Taming Finance in an Age of Austerity
Joseph E. Stiglitz
July 8, 2010
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It was not long ago that we could say, “We are all Keynesians now.” The financial sector and its free-market ideology had brought the world to the brink of ruin. Markets clearly were not self-correcting. Deregulation had proven to be a dismal failure.
The “innovations” unleashed by modern finance did not lead to higher long-term efficiency, faster growth, or more prosperity for all. Instead, they were designed to circumvent accounting standards and to evade and avoid taxes that are required to finance the public investments in infrastructure and technology – like the Internet – that underlie real growth, not the phantom growth promoted by the financial sector.
The financial sector pontificated not only about how to create a dynamic economy, but also about what to do in the event of a recession (which, according to their ideology, could be caused only by a failure of government, not of markets). Whenever an economy enters recession, revenues fall, and expenditures – say, for unemployment benefits – increase. So deficits grow.
Financial-sector deficit hawks said that governments should focus on eliminating deficits, preferably by cutting back on expenditures. The reduced deficits would restore confidence, which would restore investment – and thus growth. But, as plausible as this line of reasoning may sound, the historical evidence repeatedly refutes it.
When US President Herbert Hoover tried that recipe, it helped transform the 1929 stock-market crash into the Great Depression. When the International Monetary Fund tried the same formula in East Asia in 1997, downturns became recessions, and recessions became depressions.
The reasoning behind such episodes is based on a flawed analogy. A household that owes more money than it can easily repay needs to cut back on spending. But when a government does that, output and incomes decline, unemployment increases, and the ability to repay may actually decrease. What is true for a family is not true for a country.
More sophisticated advocates warn that government spending will drive up interest rates, thus “crowding out” private investment. When the economy is at full employment, this is a legitimate concern. But not now: given extraordinarily low long-term interest rates, no serious economist raises the “crowding out” issue nowadays.
In Europe, especially Germany, and in some quarters in the US, as government deficits and debt grow, so, too, do calls for increased austerity. If heeded, as appears to be the case in many countries, the results will be disastrous, especially given the fragility of the recovery. Growth will slow, with Europe and/or America possibly even slipping back into recession.
Stimulus spending, the deficit hawks’ favorite bogeyman, did not cause most of the increased deficits and debt, which are the result of “automatic stabilizers” – the tax cuts and spending increases that automatically accompany economic fluctuations. So, as austerity undermines growth, debt reduction will be marginal at best.
Keynesian economics worked: if not for stimulus measures and automatic stabilizers, the recession would have been far deeper and longer, and unemployment much higher. This does not mean that we should ignore the level of debt. But what matters is long-term debt.
There is a simple Keynesian recipe: First, shift spending away from unproductive uses – such as wars in Afghanistan and Iraq, or unconditional bank bailouts that do not revive lending – toward high-return investments. Second, encourage spending and promote equity and efficiency by raising taxes on corporations that don’t reinvest, for example, and lowering them on those that do, or by raising taxes on speculative capital gains (say, in real estate) and on carbon- and pollution-intensive energy, while cutting taxes for lower-income payers.
There are other measures that might help. For example, governments should help banks that lend to small- and medium-size enterprises, which are the main source of job creation – or establish new financial institutions that would do so – rather than supporting big banks that make their money from derivatives and abusive credit card practices.
Financial markets have worked hard to create a system that enforces their views: with free and open capital markets, a small country can be flooded with funds one moment, only to be charged high interest rates – or cut off completely – soon thereafter. In such circumstances, small countries seemingly have no choice: financial markets’ diktat on austerity, lest they be punished by withdrawal of financing.
But financial markets are a harsh and fickle taskmaster. The day after Spain announced its austerity package, its bonds were downgraded. The problem was not a lack of confidence that the Spanish government would fulfill its promises, but too much confidence that it would, and that this would reduce growth and increase unemployment from its already intolerable level of 20%. In short, having gotten the world into its current economic mess, financial markets are now saying to countries like Greece and Spain: damned if you don’t cut back on spending, but damned if you do as well.
Finance is a means to an end, not an end in itself. It is supposed to serve the interests of the rest of society, not the other way around. Taming financial markets will not be easy, but it can and must be done, through a combination of taxation and regulation – and, if necessary, government stepping in to fill some of the breaches (as it already does in the case of lending to small- and medium-size enterprises.)
Unsurprisingly, financial markets do not want to be tamed. They like the way things have been working, and why shouldn’t they? In countries with corrupt and imperfect democracies, they have the wherewithal to resist change. Fortunately, citizens in Europe and America have lost patience. The process of tempering and taming has begun. But there is far more yet to do.