Unjustifiable Austerity
Austerity and Its Public Justifiability: A Philosophy of Science Perspective
Arwen van Stigt
Supervisor: Enzo Rossi June 2016
Master Thesis Political Science University of Amsterdam
it's better to be driven around in a red porsche
than to own
one. the luck of the fool is involiate.
the red porsche, Charles Bukowski in Play the Piano Drunk Like a Percussion
Introduction
When a country, such as Britain, is making preparations to voluntarily leave the European Union (EU) it makes me think about the options each member-state has. I cannot help but notice some irony, although that of the especially sour kind. When Greece in 2015 faced the option of leaving the EU it choose not to, because the financial sector had somehow drained the country's public and private wealth. Where it had gone, nobody mentioned. Who should pay the price for it was crystal clear. "Greece is responsible for Greek debt, Spain for Spanish debt, and Ireland for the Irish" the German Finance Minister Schäuble said on a television broadcasting . The 1
European member-states were willing to help, but only if Greece, and the other indebted member-states, should promise to become more competitive in the international global economy. "If" president of the European Commission Barosso said, Greece, but also Spain, Portugal, Ireland and Italy, "do not carry out the austerity packages, these countries could virtually disappear in the way we know them as democracies" . So whereas Greece choose to stay despite of the harsh EU conditions, 2
the UK choose to leave because of them. It remains to be seen if the UK will 'disappear in the way we know it as democracy'. Claims made by powerful politicians, such as Barosso, might not be wholly convincing if one knows what I know. In this thesis I would like to share some of my thoughts and hope you consider them as at least an interesting perspective on how knowledge becomes a tool for power.
This thesis will be a successful project if, at the end I have convincingly showed the following: the Troika's imposition to implement the austerity policies and renounce both the Greek government's resistance and the Greek popular protests, is not publicly justifiable. An additional conclusion is that the Greek government and the Greek citizens have a duty to repudiate the austerity policies. I will argue for this by developing the following argument:
This is part of the quote from chapter one, I will repeat the full quote in chapter one.
1
This quote comes from Tom Gallagher's book Europe's Path to Crisis. Disintegration via Monetary Union p168 who quoted
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P 1: Unlike the claim of the German Minister of Finance that the Troika knows what is 'economically right', the austerity policies in the third Memorandum of Understanding are to a significant extent based on controversial conclusions of science.
P 2: For the third Memorandum of Understanding to be publicly justifiable it has to be based on uncontroversial conclusions of science.
C 1: The Troika's imposition to implement the Memorandum of Understanding and renounce the Greek government's resistance and the Greek popular protests, is not publicly justifiable (following from P1 and P2).
C 2: It is the duty of the Greek government and its citizens to repudiate the MoU (following from P2 and C1).
The third Memorandum of Understanding is a policy document in which Greek economic reforms are presented. The reforms can be said to mainly contain austerity policies. In the summer of 2015 the European Commission, together with the European Central Bank and the International Monetary Fund pressured the Greek government to sign and implement the third Memorandum of Understanding. The newly elected Greek government initially won the Greek elections because of their public resistance to the proposed third Memorandum. In this thesis I will show that the decision to pressure for the implementation of the loan agreement, which is what the Memorandum is, is not publicly justifiable. In other words, I will claim that the Memorandum of Understanding does not meet the normative requirements of public justification. Therefore, I will additionally argue, the Greek government and Greek citizens have a duty to repudiate the Memorandum. With my argument I thus question the authority of the international institutions that produced and pressured for the implementation of the third Memorandum of Understanding (MoU).
Scientifically this thesis is relevant because it provides a new way to understand a pressing political situation. By using philosophy of science and normative theory to argue for economic policy changes I hope to show that political
theory can operate in an interdisciplinary field, and contribute to the debate on the Greek and European economy.
The structure of the thesis will be as follows: in the first chapter I will introduce the Greek case. The first chapter serves as context, so the reader can understand the Memorandum's role for Greece, and why the Memorandum plays such a significant part in my thesis. In the second chapter I will discuss the paramount policy of the Memorandum, namely austerity. I will discuss some of austerity's conceptual history, and the place of austerity in economic theory. The second chapter serves as an introduction into economics, and specifically into the role of austerity in conventional economics.
In the third chapter I will argue for the first premise, namely that the economic underpinnings of the Memorandum are controversial - at least more controversial than the Troika claims it to be, and too controversial for the policy to by publicly justifiable. My argument will be twofold. On the one hand I will argue the Memorandum is based on 'internal' controversies of economics. In other words, I will argue the Memorandum is based on conventional economic theory, which is more controversial than what I call 'new school economics'. I will support this argument by discussing some philosophy of economics and use the philosophy of science account to analyse the MoU. Mainly based on works of Rosenberg, I argue that conventional economics, compared to 'new school economics', shows more significant deficiencies as a science. This points - at the least - to the controversy of the scientific status of their conclusions.
On the other hand I will argue the MoU is based on what I call external controversy. In other words, I will argue the conventional models the Memorandum is based on, when reviewed on their own terms, do not necessarily predict austerity as the right economic policy in the Greek case. It is - at the minimun - controversial to conclude conventional models would support austerity policies in Greece. Hence in the third chapter I will argue, by means of a philosophy of science perspective, the MoU is based on controversial conclusions of science.
In the fourth chapter I will present Rawls's normative theory of public justification. I will argue the Memorandum cannot be publicly justifiable because it is based on uncontroversial conclusions of science. The ideal of public justification is a concept with which one can morally asses government actions. I will thus make a normative claim and argue the Troika cannot publicly justify the MoU policy. I will additionally argue, that according to the the theory of public justification the Greek citizens and the Greek government have a duty of civility to repudiate the MoU.
Chapter 1. Greece
1. In this chapter some details are discussed concerning the relation between the Hellenic Republic, or Greece, and the European Union (EU). Specifically of concern is the Greek economy after 2009. First I will focus on key events (2) and actors (3). Second I will discuss the most recent agreements between the parties; the so-called third Memorandum of Understanding (MoU) (4). Lastly I will explain some details about the Greek aversion to the agreement, illustrated by critique from Yanis Varoufakis (5).
2. Unable to discuss all relevant events covering the Greek case from roughly 2007 to date, I will briefly outline the so-called European debt crisis, and consider causes and catalysts to the Greek situation.
In 2009 the financial crisis, which started a year earlier in the U.S., began to effect Europe. EU countries were, quite suddenly, in financial difficulties. Most notably in trouble were Greece, Ireland, Italy, Portugal, Spain (the GIIPS countries), and Cyprus. Although dissimilar these countries seem to have had at least one thing in common: their banks were out of cash. Notice that the issue was first of all mostly located in the private sector, although it soon became a government concern.
Under normal - non-crisis - circumstances banks give out loans to each other 3
via central banks . Since in Europe this mechanism was not enough to solve cash flow 4
problems, government intervention needed to prevent banks from insolvency. Accepting the consequences of insolvent banks seemed a bridge too far. Officials reluctantly decided capital would have to be redistributed (however conditional in the form of loans) from surplus countries to the troubled ones. Provided for some minor
Banks appear in many shapes and sizes. First of all one might think of a commercial bank, however a myriad of other financial
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institutions can operate as banks in the sense that they operate both in the money market, and in the capital market which when combined represent the financial system. Following Joris Luyendijk one can distinguish three categories of bank-like institutions: banks (commercial, investment, and public - note: government - banks but also pension funds, stockbrokers, and mortgage lenders operate in this category), insurance companies (ranging from car insurance to the insurance of entire coal plants, or the insurance of financial products), and investment management (asset management, hedge funds, venture capitalist). These categories can overlap, for instance a commercial bank can own a hedge fund. Large banks such as ING and Deutsche Bank operate in all these categories. A central bank supervises the system. (Joris Luyendijk, 2015: 36-38).
For the Mankiw and Taylor textbook (2011) explanation of this process see their paragraph on the money market p. 631.
changes in EU Treaty law this seemed manageable. Greece, since 2009, has negotiated three such loans from the EU. Negotiated, because according to EU Treaty law , these loans are conditional on numerous government austerity measures. 5
Following Antimo Verde, four aspects should be considered in understanding causes and catalysts to the Greek case (2011: 114). First, Greek macroeconomic indicators were unsettling. Debts and deficits during the first crisis years (2007-'08-'09) rose from 95 to 99 to 115 percent of GDP and -5, -7, and -14 percent of GDP respectively (Verde, 2011: 145). Mirroring this, interest rates and inflation rose, and growth turned into decline (ibid.). In this respect Greece was an exception to other GIIPSs because of the combination of discouraging indicators. The corresponding narrative is that foreign investors, responding to the rising debt and deficit, got rid of Greek public bonds causing the interest rate to rise and credit ratings to deteriorate (Verde, 2011: 146). The numbers indicated Greece was about to loose 6
its competitiveness and was heading for a crisis.
Second, the global financial crisis had two main consequences for the Greek economy. On the one hand the run up to the crisis spread huge unsafe investments in the world, mainly in the secondary sectors of the international financial markets and, specifically in Europe, of the European Monetary Union (EMU) (Verde, 2011: 146-147). Greek bonds consisted of collateralised debt obligations backed by EMU's 7 8
subprime debt , which was believed to be safe but turned out to be floating on air 9
(ibid.). On the other hand, due to fiscal stimuli, an increase in demand for financial resources occurred (ibid.) In other words Greece borrowed from the EU in order to
See chapter four of this thesis for the EU Treaty law and the no bail-out clause.
5
Notice the numbers I use from Verde are macroeconomic indicators to measure the stability of the Greek economy, namely the
6
deficit/GDP and debt/GDP ratio, inflation, and GDP growth. Refraining from discussing this at the moment, it is worth mentioning Daniel Mügge's argument. Mügge argues macroeconomic indicators are not merely tools but ideas that include as well as exclude particular assumptions, culturally and politically embedded (2016).
"A bond is a debt owed by a company [or government], in return for money you have lent it" (Lanchester, 2014: 84)
7
A CDO is a "structured financial product that pools together cash flow-generating assets and repackages this asset pool into
8
discrete tranches that can be sold to investors" (Investopedia, n.d.a)
"A sub-prime loan is a type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans.
9
Quite often, subprime borrowers are often turned away from traditional lenders because of their low credit ratings or other factors that suggest that they have a reasonable chance of defaulting on the debt repayment" (Investopedia, n.d.b)
recapitalise their banks, which in turn put Greece in need for more capital to pay back the loan. Hence Greece experienced difficulties.
Third, these two external imbalances (collapse of investment and demand for resources) altered the relation between trade deficit and trade surplus countries such as between the U.S. and China, and between Greece and Germany (and between France and Germany for that matter) (ibid.). As I will explain further in the second chapter for one country to have a trade surplus, another has to have a trade deficit . 10
However, trade deficit countries - all of the GIIPS countries - are in some respects more dependant on structural financial instabilities such as the financial crisis.
Characteristic of a trade deficit country is on the one hand, having a substantial amount of foreign investments and on the other hand, investing domestically by means of loans rather than savings. As a result of malinvestments, such as those of the financial crisis, cash either flows away or disappears. Greece had a large, maybe unhealthy, amount of these sorts of investments hence the balance of payment problems (Verde, 2011: 156). For instance in 2009, German holdings of Greek securities were worth about €50 billion, which is a tenth of all foreign-11
dominated holdings of Greek government securities, and an even smaller part of the myriad of other financial foreign investments in Greece (ibid.). Greece, on the other hand, did not have these kinds of investments in Germany because Germany, as a surplus country, saves more than it consumes and simultaneously invests more in domestic production than it imports, which leaves less room for foreign investments (see also Gosh and Qureshi, 2016: 9).
Lastly, the German chancellor leader Angela Merkel positioned Germany, in opposition to the GIIPS countries, as the European example of a stable economy, especially during a crisis (ibid.). Merkel advocated stable economies, unlike Greece, guard budgetary discipline, not change fundamentals in Treaty law, and grant popular
Trade deficit countries have three characteristics worth mentioning in this respect. They import more than they export, they
10
spend more than they save, and spending drives investment (expectations) which is more often on the basis of loans than of savings. See chapter two.
Securities are "any financial instrument that you can buy and sell. It's useful as an umbrella term because it includes stocks,
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opinion a voice in international decisions (which in the German case meant refrain from Greek debt relief) (ibid.). As a result of Merkel's behaviour Verde goes as far as to say: would Merkel have shown willingness to cooperate with Greece from the outset "the crisis would have been less dramatic, as investors would have been less worried" (ibid.). Merkel's behaviour was a catalyst for the Greek crisis (ibid.), and a preview of how Germany would continue to position itself in the future towards Greece: advocating austerity.
3. Often Greece is mentioned in relation to its 'creditor' the Troika, meaning the European Central Bank (ECB), the European Commission (EC), and the International Monetary Fund (IMF) . The Troika decides on the general aspects of EU loans: how 12
much capital has to be assembled for future loans towards financially unstable areas.
However the Eurogroup could be considered an influential participant in deciding on EU loans and their conditions. The group consists of the informal formation of Europe's finance ministers (from those countries which have adopted 13
the euro as their currency). The Eurogroup governs the European Stability Mechanism (ESM) which is the European pool of capital where the loans flow from. However the Eurogroup has no legal basis to act except for their informal meetings. In practice Eurogroup meetings alway include, and are influenced by, representatives of the Troika-members. Their agreements are ratified by the legally competent European Economic and Financial Affairs Council (Ecofin).
Germany is generally considered the most influential actor in the EU, because of its size and the size of its economy. Germany's recent history shows its involvement in the establishment of the European Coal and Steel Community, and subsequently the European Union and its Treaties. I already mentioned Chancellor
In practice these are the president of the Central Bank Mario Draghi or Benoît Cœuré in Draghi’s absence, Pierre Moscovici
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the commissioner of the Directorate General of Economic and Financial Affairs (DG ECFIN), and Christine Lagarde president of the IMF, or Paul Thomsen in her absence.
Although not under discussion in this Thesis it must be noted the European Finance Ministers are all white men, except for the
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Merkel. The German finance minister Wolfgang Schäuble is likewise known for advocating Greek austerity measures. In a CNBC interview he said: "Greece has to suffer structural reforms to become competitive, otherwise Greece will never be able to stand up to the expectations political leaders raise in campaigning. […] If Greece sticks to the [third MoU] agreement, and if the program gets implemented decisively and fully, then the Greek economy can grow again over the next years. […] The opportunity is given and whether it will be taken is a decision solely up to the Greek people" (Schäuble on CNBC, 2015). In another interview Schäuble elaborated on the role of the Troika. This slightly longer quote is worth mentioning because it reflects the German perspective, or at least its Minister of Finance's, on the role of the Troika:
"The Troika has been asked by the European member states to discuss this [the European crisis], and every time the members meet, its own existence, and especially the IMF's involvement is discussed. The Troika has decided the governments of the countries in need of loan programmes should not participate in the negotiation because we trust in the institutions with the most expertise, with the most experience, and that know most of the facts. Those are, first, the European Commission […] second, the very independent European Central Bank, and third, the most experienced institution, namely the IMF. These three know what is economically right. […] The conditions the Troika sets cannot be approved by the European Parliament because the Troika has the sort of independent economic knowledge, the European Parliament lacks, to take the necessary decisions" (Schäuble in an interview with Harald Schumann, 2012).
Whether austerity is the "right" policy approach for Greece remains to be seen. I hope to shed some light on this question in the following paragraphs and chapters of this thesis.
4. In July 2015 the Troika and Greece agreed upon the third reform agenda, conditional to the Greek loan (Troika, 2015). It builds on the first (2010) and the second (2013) Memorandum of Understanding (MoU). For the past few months (Feb.-June 2016) the assessment of the first results of the third MoU have been ongoing. As a result of on the one hand IMF-EU disagreement, and on the other disappointing outcomes, the official review of the third MoU, which is required for Greece to receive the next part of their loan, is postponed until after the British vote on EU membership. I find three characteristics about the third MoU worth mentioning.
Firstly, the content of the reform is monotonous; it consists largely of defining different ways of cutting the Greek welfare state rather than, for instance, implementing financial reforms. Second, and correspondingly, the myriad of unsubstantiated claims is fascinating. In other words, the reader of the MoU is not provided with enough proof or reason to accept why these, and not other, policy changes are agreed upon. Except the supposed expertise of the authors, insufficient references are made towards macroeconomic models for one to judge either the agreements as fit or the expectations as appropriate.
Third, the agreement consists of an extraordinary tone of voice disqualifying Greek public management in all suggested areas of reform. Since Greece is considered devoid of adequate public management, the Troika's decision to issue a conditional loan rather than organise for instance a redistribution of EU capital is potentially justified. However in lack of specifics on either Greek finances or Greek public management it is difficult to accept a supposed government's incompetence or, if accepted, expect them to change.
In defence a few objections could be raised. First, a reform agenda does not need to include careful considerations; it presents a strategy rather than arguments. Prior documents (for instance the Financial Assistance Agreement, and the first and second Financial Adjustment Plan) could be expected to include a more detailed examination of the reform strategy.
Second, the third MoU is written under stressed political circumstances. For instance Greece was occasionally framed in the media as a failed state facing citizen revolts, and waiting for rescue, payed for largely by Western European taxpayers . 14
One could argue, one way or another, an agreement had to be made: politics is merely one part of the solution, after formal agreements people can resume fixing what has been damaged.
However both the first and the second defence are naive. As I will show in more detail in chapters three and four, the MoU presents a critical framework for options concerning Greek recovery. Although at times vague the MoU excludes, what are considered by some, viable reform strategies, and includes what are considered self-undermining policies. Not surprisingly the Greek citizens and governments (both the Papandreou, Samaras and Tsipras government, although in a different fashion) have protested against the structural reform agreements, if anything for the retrenchment of the welfare state. To illustrate Greek discontent I will briefly discuss some critique from the former Greek Minister of Finance of the SYRIZA party who was involved in the third MoU negotiations, namely Yanis Varoufakis . 15
5. One of Varoufakis's major critiques of the MoU is that the structural defects in Greek banks, indeed in the entire European banking sector, are not addressed by the Troika . I will present two typical features of his critique: 16
See for instance BBC news (2015) 'Greece debt crisis: Eurozone summit strikes deal' and the New York Times (2012) 'The
14
Failing State of Greece'.
From January - September 2015 Yannis Varoufakis was the Greek Minister of Finance.
15
One could argue not the Troika but for instance EU structural reform plans tackle these issue. However Varoufakis argues the
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EU banking reforms, which were agreed upon after the crisis of 2008 in the Basel III report, are insufficient. Especially the increased, but nevertheless too low, capital requirements enable banks to save relatively little capital (cash) compared to their assets resulting in insufficient backups in case of emergency, or: in case of bad assets, structural conflicts of interest in the financial sector, and government debt.
Although the MoU does not mention bank reform, it must be noted that Greece was required, as a precondition to the MoU, to transpose the Bank Resolution and Recovery Directive (BRRD) into law (Armstrong et al. 2015). The BRRD introduces most notable some arguably small capital requirements and a bail-in procedure. The BRRD is the European weaker equivalent of the U.S. Dodd Frank Act, both of which were a respond to the financial crisis of 2008. European banks are now to some extend held responsible for crisis in the sense that they can only be bailed-out (using tax payers money to stop a bank from going insolvent) by states if they have exhausted their bail-in procedures. Bail in procedures make bondholders and shareholders carry the burden of a failing bank. Additionally debt is 'written down' i.e. converting debt into equity (Goodhart and Avgouleas, 2014). Goodhart and Avgouleas, however, argue bail-in procedures will not suffice during a crisis, most notably because of systemic risks (banks are interconnected) and creditor flights (ibid.).
First, the Greek banks, as well as the bulk of European banks, face structural faults inflicting debt upon governments. Varoufakis argues two faults stand out in relation to Greece: first, the European banking union is not really a banking union because the ECB can determine, without consulting the relevant member state, to recapitalise or not recapitalise banks, and more importantly, when, in what manner, and at what interest rate they choose to do so. Additionally the ECB lacks independence as a supervisor, and is closer related to European bankers than is assumed. Therefore the interests of European bankers are preserved at the cost of bank reform (Varoufakis in interview from Schumann, 2012; Varoufakis, 2013b). As a result Greek banks did not get rid of bad assets (which appeared to be bad after the 2008 crash) but kept things largely unchanged. Paradoxically the MoU accredited the ECB to appreciate the value of Greek assets , thereby temporarily giving incentives 17
for investors . Subsequently the financial market responded positively. Because the 18
problem of capital requirements and bad assets was postponed, however, another bubble grew and before long popped. Hence the banks were illiquid again (not having enough cash) and needed new support (Varoufakis, in interview from Schumann 2012).
This support, Varoufakis argues, initially comes from the Greek government, which partly therefore is now indebted. Hence member states, in the form of the ECB and the ESM, additionally provide liquidity. Varoufakis argues, because of above mentioned issues, the Greek banks, but not merely the Greek banks, continue to disfunction, stalling economic recovery no matter how much liquidity the Troika provides in this fashion. Necessary are: higher capital requirements, and a system which discards banks of their bad assets and incentives to stop issuing them (Varoufakis and Holland, 2012).
Put crudely: assets can be thought of as money used for investments, that are flying around the world rather then locked away
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in a volt. Because assets represent investments in different markets, and of different sorts, they can have different values. For example if you put one euro in investment Q it is worth 100 euro; your euro has 'appreciated'.
Investments can be thought to represent investor expectations in the market, and if investor expectations are high the value of
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the asset rises. For example if many investors think they can make money investing in the production of a certain resource, the value of that resource, in the market, might go up.
Second, the Greek debt, if not forgiven, has to be lessened by ECB management. Austerity will not do. The trouble with austerity, Varoufakis argues, is that, when implemented in a time of private sector deleveraging (i.e. when firms and households are struggling to cut down on expenditure and reduce their indebtedness), austerity is self-defeating as it reduces tax revenues faster than (or as fast as) it shrinks expenditures Varoufakis, 2013). Varoufakis proposed Greece indeed needed to reform its government management, however the government debt is of such proportion it disables any progress in Greece, let alone enables Greece to pay back its debts (Varoufakis and Holland, 2012: 4). The Greek banks are located in Greece, however their management is intertwined with a myriad of European banks. Therefore the ECB is responsible, and has the capacity to financially convert Greek debt, among other countries', into shares establishing a long term financial relationship with banks to 19
repay the shares (ibid.). So far Varoufakis' critique.
The Greek PM Alex Tsipras won the 2015 elections with the promise of 20
renegotiating the second MoU, demanding first of all debt write-off (which in practice meant implementing Varoufakis' propositions) second, aim for a balanced trade budget rather than a surplus, and third lowering some of the previously increased taxes (the Guardian, 2014). However not all anti-austerity advocates are part of Greek politics - the latter, it could be argued, biased by the political business cycle . 21
Shares are, crudely, profitable pieces of products or services.
19
During the planned 2012 elections Greek political parties advocating against the upcoming second MoU, and its continuing
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austerity, gained popularity. The biggest anti-austerity party was the left SYRIZA; established in 2001, with their first members in Parliament in 2004. In 2012 not SYRIZA but the moderate, and not unwilling towards the MoU, Democratic party won the elections. However, in January 2015 the Greek Parliament dissolved because they were unable to elect a new president of state. After snap elections were held at the beginning of 2015, SYRIZA, still advocating against the, by now third, upcoming MoU became the largest party in Hellenic Parliament receiving 36.3% of the vote. Their victory was introduced by the media as "Tsipras declares end to 'vicious cycle of austerity' after Syriza wins Greek election" (Guardian, 2015) and "Syriza’s 40-year-old leader, Alexis Tsipras, campaigned on a promise to write off some of Greece’s roughly 320 billion euros of debt" (NRC, 2015).
Pointing at populistic politics rather then pragmatism. I will explain this concept further in chapter 2, paragraph 6.
Approaching the 2015 elections numerous economists argued austerity should indeed be renegotiated in favour of debt relief . 22
The anti-austerity protests in Greece, occurring every now and then in various set-ups since 2010, might be partially explained by these anti-austerity narratives. I will end this chapter quoting Chancellor Merkel who argues, in contrast to Varoufakis: "there was no alternative to the Greek budget cuts and bailout loans from the Troika, because their deficits were simply too high" (Social Europe, 2015) and Minister Schäuble saying: "Spain is responsible for the Spanish crisis, Ireland for the Irish, and Greece for the Greek" and "the cause [of Europe's crisis] is that some countries on the one hand do not have a healthy financial system, and on the other lack necessary competition" (Schauble in conversation with Harald Schumann, 2012). In the next chapter I will discuss the concept of austerity and its relation to, among other things, government deficits, financial systems, and competition.
See for instance the list of professors confirming con-austerity arguments from Financial Times journalists such as Gillian Tett,
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Wolfgang Müchau, Peter Spiegel and additionally arguing for, similar to Varoufakis, Greek debt reduction, investment in exports, and macroeconomic reforms rather than austerity. The list consists out of: Prof Joseph Stiglitz Columbia University, Nobel Prize winner of Economics; Prof Chris Pissarides, London School of Economics, Nobel Prize winner of Economics; Prof Charles Goodhart London School of Economics; Prof Marcus Miller Warwick University Michael Burke Economists Against Austerity; Prof Panicos Demetriadis University of Leicester; Prof Stephany Griffith-Jones IPD Columbia University; Prof Gustav A Horn Macroeconomic Policy Institute (IMK); Prof Mary Kaldor London School of Economics; Neil MacKinnon VTB Capital; Prof Jose Antonio Ocampo Columbia University; Avinash Persaud Peterson Institute for International Economics; Helmut Reisen Shifting Wealth Consult; Robert Skidelsky Emeritus Professor, University of Warwick; Prof Frances Stewart University of Oxford; Prof Robert Wade London School of Economics; Hilary Wainwright Transnational Institute, Amsterdam; Prof Simon Wren-Lewis Merton College Oxford (Financial Times, 2015b).
Chapter 2. Austerity
1. In this chapter I will introduce the key concept of austerity, to prepare the reader for my argument. Although the MoU, discussed in the previous chapter, does not inform us on substantial austerity arguments, one can assume they exist. But what does one need to know about austerity? Two questions seem relevant: what kind of policies does austerity entail (2)? And, what economic theory and which of their models explain austerity (3-6)? In the following paragraphs both questions will be dealt with, followed by some concluding remarks (8). Using Mark Blyth's history on austerity as a map I will take various side roads. Because Blyth largely makes a case against austerity, I will complement his history of austerity with present day textbook economics - which can be said to represent the conventional view on economics - to 23
try and introduce a diverse theory of austerity. This discussion results in an understanding of austerity, which I will revert to several times in the chapters to come.
2. Austerity - for now - can be defined as follows:
"Austerity is a form of voluntary deflation in which the economy adjusts through the reduction of wages, prices, and public spending to restore competitiveness, which is (supposedly) best achieved by cutting the state's budget, debts, and deficits" (Blyth, 2013: 2).
Let's break this down. With cutting the state's budget, debts and deficits 'the economy' adjusts by reducing wages, prices, and the overall public spending. This adaption is commonly referred to as deflation: the process of money gaining value over time,
For the textbook knowledge I use the second edition of 'Economics' by Mankiw and Taylor (2011), and 'Economics, Key
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Concepts' by Rutherford (2007) (both used at the University of Amsterdam), and Investopedia which is an online encyclopedia for economics, business and finance (2016). For a different reading on finance I use 'How To Speak Money, What The Money People Say…and What They Really Mean' by Lanchester (2014)
hence prices (and wages and spending) gradually going down (Lanchester, 2014: 24
112). Voluntary deflation is issued either by a government or a central bank through 25
the process of reducing money creation, or at least reducing the money circulating in the economy. Hence we have established the answer to the first question: austerity measures are the kind of policies issued by a government or central bank. They reduce the state's budget, debts and deficits with the aim of offsetting deflation (reducing wages, prices and public spending) with the ultimate goal of restoring competitiveness. One could add to this description the ability of governments to raise tax revenues (Varoufakis, 2013; Wren-Lewis, 2016). As a result of raising taxes while reducing government spending, debt and deficits can be reduced.
At this point one might wonder how so many seemingly unpleasant interventions - after all who would want their wages reduced and benefits abolished? - could help restore the economy's competitiveness without doing too much damage. One might wonder, at this point, if competitiveness is desired in the first place. In the following paragraphs I will discuss several economic theories that will hopefully make this more clear.
3. Which economic theories explain austerity? Mark Blyth distinguishes four economic schools, and their theories, that provide austerity arguments (2013: 152). The first is classical liberalism, which produces austerity by "default". The second is both the Austrian and ordoliberal school which produce austerity by "design", and the last is neoliberalism which produces austerity by "exclusion" (Blyth, 2013: 152).
Deflation can be explained in numerous ways because it indicates a relation between value and money (creation). Depending
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on how one defines this relation deflation can be used to point to processes either considered good or bad. However, in most economic textbooks deflation is referred to as a process of excessive money creation causing declining prices. If they persist, they generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. See the Economics textbook of Mankiw and Taylor (2011: 660) and the Investopedia website (2016).
In a monetarist view, often associated with Milton Friedman, central banks can control inflation by printing money, hence they
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can control deflation by stop printing money. The primary goal of central banks is to provide their countries' currencies with price stability. A central bank also acts as the regulatory authority of a country's monetary policy and is the sole provider and printer of notes and coins in circulation. Central banks, since the 90s, are often independent from government fiscal policy and therefore uninfluenced by the political concerns of a regime, however in practice this often turns out differently. See Lanchester (2014: 95) Rutherford (2007: 14) and Blyth (2013: 158).
4. Classical liberalism produces austerity because without it, the narrative goes, a state would default (2013: 152). The roots of austerity can be traced back to the ideas of John Locke, David Hume and Adam Smith. It is worth going into some of these ideas to understand the supposed theory.
Locke (1632-1704) laid the foundations for the market by presenting it as if it were a separate power - and a more benign one - from the state. The power of the state was, more or less, to protect its citizens from invaders (and dissidents) and instability. Locke was suspicious towards this primary state task, which - since he is writing in the aftermath of the English civil wars of the 17th century - makes sense. Hence according to Locke the power of the market was to protect citizens from each other, and above all to protect citizens from their government (Blyth, 2013: 104-106).
The market, Locke argued, would provide protection from governments as a result of, more or less, property rights. Property rights denied governments to claim profits deriving from labour on, what used to be, the common lands. If there wouldn't be money for the government to collect, mal-investments or exploitations wouldn't occur. Property rights would enable certain people to claim their own property and, in return for letting workers exploit their land, generate profits from their workers for themselves - leaving everyone provided for and happy (ibid.).
The only taxes governments would be allowed to raise were taxes deployed to secure these property rights. However, and this is important, because one cannot trust a government to keep to such strict budget rules, taxes should be kept as low as possible. This is the birth of the liberal dilemma that generates austerity "The state:
can't live with it, can't live without it, don't want to pay for it " (Blyth, 2013: 106).
Hume (1711-1776) complemented Locke's distrust of government spending with the suspicion of governments making debts to spend even more. Hume argued government debt could only lead to excessive government debt. As a result of officials who, to stay in power, keep spending for the sake of the 'public good', costs are levied onto the next generation to evade short-term tax increases - which would reduce their popularity. Eventually the debt, after it has become unsustainable, would be issued abroad undermining the power of national authorities. Excessive debt also leaves no
room to absorb financial shocks. Hume leaves us without a remedy, arguing eventually everything will lead to "a state of languor, inactivity and impotence" (Hume as in Blyth, 2013: 108) (Blyth, 2013: 107-109).
Similar to Hume, Smith (1723-1790) concludes government debts will keep rising because it is in the nature of states to keep borrowing. However where Hume argues debts will eventually undermine state power, cause financial instability and government failure, Smith argues the state will corrupt the nature of merchants which will put an end to growth. Merchants are by nature savers, and saving is the engine of the economy because it can, and will be invested in industry. Smith argues a state corrupts the merchants because it offers its debts at attractive rates. Merchants will buy the debt, despite their nature. In hard times, the argument continues, a state will devalue its coin to let the interest rates on their outstanding debts fall (inflation). When a coin is devalued merchants will either move their capital or see the worth of it deteriorate. Unable to save or invest, Smith predicts, the engine of growth and progress (i.e. merchants) will be destroyed. Smith arrives at a clear policy advise towards states: in order to prevent bad things from happening the state needs to save, rather than borrow (Stilwell, 2012: 67-68 and Blyth, 2013: 109-113).
The previous can be summarised as follows: The classical liberalist theory produces austerity because without it a state will default as a result of:
1. officials spending money according to their own rather than the public interest 2. a state will keep on borrowing with the results of:
• public debt becoming unsustainable and financial shocks as well as foreign debtors undermining state sovereignty and stability
• public debt gives out perverse incentives towards merchants. Merchants buy the debt, the debt will keep on growing until the the government chooses to inflate at which point investors move their investments abroad
In present day textbook jargon we find some concepts supporting the classical liberal narrative. Naturally times have changed but the Lockean argument can be said to correspond with the so-called seventh principle of economics: a market needs a government to protect the rules of the market (Mankiw and Taylor, 2011: 11).
However, next to that, a present-day market, according to Mankiw and Taylor, also needs a government to provide efficiency (in case of market failure ) and promote 26
equity (to enable those outside the market to participate) (2011: 148). Hence some, preferably small, taxes are allowed. However taxes always impose deadweight losses on the total surplus, which must be minimised by keeping demand steady and supply flexible (Makiw and Taylor, 2011: 159-168).
The eighth textbook principle of economics can be said to correspond with the Humean and Smithean argument - against public debts: "A country's standard of living depends on its ability to produce goods and services" (Mankiw and Taylor, 2011: 563). The production of goods and services in its turn depends on resources, technology, and savings (ibid.). All three are necessary. However if a government borrows - to finance its budget deficit - rather than saves, it 'crowds out' private borrowers who are trying to finance investment (Mankiw and Taylor, 2011: 567). When a government reduces the supply of 'loanable funds' - through borrowing - to 27
compensate, the 'equilibrium' interest rate will rise (2011: 558-565). Note that this is 28
the result of inflation, as with Smith, Mankiw and Taylor explain rising interest rates discourage firms and households to invest.
The difference between investment and government borrowing is relevant here. For Smith investment was funding the production of goods with savings. Governments, on the other hand, by nature spend and borrow rather than invest. If they spend too much they have to borrow and since they are not able to invest their debts keep growing. Mankiw and Taylor add to this while investment equals saving in the overall economy, in particular cases saving differs from investment because the
Market failure is defined as "the inability of some unregulated markets to allocate resources efficiently" (Mankiw and Taylor,
26
2011: 155). Market failure occurs when the assumptions about market efficiency, such as general equilibrium theory, are not met by reality (ibid.). However according to Mankiw and Taylor assumptions about market efficiency in many markets work well and apply directly (ibid.). Market failure can also be defined as externalities (i.e. markets produce an outcome such as greenhouse gasses that are not the sole responsible of one market player but an externality created by the market
The supply of 'loanable funds' is an illustrative concept referring to the rule of supply and demand that governs the engine of
27
the economy, i.e. saving and investing (Mankiw and Taylor, 2011: 558-565). When public and private savings rise (i.e. supply), investments also rise (i.e. demand), and vice versa. Hence, if governments borrow rather than save, investments will dry up. If investments dry up, goods and services diminish and a crisis lures.
Supposedly in a market system the prices and production of all goods, including the price of money and interest, are
28
interrelated. The equilibrium interest rate occurs when all prices in all markets have reached a point when suppliers and consumers are satiated, so to speak.
latter refers to the purchase of new capital, while the former refers to the accumulation of existing capital (2011: 560). Investments thus either add to the real national income (production of goods) or, as financial services today have become a large part of some nation's economies, lead to the inflation of the money value of financial capital enlarging the national wealth (as with securitisation) (Rutherford, 2007: 123.).
Similar to Smith, Mankiw and Taylor explain governments spend (or: consume), rather than invest (2011: 566). Subsequently if governments spend more than they collect in taxes a budget deficit occurs (ibid). The accumulation of past government's budget deficits becomes a government debt (ibid.). Financing a government debt at the cost of saving (i.e. have tax revenues exceed spending) decreases the market for loanable funds. That is to say, government savings can potentially be borrowed by investors for the production of goods and services (Mankiw and Taylor, 2011: 561). Notice, while no mention of austerity, it appears the textbook narrative presents the economy as having, in principle, no use of government debts only of government surpluses.
5. In this section I will briefly present the Austrian and ordoliberal school, and their understanding of austerity. Both the Austrian school and ordoliberalism designed austerity to produce the most efficient economy, the first in theory and the latter in practice (Blyth, 2013: 152). Introducing the Austrian and ordoliberal school requires me to elaborate a bit on their adversaries from New Liberalism, after which I will again compare some economic textbooks analogies both pro and con austerity.
Since the term crowding out is already mentioned I will start with forwarding to the 20th century to illustrate the history of the so-called Treasury view in the U.K. of the '20s and '30s (Blyth, 2013: 123). In respond to the Great Depression, the U.K. Treasury argued the government - to finance their spending - would have to offer better terms on their bonds than available elsewhere. However by doing so, private investment would be crowded out - as in the economics textbook - reducing overall investment. They concluded, accordingly, government borrowing, as with Hume and
Smith, would depress trade, thus should be avoided where possible (Blyth, 2013: 118-123).
This idea - government interference depressing the market - developed from the British adaption of the Austrian school's "fundamentalist reaction against the modern economy" which indeed build on elements of Smith and Hume (ibid.). This fundamentalist respond was aimed at New Liberal economics. New Liberals like John Maynard Keynes gained popularity after classical liberalism and its advancements were considered unable to explain the Great Depression nor the way forward. With its critique, however, the Austrian school also failed to develop a satisfying explanation. Thus Austrian economics mainly survived piecemeal for political reasons - as in the UK - and, although transformed, as a theoretical endeavour in a region of Europe where it found resonance: Germany (ibid.).
The Austrian school responded to the New Liberalism of Keynes and Marshall which in turn was inspired, partly, by John Stuart Mill (1806-1873). Just after Smith's classical liberalism, J.S. Mill envisioned a larger role for state intervention to secure a stable economy, and he pronounced specific state actions which would improve the economy at large (Stilwell, 2012: 85-86). Mill argued as long as government borrowing would not compete for capital, and thus drive up the rate of interest, issuing debt is acceptable even if taxes are preferable (ibid.). This seems rather vague but it points to something worth mentioning: state borrowing does not necessarily have to crowd out investment.
Although Mill argued for a more prominent role for government-led economic growth, Keynes (1883-1946) offered a truly new perspective. Keynes argued consumption, in contrast to saving, generates investment hence spending and borrowing would remedy rather than destroy the, then ongoing, crisis (Blyth, 2013: 127). Consumption affects prices, Keynes argued, and thus drives investor
expectations (ibid.). "Confidence is an effect of growth, not a cause" (Keynes as in 29
Blyth, 2013: 127). According to Keynes the supposed effects of austerity were a myth. I will elaborate on Keynes' theory shortly when discussing textbook comparisons. First let me introduce the Austrian and ordoliberal school.
Carl Menger (1840-1921) is generally considered a key figure in Austrian economics, born in Austrian Galicia what is now known as Poland (Rutherford, 2007: 18). A main principle in Austrian economics, Menger argued, is that value derives from subjective utility and relative prices, rather than from a function of costs of production - as in classical liberalism. This principle has the following consequences: when a state either issues bonds at low rates or stimulates cheap credit for firms and individuals, credit gets expanded beyond that which real savings would produce. The real value of the credit, Menger argues, needs to be restored by curtailing consumption through austerity. History shows, however, that in 19th and early 20th century Austria the ideas of Menger and like-minded economists were ignored and defeated. Which is why the theory, with figures such as Schumpeter and later Hayek, moved to the U.K. and even more so to the U.S. finding allies within American conservatism. In Europe, although in a new format, Austrian economics survived in Germany for reasons elaborated on below (Blyth, 2013: 143-147).
Out of Austrian economics ordoliberalism, literally translated from German to 'order-liberalism', developed in Germany because of something called the social market economy. It is wider known as the policy that drove post WOII Germany to its
Wirtschaftswunder . The German economy, the ordoliberal history shows, consisted 30
of few enormous companies supported by complex state-bank relations. In contrast to the numerous entrepreneurs in early industrialised countries such as the U.K., the
Investor expectations can be thought of as part of the of economic relations of, first of all depositors who deposit money at the
29
banks, second, bankers who loan it to investors, and last investors who make a profit. Subsequently the money flows back to the banks and the depositors (Minksy, 1992: 3). Investor expectations together with bankers determine the terms of exchange of depositor's money for future money and: businessmen interpret the numbers and the expectations as enthusiasts, bankers as skeptics (Minksy, 1992: 4). Both bankers and investors strive for financial innovation because their profits derive form leveraging. Thus, according to Minksy and Keynes, the economy is partly structured by the characteristics of these financial relations and especially investor expectations (ibid.).Hence if prices rise, Keynes argued, investments increase because investors expect higher returns.
Wirtschaftswunder is a concept coined by the The Times to describe the rapid growth of the German economy after WOII.
large scale German production of goods was carefully planned precisely to challenge the established international competitiveness (Blyth, 2013: 132-137).
Planning such large scale production requires investments no individual, or firm for that matter, can easily make. The German state (which emerged in 1871) therefore designed economy wide mechanisms and institutions enabling competition, and aiding market adjustments - roughly according to an Austrian understanding about how the market operates (ibid.). Above all the state designed regulations suppressing consumption and increasing savings to provide adequate pools of capital for these large industrial investments (ibid.).
The ordoliberals set a legal framework constituted supposedly by the cooperation between members of the community and the government, governing both firms and the state. For ordoliberalism to work people have to obey the rules, which in turn further legitimises them. Key to ordoliberalism appears to be the law, and indeed the German central bank as an independent institution (i.e. not directly accountable to parliament) coordinated much of the economic regulations (ibid.). The regulations were to impose "a system of legal rules which satisfy the general feeling of justice which ties citizens to the economic constitution as they realise its benefits". Crucial laws in the social market economy are the ones that dissolve economic power-groups or limit their functioning (i), suppress consumption (ii), stimulate saving (iii), keep prices stable (iv), stimulate the production of goods (v) and specifically export (vi) (Blyth, 2013: 136-141).
Summarising, Austrian economics and ordoliberalism studied and designed austerity measures to optimise the economy. The Austrians consider all state intervention in the economy (especially deficits, bonds and cheap credit) disruptive hence the state should cut back to the absolute minimum. The ordoliberals on the other hand curve state intervention to support growth. However Keynes argued that government debt as well as private consumption stimulate, rather than destroy, investment and growth. This adds a prerequisite to the German strategy, namely until
other countries appear unwilling to import a large-scale company economy could
Which present-day textbook principles correspond with these theories? According to Mankiw and Taylor in an open economy a country either has a trade surplus, trade balance, or a trade deficit. The first one has been discussed (Germany). The second one becomes clear after reviewing the third one, which is a country with three characteristics. First, imports exceed exports. Second, the overall income of the country is less than the overall spending, and third saving is less than investment. In other words consumption drives imports, and some goods and mainly services remain domestically produced largely for domestic consumption. Also individuals, firms and the government borrow rather than save to invest internationally, however the bulk of investments goes to domestic production (Mankiw and Taylor, 2011: 671-672)
In a trade deficit situation the Keynesian theory of demand appears to dominate: consumption drives investor confidence. Also Mill's argument applies: a government borrows to invest. Rather than spend, drive up interest rates, and crowd out private investment, trade deficit-governments appear to participate in the economy.
Concerning the relation between competitiveness and growth, Mankiw and Taylor argue monopolies or monopolistic competition (oligopoly), compared to competitive markets, are not undesirable. Although monopolists determine prices, their power is constrained by the demand-side of their market (Mankiw and Taylor, 2011: 313). Therefore monopolists do not necessarily change prices to such an extend it hurts either consumers or growth. If they do, the monopolists either produce too many or too little goods for too high or too low a price, and thereby dig their own grave, so to speak. Perfect competitive markets differ from monopolistic markets because available goods and services are homogeneous, and hence prices are determined by "market forces" (Mankiw and Taylor, 2011: 69). In both markets - monopolistic or competitive - in this scenario, there is no impediment to growth.
Let's have a look at Menger and the Austrians in comparison to the textbook. As I wrote: value in Austrian economics derives from subjective utility and relative
prices. This touches upon economic fundamental concepts: value and price. Although
their principles. Consider subjective utility. It is the attractiveness of an economic opportunity as perceived by a decision-maker (Investopedia, 2015a). Now consider relative price, which is the price for a good or service in terms of another price (BusinessDictionary, 2016). The indicators correspond to the second principle of economics: the price of something is what you give up to get it (Mankiw and Taylor, 2011: 5).
Mankiw and Taylor explain this second principle as the opportunity cost, which is whatever one must give up to obtain something thus sacrificing the value of the benefits (2011: 6). It is like comparing costs and benefits of alternative courses of action when deciding on something one wants. Value, for Mankiw and Taylor indeed appears to derive from subjective utility and relative prices. Does this lead to austerity?
On the one hand, Mankiw and Taylor argue import, consumption, and borrowing can lead to investment and growth . On the other they argue credit has to 31
return to its 'natural' value through saving, investment and government cuts . The 32
discrepancy lies in the long versus short run predictions. According to Mankiw and Taylor Keynes's argument applies in the short run (which, arguably, was precisely Keynes' point because the short run is what is of economic importance). Mankiw and Taylor argue in the long run, however, prices (have to) return to their 'natural' (or 'real' as Menger argued) value as a result of the overall equilibrium in the economy.
Since equilibrium theory is crucial to any economic principle Mankiw and Taylor discuss it not as a principle in itself, it is simply: how the economy works (2011: 68-90). Equilibrium is the situation where supply equals demand hence the equilibrium price is reached (2011: 83). In an equilibrium situation consumers as 33
well as suppliers couldn't be better off. The law of supply and demand reads that the price of any good or service adjusts to bring the quantity supplied and demanded into
See Mankiw and Taylor's (2011) chapters on Keynes's theory of demand (chapters 33-36).
31
See their (2011) chapters on how markets work (chapters 4-6), the economy in the long run (chapters 25-28), and the Phillips
32
curve in the long run (chapter 36).
General equilibrium theory contrasts to the theory of partial equilibrium, which only analyses single markets (or perhaps more
33
accurately: analyses the price of a single good) whereas general equilibrium occurs when the entire goods market is in equilibrium (deduced from Mankiw and Taylor, 2011: 714).
this equilibrium (2011: 82). Whatever happens in the economy in the short run 34
(disruptions, crisis, interventions) in the long run supply and demand must, and will, return to their natural equilibrium . 35
This answers the question raised at the beginning of this chapter namely why competition is desirable. The equilibrium price is never set (by a government or cartel) but arrives naturally as the result of the law of supply and demand (i.e. consumers choose among a range of suppliers). Because competitive markets expand the system of resource allocation, the prospects increase of approaching an equilibrium.
The textbook appears to correspond to the ordoliberal's argument that the economy is postponed from returning to an equilibrium if a country has a budget deficit. Equilibrium seems to be the desiderata of the competition laws in ordoliberal Germany: as long as governments have debts, markets will operate sub-optimal leaving everyone in it worse off. Mankiw and Taylor's fifth and sixth principle indeed are: trade can make everyone better off (5) and markets are usually the best way to organise an economy (6) the exception to both being when supply and demand concern public goods . Hence the ordoliberal argument for austerity, considered in 36
the long run and save public goods, can be said to correspond considerably to conventional textbook economics.
6. In this section I will introduce neoliberal theory and explain how it produces austerity based on the argument that, by definition, any other policy will fail. I will again conclude with textbook comparisons.
General equilibrium theory both studies economies using this model of equilibrium pricing, and seeks to determine in which
34
circumstances the assumptions of general equilibrium will hold.
In the real world a market equilibrium might never exist, however most economists might say this is not a problem to utilise
35
equilibrium theorising. Why this is so I will come back to in chapter three. Generally why a market equilibrium is a plausible idea one can think of, for instance, the following example. Let's say a brother and sister sleep in the same room and they have to determine at what time they will shut the lights and go to sleep. The brother wants to sleep at 8, the sister at 10. They agree to 9 PM. The sister, however, because her bed is near the light switch, always leaves the light on a bit longer. Now image the brother and sister would earn some money by working the Saturdays at a diner. By participating in the economy they can both by their own night lamp. Very crudely and oversimplified: the market is an instrument for people to get what they want hence it is fruitful to study under what circumstances most people (whether suppliers or consumers) can get most things they want (whether products or services).
See Mankiw and Taylor's (2011) chapters on the economics of the public sector (chapter 10-12).
Monetarism and public choice theory together transformed classical liberalism into neoliberalism (Blyth, 2013: 152-155). Monetarism is a set of ideas popularised in recent history most notably by Milton Friedman (1912-2006). Friedman argued unemployment has a natural rate, similar to the phenomenon of natural equilibrium prices. If markets operate optimal everyone who wants to work, has a job (Blyth, 2013: 154). This assumption makes sense if one also assumes, like Friedman, employment or unemployment is a choice (Blyth, 2013: 153). This is important because it attacks Keynesianism.
Keynes argued consumption leads to inflation but also drives investment and employment (Rutherford, 2007: 126). Employment is correlated to inflation but does not have a natural rate, or if it has it it does not seem to be of importance to Keynes. Friedman on the other hand argued consumption leads to inflation and unemployment, hence to more inflation (Blyth, 2013: 154). When prices rise, the argument goes, people will either demand higher pay (which employers will respond to by increasing prices hence real wages stay low) or decide to be unemployed living off benefits or something of the sort (which equals spending, and again leads to inflation). Keynes's theory, Friedman argued, can never work. The solution to inflation is deflation, i.e. austerity (Blyth, 2013: 143-154).
Public choice theory, on the other hand, adopts microeconomic assumptions to explain public interactions (Stilwell, 2012: 206-207). It can be related to New Public Management in which economic principles, mainly on efficiency, are implemented in the management of public goods and services. Bureaucrats and politicians, public choice theorists argue, behave no different from agents elsewhere: maximising their incomes subject to their constraints (Rutherford, 2007: 142). James Buchanan and George Stigler for instance argued, similar to Hume's argument from the beginning of this chapter, politicians choose to inflate in order to reassure their re-election (Blyth, 2013: 155). This inflation will make citizens feel, only in the short term, as if they are wealthier as the result of rising salaries. Deflation on the other hand will cost votes hence politicians will rather safeguard their positions by inflating.
Neoliberal theorists, again echoing in Merkel and Schäuble's claim, reinvented the twofold ordoliberal solution to the inflationary doom-loop: independent central banks deciding to deflate when necessary, and simultaneously cut spending to increase growth by improving investor expectations (resp. Blyth, 2011: 156-57, and 169). Neoliberals thus produced austerity while reiterating classical and ordoliberal ideas in direct response to Keynes's theory, and presented them in a TINA format: There Is No Alternative.
The inflation-loop, growth, and central banks, are reflected upon in the Mankiw and Taylor's textbook. I will briefly discuss each concept. The inflation-loop referred to by Friedman resembles what Mankiw and Taylor, among many, define as stagflation: a period of both rising unemployment and rising prices (2011: 751). Whereas Friedman argued stagflation is worsened by (government) spending hence austerity is the only solution, Mankiw and Taylor present two different policy approaches towards stagflation. The first is doing nothing, and letting the long term aggregate supply and demand recover to its equilibrium. By doing nothing employment will keep rising until the expectations of investors adjust to the higher prices. If expectations adjust, investments eventually increase and unemployment start to fall to its natural rate. Notice employment is understood as a choice, with a natural rate, similar to Friedman's conception.
Friedman might have responded that cutting spending will establish investor expectations to change more rapidly. However, Mankiw and Taylor are less concerned with government policies such as austerity which implies intervention would not have significant effect. Indeed the second policy response refers to the, what they call "short term", Keynesian demand theory. Increased government spending will keep unemployment stable in the short run, approximately around two years. However, prices will rise, and the direction of the unemployment rate in the long run is uncertain. Eventually, in the long run, investor expectations are the turning point, whether employment is kept stable or not. However, in general, cutting back the state is desirable. As we have seen Mankiw and Taylor argue a state, where possible, should make room for private investments.
