What is Austerity Meant to Achieve?

by Alberto Russo

Conventional wisdom is increasingly of the view that austerity isn't working. The combination of tax increases and public spending cuts is typically justified as a necessary measure to reduce public debt-to-GDP ratios, yet after years of austerity the public debt-to-GDP ratio is increasing in many European countries. Austerity's supporters respond that what looks like failure is merely the short-term pain of transition towards economic sustainability. Once economic growth resumes, they insist, the positive effects of the restructuring of public finances will be manifest in a structurally balanced budget and a reduced public deficit.

Key to this dispute is how long it will take before economic growth picks up again. If the recession ends fairly quickly, the sacrifices demanded by austerity may be at least partly justified. If the economy does not improve within a relatively short period of time, however, the costs of austerity are likely to be counterproductive as well as painful: in an extended crisis scenario the working of automatic stabilizers (as when a decline in GDP reduces tax revenues; rising unemployment requires more state subsidies; and so on) will, when combined with fiscal austerity, produce a vicious circle of recession-austerity-recession. 

This cycle, and all the catastrophic social consequences it entails, is already visible in Greece. For this reason economists such as Paul Krugman and Joseph Stiglitz maintain that, if the goal of austerity is to consolidate public finances and free up resources to restart the economic system in a relatively short time, it is a failure. 

But why, then, are governments continuing to implement it? One possibility is that the officials in charge of economic policy are incompetent, or ideologically blinkered. Another possibility, however, is that they are quite capable, but have different objectives in mind. 

It may be, for instance, that austerity is intended to solve the problem of large trade imbalances between European countries, in which creditors (Germany) are running large trade surpluses and debtors (Greece, Spain, Italy) large trade deficits. Reducing these imbalances requires increasing the net exports—the difference between the exports and the imports—of debtor countries. But how can this be done? 

Let's start with imports. These are declining in 'peripheral' countries, because GDP is falling. Now let’s look at exports. Rising unemployment (in parallel with a declining GDP) and state interventions aimed at increasing labour flexibility have the effect of slowing wage growth. This reduces production costs and thus increases competitiveness, which should in turn promote exports. So if the goal of austerity is to achieve balanced external accounts in the Eurozone (and thereby to reduce external indebtedness), there are reasons to think it might work. 

The main limitation of such a strategy is that not all countries can become net exporters at the same time—by definition, the world must show a trade balance as a whole. In Europe, according to this strategy, Germany should reduce its exports to debtor countries. The latter, in turn, will need foreign demand to become net exporters (and future creditors). From this point of view, Germany and other countries that follow an export-led growth model in a context of sluggish domestic demand should reorient their exports towards the demand coming from the global 'new rich' (for example, rich people living in BRICS countries, who are relatively few in comparison to their populations, but relatively many compared to our numbers). However, some of these rising economies are themselves strong exporters and may be affected by the European crisis: if Europe imports less from them their growth will slow, which will in turn adversely affect European exports to them, and so on in a vicious cycle. While intriguing in theory, then, the 'German solution' is unlikely to work. 

If austerity is not primarily directed towards reducing public deficits or rebalancing European trade, what else could be driving it? Recall that increased unemployment caused by the recession has kept wage growth below price increases, which has in turn allowed profit margins to be sustained and even increased. It is true that wage compression, cuts in public spending and the welfare state, laying off of public employees, and so on, reduces consumer spending, with negative consequences for domestic demand. This decrease, however, can be offset by increased foreign demand; in other words through increased exports, as described above. Seen in this light, increasing unemployment may be intended as a mechanism of macroeconomic regulation, with distributional effects in favour of profits. The increased labour flexibility that accompanies restrictive fiscal policies makes this regulation mechanism more effective, since with higher flexibility and more unemployed people, the threat of firing becomes a more effective device to discipline workers. 

So understood, it should be clear why austerity has prioritised tight fiscal policies ahead of economic stimulus to boost growth. Increased labour flexibility and rising unemployment produces a deterioration of the material conditions in which the working class operates, and only later, once labour costs have been sufficiently diminished and workers properly disciplined, is it possible to stimulate growth such that the consequent decrease in unemployment does not squeeze profits. In other words, increased labour discipline reduces the potential wage inflation that typically follows a reduction of unemployment (as per the Phillips curve). 

In general, the causes of the current crisis are tied to the neoliberal shift of the late 1970s and 1980s, which replaced economic policies based on Keynesian demand management. It entailed a broad process of deregulation—from  the labour market to the globalisation of production, from national to international finance—that permitted a partial recovery of profitability in the capitalist system, ending the post-war decline in the rate of profit that had produced the “stagflation” of the 1970s. This was followed by a decline in labour's share of profit, especially for low-skilled workers, and increased inequality. Cuts to the welfare state were partly offset by the “wealth effect” produced by stock market and real estate bubbles, while the expansion of consumer credit partially compensated for lack of aggregate demand. The profits derived from neoliberal deregulation were only partly reinvested in the real economy of Western countries: production was increasingly located in low-cost countries, and an increasingly significant share of profits went to the financial sector. 

In the absence of financial sector growth, real wage stagnation over the last few decades would have resulted in an overproduction crisis in Western economies long before 2007. Accordingly, financial expansion has operated as a countertendency to the decline of manufacturing. However, financialisation brought its own problems: the relentless accumulation of debt and the increasing complexity of financial products produced a highly fragile system, which eventually collapsed. 

In short, neoliberal deregulation boosted profits and capital accumulation through labour market flexibility, a global relocation of production and increasingly risky financial transactions. However, the same components of the neoliberal model—deregulation, financialisation, globalization—combined to produce crises of increasing severity, culminating (for now) in the 2007-8 crash, as a result of the huge increases in income and wealth inequality, financial instability and trade imbalances attendant on financialisation. 

Current austerity measures ought to be seen as a strategy aimed at prolonging the neoliberal era. If the purpose of austerity policies is to ensure high rates of profit through the depression of wages, the reduction of the welfare state, and the further privatisation of public services, leaving financial regulation essentially unchanged, then the evaluation of the efficacy of government interventions should be quite different from that based on the simple goal of reducing the public debt-to-GDP ratio. Rising unemployment, far from being a failure or an unintended side-effect of austerity, may instead be a mechanism to regulate the capital-labour conflict so as to ensure a containment of wages. Austerity configures a route out of the crisis that is based on further weakening the working classes, and continued financial domination of the economic and political arena. However, in my view, this strategy leaves unsolved the underlying problems (huge inequalities, financial instability) which threaten the global economy, and augur the next crisis. 

Alberto Russo is Assistant Professor of Economics at the Department of Economics and Social Sciences, Università Politecnica delle Marche, Ancona (Italy). He can be contacted at alberto.russo[at]univpm.it.

This is a revised version of a previous article published in MicroMega online and on the blog Lakrisi.com. The author is very grateful to Jamie Stern-Weiner for useful comments and for greatly improving the English translation from the Italian version.

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First published: 25 June, 2013

Category: Economy, Europe

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3 Comments on "What is Austerity Meant to Achieve?"

By Midnight max, on 25 June 2013 - 21:46 |

Great article

By Chris2, on 28 June 2013 - 02:56 |

Austerity is designed to crush and atomise the working class. It is testing the institutions of the working class, the unions and the political alliances, to destruction. It is the systematic, democratic way of doing what Pinochet did in Chile. 
  The one positive aspect of this nightmare for millions is that it has exposed not only the Sociall Democrats and the union bureaucracies but the sectarian left as impotent, clueless and irrelevant.   

By PsychJim, on 31 July 2013 - 12:37 |

The problem lies in the lack of unity! Whilst the media generates conflict upon conflict, bamboozeling the masses with false threats and moral panic, the reality of these economic issues becomes hidden. Only when the death rate directly associated with austerity measures increases to a critical mass will the new ‘Peterloo’ protestors return! I hope by then its not too late!!

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