current inefficiencies in the system.
Right now, the only economic stimulus that the USG can focus on is extending unemployment benefits as the main method to support consumption. There's no vision on long term economic development, no concept of promoting next generation industries as sources of future jobs and export potential. Everything is targeted to returning the economy back to 2007 with perhaps an small attempt to tighten lending standards.
We need to agree that an economy where the profits and growth of profits comes from the merely parasitic financial industry that supports few jobs and little in the way of exports is detrimental to long term economic health. In the past extractive industries were engaged in mining and supplied raw material for everyone else to produce "stuff." Now the only extraction that takes place is in finance where large chunks of productive activities are "mined" and wealth is "extracted" to enrich a small percent of the population with no downstream benefits to the broader economy. In fact, the financial industry is also involved in creatively destroying functioning elements of the overall economy if a small percentage of that destroyed wealth can be extracted in the process.
Make banking boring and let our brightest and best get back to making "stuff" instead of making "deals" and we'll see greater opportunities for economic stimulus both public and private to be productive and beneficial.
Panayotis 01:51 12 Jul 10
Outstanding article. More thinkers like Stiglitz are needed. However, I am concerned that he is not giving the same advice to George Papandreou who in a course of destoying the Greek economy with austerity measures, raising unemployment, inflation, poverty and eventually defaulting on Greek debt. Instead of restructuring Greek debt, fighting waste, tax evasion and promoting development projects, George Papandreou is following the IMF, ECB and EU prescriptions to ruin the country!
spz 01:14 06 Nov 10
@benhopper
What you missed out was that the economic dogma of those days was to "balance the budget at all costs". As the economy contracts, tax revenue fell rapidly. In a fatal attempt to balance the budget, Hoover cut spending and then passed the largest peacetime tax hike in US history: the Revenue Act of 1932. The economy plummeted further and the deficit widened because further contraction of the economy means further slides in tax revenue: the worse of both worlds.
benhopper 04:03 08 Jul 10
Stiglitz also said, "And yet one should read history and theory carefully: preserving financial institutions is not an end in itself, but a means to an end."