In a nutshell, austerity assumes that public debt is bad for growth, and that the only way to reduce it is to cut government spending and debt by running a budget surplus, irrespective of the possible social cost. With debt down to an unspecified level and government finances ‘sound’, the private sector will be freed to reignite prosperity.
The politics of ‘austerity’ has framed the policies of successive UK Chancellors of the Exchequer and European finance ministers for almost a decade. In the US, from Newt Gingrich in the 1990s to the legally mandated spending cuts – sequestration – after the last financial crisis, Congress has threatened periodically to shut down the Federal government unless lower budget targets are met.
But this fixation on austerity to reduce debt misses a basic point: what matters is long-run growth, its source (what is being invested in), and its distribution (who reaps the rewards). If, through austerity, cuts are made to essential areas that create the capacity for future growth (education, infrastructure, care for a healthy population), then GDP (however ill defined) will not grow. Moreover, the irony is that just cutting the deficit may have little effect on the debt/GDP if the denominator of the ratio is being badly affected. And if the cuts cause more inequality – as the Institute for Fiscal Studies has shown was the case with the UK austerity measures of the last years – consumption can only grow through debt (e.g. credit cards), which maintains purchasing power. Instead, if public investment is made in areas like infrastructure, innovation, education and health, giving rise to healthy societies and creating opportunities for all, tax revenues will most likely rise and debt fall relative to GDP.
It is crucial to understand that economic policy is not scientifically ordained. You can impose austerity and hope the economy grows, even though such a policy deprives it of demand; or you can focus on investing in areas like health, training, education, research and infrastructure with the belief that these areas are critical for long-run growth in GDP. In the end, the choice of policy depends heavily on one’s perspective on the role of government in the economy – is it key to creating value, or at best a cheerleader on the sidelines?
Magic Numbers
The current debate about austerity has avoided any mention of public value. Neither budget doves nor budget hawks have seriously questioned the theory of value that underpins much ‘common-sense’ understanding of market processes. A major reason for this lack of curiosity is that both camps seem to have been in thrall to the so-called ‘magic’ numbers which have framed the debate.
When, in 1992, European integration came into being through the Maastricht Treaty, there were various obligations that the signatory countries signed up to, one of which was to keep spending in check. Total public debt was to be limited to 60 per cent of GDP, with annual deficits (debt is the accumulation of deficits) not larger than 3 per cent of GDP. These numbers purport to set objective limits to government indebtedness. But where do they come from? You might imagine they are arrived at through some kind of scientific process – but if so, you’d be wrong. These numbers are taken out of thin air, supported by neither theory nor practice.
Let’s start with debt. In 2010 the American Economic Review published an article by two top economists, professors at Harvard University: Carmen Reinhart, ranked the following year by the Bloomberg Markets magazine among the ‘Most Influential 50 in Finance’; and Kenneth Rogoff, a former chief economist of the IMF.4 In this piece the pair claimed that when the size of government debt (as a proportion of GDP) is over 90 per cent (much higher than the 60 per cent of the Maastricht Treaty, but still lower than that of many countries), economic growth falls. The results showed that rich countries whose public debt exceeded that percentage experienced a sharp drop in growth rate for the period 1946–2009. This was a very important finding, as so many countries’ public debt levels are close to or exceed this percentage. According to IMF data the US debt/GDP ratio stood at 64 per cent in 2007, and 105 per cent in 2014. For the UK the equivalent numbers were 44 per cent and 81 per cent; for the European Union 58 per cent and 88 per cent, and for the Eurozone 65 per cent and 94 per cent.
Aware that the argument clearly gave ammunition to advocates of the smaller state, the authors hastened to reassure their readers that they had no skin in the game: that their argument had no ideological foundation, but was based purely on empirical data. They even went so far as to stress that their research had no underlying theory of government: ‘our approach here’, they emphasized, ‘is decidedly empirical’.5
Predictably enough, politicians and technocrats eager to ‘balance’ public spending seized on Reinhart and Rogoff’s research, which proved highly influential in the post-2008 crisis debate about austerity measures. In his Federal Budget Plan for 2013, passed by the US House of Representatives, the Republican Congressman Paul Ryan cited the study as evidence for the negative impact of high government debt on economic growth. It also informed austerity policies proposed by then UK Chancellor George Osborne and the EU Economy Commissioner, Olli Rehn.
Also in 2013, as part of his PhD studies, Thomas Herndon, a twenty-eight-year-old student at the University of Massachusetts Amherst, tested Reinhart and Rogoff’s data.6 He couldn’t replicate their results: his calculations showed no steep drop in growth rates when debt was high. Examining the professors’ data sheet, Herndon found a simple spreadsheet error. He also discovered inconsistencies in the countries and data cited.7 In two articles in the New York Times,8 the professors defended their general results, but accepted the spreadsheet error. Magic numbers were not so magic after all.
Now on to the other magic number held so dear by EU economists: the number 3. The ‘periphery’ countries of the Eurozone have been urged to restore their competitiveness by downsizing the state. In line with the Maastricht criteria, bailouts for countries like Cyprus, Greece, Ireland and Portugal have been conditional on their cutting spending. If that spending goes above 3 per cent of GDP then bailouts are jeopardized. Between 2010 and 2017, Greece received €260 billion in bailout aid, in exchange for cutting state expenditure. However, since its problems were too structural to be solved by a simple ‘austerity’ measure, the cuts pitched it into a deep recession, turning into full-blown depression. And, rather than decreasing Greece’s debt, the lack of growth has caused the debt/GDP ratio to rise to 179 per cent. The cure is killing the patient.
This obsessive focus on countries’ deficits ignores a stark reality. Some of the weakest Eurozone countries have had lower deficits than the stronger countries – Germany, for instance. What matters is not the deficit but what government is doing with its funds. As long as these funds are invested productively in sectors like healthcare, education, research and others that increase productivity, then the debt/GDP denominator will rise, keeping the ratio in check.
Italy is another glaring example of how magic numbers don’t work. For the last two decades Italy’s budget deficit has been lower than Germany’s, rarely exceeding the 3 per cent limit specified for euro membership. Indeed, Italy has been running a primary budget surplus since 1991, the only exception being 2009. And yet Italy has a high and rising debt/GDP ratio: 133 per cent in 2015,9 way above the 60 per cent ceiling. The ratio is less affected by the numerator (the budget deficit) than by the lack of public and private investment determining the denominator (growth of GDP). After three successive years of austerity, GDP grew by just 1 per cent in 2015 (0.1 per cent in 2014, 0.9 per cent in 2016). (In fact, the austerity years were responsible for an outstanding fall in real GDP: −2.8 per cent in 2012, −1.7 per cent in 2013.) So why has the economy stagnated? The answer is complicated, but in part it is the result of inadequate investment in areas that raise GDP, such as vocational training, new technology and R&D. To make matters worse, a prolonged squeeze on government spending has weakened demand in the Italian economy and lowered the incentive to invest.
Yet Eurozone policy blindly persists in the conventional view that austerity is the solution, and that inadequate growth
indicates insufficient austerity. Back in 2014, in a stinging attack on Eurozone political economy,10 Joseph Stiglitz wrote: ‘Austerity has failed. But its defenders are willing to claim victory on the basis of the weakest possible evidence: the economy is no longer collapsing, so austerity must be working! But if that is the benchmark, we could say that jumping off a cliff is the best way to get down from a mountain; after all, the descent has been stopped.’ The austerity policy of cutting taxes and government spending does not revive investment and economic growth, when the real problem is weak demand. And in countries like Greece and Spain, where 50 per cent of young people cannot find work, pursuing policies that don’t actually affect investment – and hence jobs – means that an entire generation can lose its right to a prosperous future.
Questions of government debt and budget deficits are often also confused with ones about the size of government, usually measured as the ratio of government spending to the size of the economy. And yet there are no magic numbers for what is too big or too small. France, frequently touted as an example of ‘big government’, has a government expenditure/GDP ratio of 58 per cent. The UK government’s spending is also often regarded as quite big, but at about 40 per cent its ratio is not much different to that of the US at 36 per cent – although the US is often cited as an example of ‘small government’. Surprisingly, China, often perceived as a state-run economy, has a ratio of only 30 per cent.
However, recent research into the impact of government size on economic growth has found almost unanimously that small government is ‘bad’ if, for example, it cannot even maintain basic infrastructure, rule of law (e.g. funding of police) and the educational needs of the population. Conversely, the same research concludes that bigger government might be ‘bad’ if it is a result of activity that ‘crowds out’ (reduces) the private sector11 or unduly restricts private-sector activity and interferes too much in people’s lives.12 But within these rather obvious limits, the ideal size of government is hard to quantify – not least because it depends heavily on what you want government to do and how you value government activity. And here we have a problem: there has been a dearth of thinking by economists – both historically and in recent decades – about the value created by government.
GOVERNMENT VALUE IN THE HISTORY OF ECONOMIC THOUGHT
Economics emerged as a discipline in large part to assert the productive primacy of the private sector.
Starting with the French physiocrats, economists found that government was required for the orderly functioning of society and thus for setting conditions for the production of value. But in itself, government was not inherently productive; rather, it was a stabilizing background force. The physiocrats pleaded with King Louis XV to laissez-faire – not to micro-manage the economy by siphoning off as much gold as possible, and thereby upset the intricate mechanism by which value was really created13 – through productivity of the land, not by accumulating precious metal. We saw in Chapter 1 how, according to Quesnay’s Tableau Économique, value produced in agriculture flowed through the economy. But government was absent, ‘unproductive’. As part of the ruling class, members of the government got a share of the value apportioned simply because they were in power.14
Nevertheless, Quesnay knew, the Tableau did not work by itself. There was something to be ‘governed’. Quesnay argued that the wealth of the nation could only be upheld through ‘proper management by the general administration’ – what we would call government regulation.15 He thought that free competition would best benefit the economy – but to achieve this, far from excluding government, he favoured an activist state that would break monopolies and establish the institutional conditions necessary for competition and free trade to flourish and value creation to thrive.16
Adam Smith, meanwhile, devoted the fifth book of his The Wealth of Nations to the role of government in the economy. His aim was not only to explain the prosperity of the nation, but also ‘to supply the state or commonwealth with a revenue sufficient for the public services’.17 Like Quesnay, Smith believed the state was necessary. Indeed, he was convinced that national wealth could only be increased through division of labour in ‘a well-governed society’,18 in which he singled out three crucial functions of government: the military, the judiciary and other public services such as provision of infrastructure.19 These are public goods – producers cannot exclude anyone from consuming them. For Smith, such public goods had to be paid for by the state;20 some sort of taxation was therefore necessary.
David Ricardo was perhaps the most anti-government of the classical economists. Although the title of his The Principles of Political Economy and Taxation contains a key activity of government (taxation), he never considered how taxation could allow government spending to encourage production and hence value creation. For Ricardo, taxes are the ‘portion of the produce of land and labour, placed at the disposal of government’ to spend on areas such as education.21 If these expenditures are too high, he writes, the capital of the country is diminished, and ‘distress and ruin will follow’.22 Ricardo never asks, as Smith did, whether some taxes are necessary to help capitalists carry out production. He assumes infrastructure – the judiciary and so on – as a given. In effect, Ricardo narrows the production of economic value strictly to the private sphere. Admiring Ricardo’s rigorous analytical arguments, in comparison with Smith’s more fluid and interdisciplinary philosophical and political approach, economists followed him and excluded government from the productive sector.
Marx’s view of government, meanwhile, derived from his materialist view of history, whereby the organization of society (including government structures) reflects the economic system (which he called the mode of production) and the underlying social relations: the interaction between classes. So, in his view, under the capitalist ‘mode of production’ – based on surplus value generated from exploitation of labour – government and law reflected the needs of capitalists. Marx ridiculed some followers of Smith and Ricardo for haranguing state officials as ‘parasites on the actual producers’, then realizing that they were after all necessary to support the capitalist system. Nevertheless Marx, like Smith before him, while stressing the necessity of some functions of the state, placed state officials in the category of unproductive labourers outside the production boundary. The capitalist class had an interest in maintaining the state in a position strong enough to guarantee the rule of law and advance their class interests – but nothing more than that: ‘The executive of the modern state is nothing but a committee for managing the common affairs of the whole bourgeoisie.’23 The question concerning Marx was what constituted the ‘right’ size of government to provide the necessary services without taking away any additional profits.
While the neoclassical economists broke with the labour theory of value, they did not depart from their predecessors’ view that government was necessary but unproductive. Marginal utility, as we have seen, locates value in the price of any transaction that takes place freely in the market. According to this perspective, government produces nothing: it cannot create value. And government’s main source of income is taxes, which are a transfer of existing value created in the private sector.
The immensely influential Alfred Marshall was quite nuanced in his discussion of economic life in his Principles, but still recommended that economics should avoid ‘as far as possible’ the discussion of matters associated with government.24 He believed that government interference in, or regulation of, the market would often happen in response to attempts by vested interests to rig the market in their favour (i.e. government would be ‘captured’ by such interests) – thus only hurting a particular competitor rather than benefiting society as a whole.25
KEYNES AND COUNTER-CYCLICAL GOVERNMENT
To the humble citizen, however, it might not be so obvious that government does not create value. We have already seen three ways in which it does so: bailing out the banks; investing in infrastructure, education and basic science; and funding
radical, innovative technologies which are transforming our lives.
The crucial point is that many of these activities involve taking risks and investing – exactly what austerity doesn’t do – and in so doing they create value. But that value is not easily visible, for the simple reason that much of it goes into the pockets of the private sector. One man at least partly understood this problem: John Maynard Keynes.
When in 1929 the global economic crisis struck, recovery seemed elusive. The Great Depression shattered the idea of unbounded economic progress because, contrary to the prevailing theoretical consensus, the economy did not recover by itself. Keynes’s explanation for this was a radical departure from the conventional wisdom of the time.26 Markets, he claimed, are inherently unstable and, in a recession, may remain ‘in a chronic condition of sub-normal activity for a considerable period without any marked tendency, either towards recovery or towards complete collapse’.27 In these circumstances, he stressed, the role of government is crucial: it is the ‘spender of last resort’.
Let’s remind ourselves that Keynes was concerned in his General Theory to explain how an economy might find itself in a state of ‘involuntary unemployment’ due to insufficient demand – that is, workers who wanted work would not be able to find it. This, he argued, would produce a low level of GDP, compared to a situation in which the economy would be running at full capacity (and full employment). Neoclassical economic theory is ill suited to explain this situation because it assumes that people choose what they prefer, including how much labour they ‘supply’ to the market at a given price (the wage), and that the market makes sure to sort things out so that everyone gets the maximum utility out of it. In such a view, unemployment becomes voluntary.
The Value of Everything (UK) Page 28
