Is Austerity a Bad Idea?

Chances are you haven’t missed the ongoing global debate going on about whether austerity or Keynesianism is the better macroeconomic policy in an economic downturn. One of the rewards of looking up “austerity” on Wikipedia is that you discover this little gem of information:

Merriam-Webster's Dictionary named the word "austerity" as its "Word of the Year" for 2010 because of the number of web searches this word generated that year. According to the president and publisher of the dictionary, "austerity had more than 250,000 searches on the dictionary's free online [website] tool."

There are strong arguments for and against both austerity and Keynesianism. However, some recent writings should make us remember to question the terms of the argument itself. While evidence-based economics is important, it can also mislead.

Recapping the debate

On one side, so-called austerians believe that if a country has spent too much, gotten deep in debt and is now in recession, it ought to cut back on spending and pay down its debt.

That sounds reasonable, doesn’t it?

But so does the other side. The Keynesians say this is a fallacy of composition. They say it erroneously analogizes the condition of an entire country to the condition of a household. Yes, if a household is deep in debt and paying big credit card bills, it ought to cut back on spending and pay down its debt (beginning with those credit card balances).

But, the Keynesians say, your spending is my income. If we all cut back on our spending, then all our incomes will get cut back too, and a lot of us will be unemployed. Nobody will be spending, earning or working.

What to do? When too many households are cutting back it’s time, say the Keynesians, for the government to step in, borrow heavily and increase its spending to stimulate the economy, put people to work and shore up incomes. Do that, and the economy will pull itself out of the doldrums. Then, and only then, should the government cut back.

Knock-on effects

But it’s never that simple in economics. Any action – by government or by the private sector – will have knock-on effects. The ultimate outcome depends on the feedback loops into the economy that those knock-on effects produce.

For example, if you don’t believe in Keynesianism, you can argue that if the government spends money – by cutting back taxes, investing in infrastructure projects or just plain handing it out – people will know it’s not going to last.