A polemic against Neoliberalism, but solidly backed by evidence and historical context
Review of Austerity: The History of a Dangerous Idea by Mark Blyth
In political economy, there are 2 principal lines of reasoning: the state should not intervene in the "free market" or it should. The difference between them is ideological, sentimental, and of great consequence. In this brilliant book, Blyth cuts through the rhetoric and makes the case that austerity – letting the market punish those who "violate the rules" of neo-liberalism – is a catastrophically misguided policy. Intervention in the market, he argues, can help and indeed is a far more humane antidote to our economic dilemmas than letting the market take its course. All you have to do, he says, is look at the historical record.
I found Blyth's historical perspective extremely useful. Classical economics emerged in the 17th century, largely in reaction to the capricious behavior of absolutist kings and their aristocracies, who at any time could confiscate the wealth that others had earned. Locke argued for private property and justice by the rule of law; inequality would arise and was good, increasing savings; citizens had the right to rebel. Hume added that merchants, and not the state, were the creators of wealth, i.e. that entrepreneurs would invest their savings into businesses, which benefited everyone. In other words, the "free market" should replace a capricious and ineffective state; any intervention by the state distorted the evolutionary logic of this market, which was taken to be a law of nature, almost as a religious faith. Adam Smith largely agreed, arguing in Presbyterian terms that "personal frugality and parsimony" represented the key to capitalism. It naturally followed that, in difficult times, austerity would return the economy to its "optimal equilibrium state". All the state could ever do was generate debt and inflation. This is the essence of the "supply side" as principal actor, far more a sensibility than an evidence-based theory.
Though many schools of classical economics followed, they essentially only elaborated on this with fancy twists like Schumpeter's "creative destruction" and Friedman's "voluntary unemployment" and an "underlying economy" that the state doesn't influence. However, Blyth argues, there was a fundamental contradiction at the heart of their logic: the state was bad, but it was needed in order to maintain the legal framework and protection of the free market (for which no one wanted to pay). This led some economists, including John Stuart Mill and even Adam Smith, to acknowledge that some role for the state was needed.
It was not until Keynes that a fundamental alternative to the supply-side logic emerged. Keynes argued that it was the demand side – consumers with money to buy goods – that stimulated investment rather than savings (read profits) by thrifty merchants. Governments, in his scheme, could increase aggregate demand, "priming the pump" so to speak, which in turn would cause the economy to grow in a self-reinforcing movement. This was, Blyth asserts, the way that the West grew out of the Great Depression, at first with FDR's New Deal and decisively with the deficit-driven expenditures for World War II. At present, he notes, Keynesianism is in retreat. Neoliberalism in the US (supply side economics and various other schools) and Europe (Germany's ordoliberalism) is the dominant economic ideology. This has led to a resurgence of austerity policies.
With the use of detailed case studies, Blyth makes the case that austerity doesn't work. The 2007 crisis began with deregulation of the banks in the 1980s. To meet short-term cash flow needs, companies were allowed to take the traditional place of banks, offering loans that were secured by various financial instruments, in particular mortgage securities. Banks became the bundlers of these collateral instruments, an extremely profitable paper enterprise that hid the risks under a variety of algorithmic techniques. Unfortunately, once the real-estate bubble burst, these securities became worthless as everyone tried to dump them in a panic. It was only the intervention of the government – at the cost of increasing debt by 40% of the GDP! – that bailed out the banks. Though private sector actions caused the crisis, ideologues blamed the government and called for austerity, prolonging the crisis in Blyth's view, most ruinously in Greece and Spain.
The most interesting case study is the Euro. Based on German ordoliberalism – the state keeps the market in order so that companies can compete fairly, but otherwise hesitates to intervene – the Euro created a modern-day gold standard. Without floating currencies, the normal adjustment mechanisms of devaluation and inflation become impossible, leaving only deflation or default on payments as remedies. Because the EU lacks the policy instruments to address the crisis, which would require supra-national fiscal policies, the bailout task is too big for any national country to undertake. This locks all EU nations into dependency on Germany, which imposed austerity at terrible political consequence, perhaps even the end of the European political project.
Blyth concludes that austerity fails in virtually every instance. As Keynes argued, if the state does nothing there is no reason for the economy to "right itself", i.e. return to full employment. Depressions can last a very long time – because of debt deflation, whereby employment drops and debts increase, which in turn are harder to pay off as consumption shrinks further. Moreover, investment under such circumstances is irrational: businessmen see that no one can buy. In addition, there is no evidence that the free market automatically results in "optimal allocation" of resources or that recession "purges the bad actors". Finally, asset inflation – the basis of profitability for the banks providing collateral instruments – cannot go on forever. It eventually crashes and governments are left with the bills for private follies.
I know the last 3 paragraphs were absurdly abstruse and technical, but they are at the core of Blyth's argument. If you don't want to make the effort to understand them, this book is probably not for you. At a minimum, this book is high undergraduate level. It is at times very difficult terrain, even for me, who studied political economy at the graduate level. I think the rewards are great, and I completely agree with Blyth's conclusions. Furthermore, there are so many interesting details that this is fundamental reading. Indeed, this is one of the best economics books I've ever read.