John Buell

Austerity in Crisis

The European Union is in recession, and the periphery faces conditions not seen since the Great Depression. In Spain, unemployment tops 27%, with half of its youth unemployed. Not to worry, say the elites of the European Central Bank. Spain, Italy, Ireland, Portugal, and Greece, aptly abbreviated as the PIIGS, are just getting what they deserve. They have spent beyond their means. Once they reduce their deficits—preferably by cutting benefits and services— confidence in the markets will increase and investments will flow in. Swallow your medicine, eat your vegetables, and all will be okay. Here in the US, despite persistent unemployment, budget deficits remain an obsession, at least with the elites. This conventional wisdom now has a new name, expansionary austerity. Austerity in its various forms and guises is the subject of a comprehensive and provocative new study, “Austerity: The History of a Dangerous Idea” by Brown political economist Mark Blyth.

Blyth cites the many failings in both the diagnosis and prognosis propounded by advocates of that pompous oxymoron. Some of these failings will not be unfamiliar to regular readers of Paul Krugman’s New York Times column and blog, but Blyth correctly attributes more importance to the role of investment banking and has added a deeper more interdisciplinary approach to the crisis.

For starters, with the exception of Greece, none of the PIIGS had levels of debt that disturbed markets in earlier eras. Ireland and Spain were in fact models of fiscal rectitude. The sovereign debt crisis emerged only after their private sector banks had inflated a massive real estate bubble. This process was driven by a major transformation in the private banking world. In the eighties, as banks lost customers to the corporate short- term capital markets, they needed another business model. That model evolved to include consolidating and offloading mortgage securities. These securities bundled many homes at different levels of borrower economic strength. Risk calculations for each level were based on sophisticated mathematical models. These assumed a normal, bell curve shaped distribution with Texas housing losses during the 1980s S&L meltdown of 40%, the worst in their sample, as the outer bound, lowest probability event. Thus the probability that all mortgages in a portfolio would lose such value was deemed to be too remote to take seriously. This market was further pumped up by a new form of security, the Credit Default Swap (CDS), which allowed purchasers of these multilayered securities to obtain insurance against their default.

The problems with this business model are legion. Assuming a normal distribution, the economists argued that all the mortgages in a portfolio would decline 40% were once in a third of the life of the universe. But as Blyth points out, “if you haven’t been around for a third of the life of the universe, then how can you know what is possible over that time period? It is the assumed distribution that tells you what is possible, not your experience.” In addition, the providers of the CDS securities that so pumped up this market were unregulated, allowing them to become enormously overextended.

Practitioners of this model constructed a witches brew that evolved in ways they could not and did not foresee. The sum had a dynamism not reducible to the sum of the parts. They could not imagine that “the meshing of elements that were each intended to make the world safe, such as mortgage bonds, CDSs, and banks risk models, could make the world astonishingly less safe. “ The only surprise should be that the bubble lasted as long as it did.

In Europe, the situation was even worse. This business model brought these banks, which were more concentrated and more highly leveraged than even US banks, to near insolvency and the complete collapse of their financial system. In order to avoid such disaster, the governments of Ireland and Spain absorbed the debt, thus staining their own once pristine balance sheets.

If government deficits did not cause the problem, public sector retrenchment will not solve Europe’s or the world’s financial problems. Households, having lost much of their net worth in the collapse of the real estate bubble, are retrenching. If governments also choose to save, from where does the spending upon which the economy depends come? Your spending is my income. Advocates of expansionary austerity argue that confidence will be restored when governments cut spending, thus assuring businesses that future profits will not be taxed away. But business is likely to respond only to real demand in the market place rather than to uncertain promises.

But orthodox economists have built a wall against the policy tools that might respond to the uncertainty and unpredictability of markets. Government employment guarantees and job creation might produce new consumer demand.  Europe is the most extreme case. The Eurozone has been constructed as a monetary union absent any fiscal consolidation. One currency governs all transactions and its value is determined by an independent central bank mandated only to prevent inflation regardless of the economic circumstance. There is no central government with the power to tax and spend. When a bubble in Spain collapses, the Spanish government cannot devalue its currency. Nor can it spend more to reflate its economy and recapitalize its banks without seeing interest rates rise to unsustainable levels. And once markets see this process unfolding in one vulnerable nation, speculators look around for the next most vulnerable. Their actions often provoke the next crisis. This is a true doomsday machine, as Blyth argues.

Blyth meticulously compiles the contemporary and historical case against austerity. The experience of Europe and the US both now and in the thirties provides about as strong a case as one can ever get in the social sciences. Austerity advocates, who like to deem themselves as orthodox scientists swayed by the data, are unmoved by a totality of evidence that would surely prove persuasive in other contexts. Why austerity persists and how it may be overcome will be the theme of my next column.

John Buell lives in Southwest Harbor, Maine, and writes regularly on labor and environmental issues. Email jbuell@acadia.net.

From The Progressive Populist, June 1, 2013