In Focus

Growth vs Austerity - history repeats (again)

Thursday July 12, 2012 Dr Ganesh Nana

“Those who do not learn from history are doomed to repeat it”.  So, just when we need them, it seems there are not many history scholars out there.  Yes, the growth versus austerity argument is with us again.  Despite few examples of nations recovering to become strong and prosperous on the back of an austerity programme, the prescription of austerity in the face of financial ills is not new. 



Helping underpin such views, it seems, is the widespread common sense of it.  If you have overspent your income and got yourself into trouble because of it, it is plainly obvious that you need to rectify your habits by adjusting your spending propensities accordingly.  And it also fits well with the advice given to us by our parents, you know the one about “pain before gain”, or needing to “trim your cloth to suit”, or “your past frivolous spending means you now need to start working hard”.  But, while such advice may apply to you and me as individuals, do they apply to all of us?


Here is when some history needs to come into play.  Up until Keynes (later Lord Keynes) wrote his General Theory, the solution to unemployment was widely regarded as simple.  Just like any market where there is excess supply (which is what unemployment was according to the textbooks of the time), the solution lay in reducing its price.


While this made intuitive sense on the microeconomic (or individual market) front, a reduction in the price of labour (i.e. wages) turned out to also have an impact on the incomes of consumer households.  However, the impact on incomes does not enter into the analysis in the individual market focus of microeconomics.  But, the impact of lots of individual households experiencing a reduction of income inevitably impact on the combination of all markets (i.e. the macro economy).   


Lower incomes flowed through to lower consumer demand for goods and services, which in turn reduced the demand for labour as firms adjusted to lower demand;  This led to increased unemployment and a vicious cycle of despair ensued.


It was not until a realisation (and acceptance) that the analytical tools for an individual market were insufficient when all markets are brought together that progress could be made.  That is, there needs to be an understanding that there are relationships between individual markets and the combination of all of them. Thus, macroeconomics was born.


And so it is true that while stringency and austerity may be right for individuals when we get into financial trouble, the same prescription may not be applicable when all of us are in trouble at the same time.  What’s good for us as individuals, may not good for us as a group.


In response to the share market meltdown and the consequential financial crisis of the early-1930s, US Treasurer Andrew Mellon’s prescription was to liquidate everything.  “It will purge the rottenness out of the system.  People will work harder, live a moral life.  Values will be adjusted, and enterprising people will pick up the wrecks from the less competent people.”  Unfortunately, but not unsurprisingly, that response further accentuated the crisis.  While it made sense for individuals to sell up and run, all of us trying to get rid of worthless assets at the same time just saw prices plummet and losses become insurmountable.


The contrast between Europe’s recovery from WWI and WWII is similarly informative.  Post‑WWI saw the imposition of reparations.  The seeds sown in Germany when faced with externally imposed austerity did not augur well for the future of Europe at the time.  Post-WWII saw a concerted effort from the allies to rebuild Europe.  This, at the least, helped in establishing a relatively stable economic and political basis for the development of post-war western Europe.


So, if the response to this century’s crisis follows an austerity prescription, the prognosis for Europe (and the world) is unlikely to be attractive.  But, a concerted effort to build and revitalise the community, physical and financial infrastructure of Europe (not to mention the global) economy would certainly see a better longer-term outcome.  I’m just not sure the leadership of Europe (or, indeed, the world) are interested in such longer-term, collective, development goals.  It’s just that much easier to assign blame to individual nations.