Calling Out the Austerians

Just what do austerity policies really do to an economy? For countries at risk of defaulting on their debts, austerity may provide a path back to international credit markets. But for those with no trouble borrowing, austerity may have a much simpler and more sinister result: greater inequality.

Though backers of austerity may cloak their arguments in talk of budget deficits and belt-tightening, many of them have long wanted to reduce the size of the public sector. George Osborne, now the British chancellor, told me in 2005 that the heavy cuts he supported then were "not what you might call efficiency or productivity savings in the main" but rather "a reduction in government activity."

At the time, the United Kingdom was enjoying its 13th straight year of strong economic growth. Osborne’s rationale had nothing to do with smoothing out the business cycle or trimming the country’s debts. He simply thought that the British government played too big a role in the economy.

Given the chance to pursue his agenda under the cloak of austerity when the Tories took office in 2010, Osborne grabbed it with both hands — as have right-leaning politicians around the world. During the worst days of the Great Recession in the United States, John Boehner, the Republican speaker of the House, repeatedly said that government was the problem, urging Congress to "get really serious about cutting spending." In a later speech, in 2011, he said the government had "crowded out private investment by American businesses of all sizes." With his colleagues, he succeeded in fending off a second major stimulus package.

Osborne’s and Boehner’s rhetoric might make sense from an ideological point of view, or perhaps even in some textbook models. But their policies do not take account of the realities of the economic downturn. Moreover, their words and actions make clear how little they understand of the way businesses and the economy as a whole actually work.

First, let’s consider Osborne’s prescription for the United Kingdom. The cuts he so dearly desired did not have the same effect in 2010, when he became chancellor, as they would have had when I interviewed him five years earlier. In April 2005, with the economy booming and the unemployment rate at just 4.7 percent, workers let go by the public sector might have been absorbed fairly quickly into the private sector; there was almost no slack in the labor market.

But in May 2010, the unemployment rate was 7.8 percent. It rose as the cuts began to take hold, peaking at 8.3 percent and not returning to 7.8 percent until July 2012. The suffering caused by the cuts was much greater than it would have been five years earlier.

Now let’s look at Boehner’s statement about private investment. In a closed economy, where all credit has to come from within the country’s borders, crowding out can indeed occur. If the government borrows more, there is less money available to the private sector; interest rates rise, and private investment falls.

But the United States is not a closed economy. In fact, foreigners seeking relatively safe investments flooded the country with money during the economic downturn. They not only helped to finance private investment; they also helped to preserve the value of the dollar, even as the Federal Reserve injected billions into the markets by buying up securities. With a glut of foreign cash and an activist central bank, long-term interest rates hit rock bottom. There was no shortage of money for businesses looking to invest.

In short, austerity policies offered a way to make credit cheaper when credit was already cheap, and to deluge the labor market with jobless workers when the jobless rate was already high. Might they still have had a stimulating effect on the economy?

Let’s say you’re thinking about a big purchase — something you’ll be able to use for years to come, like a car. For you, a car is a capital investment. What do you think about when deciding whether to buy and how much to spend? One consideration is whether you’ll be able to make the payments in the future or, if you’re going to buy the car for cash, whether you might need those savings for something else. At the very least, you’ll probably ask yourself how certain you are of your income in the years to come. And then you might try to figure out just how much benefit you’d get out of the car versus, say, taking public transportation. For a company, the decision is similar. Before making a big investment, its executives will gauge the effect on the firm’s liquidity and conduct a cost-benefit analysis.

During the economic downturn, both of these assessments — for households and for businesses — were complicated by uncertainty. Companies wanted to see a few quarters of strong profits and good prospects for more before investing in new capacity. But austerity policies delayed this recovery in profits by keeping unemployment high, incomes stagnant, and demand low.

Austerity policies did not soften the immediate pain of the economic downturn, at least in countries with plenty of access to credit. Instead, their policies’ main effect was to reduce the absolute size of the tax burden for people today and in the future. Did this actually make people better off?

The answer will depend in large part on what happens to incomes. A lower tax burden is wonderful as long as your income doesn’t fall as well — yet that’s exactly what may happen to the long-term unemployed, who have likely suffered a permanent dent in their incomes as a result of austerity policies.

These workers tend to have lower incomes to begin with, which also means they pay very little in taxes. Meanwhile, the people who usually pay the bulk of income taxes have suffered much less joblessness. In other words, the outcomes of austerity policies may be lower taxes for high-income people and lower incomes for people at the other end of the spectrum.

There can be no better recipe for greater inequality. In the long term, it will depress economic growth, worsen social problems, and erode our meritocracy. Austerity policies may come clothed in the vestments of virtue and responsibility, but they will hurt our economies in other ways for years to come. Will it take the creation of a new, long-term unemployed underclass to see these policies for what they really are?