Will ‘austerity’ lead to a new recession?

With developed countries announcing severe cuts in government spending and new taxes, there is concern a new global recession may be in the making, writes MARTIN KHOR

A DEBATE is raging among economists and policy-makers whether the recent sharp shift in economic policy from “fiscal stimulus” to “fiscal austerity” will help the global recovery or cause a new recession
It is more than an academic debate. Depending on what the answer is, there could be a continuation of the recovery or a slip into a “double-dip recession” or even a depression.
The rush to austerity started in Europe, when the near debt default in Greece quickly created fears of contagion of sovereign debt crises to Portugal, Italy and Spain.
These countries quickly announced severe cuts in government spending and new taxes. Other countries that are thought to be safe from crisis followed, including France and Britain.
This was a big about-turn from the policy consensus that the threat of a depression must be fought by the Keynesian policies of increased government spending, through higher budget deficits and low interest rates.
It is widely acknowledged that the re-discovery and implementation of Keynesian policies in the past few years saved the world from a prolonged recession or even a Great Depression.
But the Greek crisis has struck fear into governments that if their budget deficits are too large, they may not be able to borrow enough at a reasonable rate of interest, and may be forced to default.
Actually, most governments have the options of borrowing from their own central banks (or to “print money”) and also devaluing their currency (so as to expand their exports by making them cheaper).
But countries in the Eurozone, such as Greece, do not have this option as they cannot lend to themselves and do not have their own currency to devalue. Thus, Greece had to rely on the market to lend to it.
When the market demanded interest that was too high, Greece had to be bailed out by loans from Europe and the International Monetary Fund (IMF).
Last month, Britain became the latest country to go for austerity.
The new Tory-Liberal government cut spending by £83 billion and raised taxes by £29 billion.
As Britain is not in the Eurozone, it has more options to continue with fiscal stimulus, but the government chose instead an austerity budget.
Well-known economists and media commentators like Robert Skidelsky, Martin Wolf and Will Hutton have been critical. Skidelsky, the biographer of John Maynard Keynes, criticised the “conversion to austerity” for being caused by the need to restore “confidence in the markets”.
“If markets have come to the view that deficits are harmful, they must be appeased, even if they are wrong,” he wrote about the change in policy.
He pointed out that in a parallel situation in 1931, a British government committee recommended a drastic cut in government spending in order to balance the budget, and this was supported by almost all politicians and the business sector.
Keynes was one of the very few who opposed it.
He commented that deficits are “nature’s remedy for preventing business losses from being … so great as to bring production altogether to a standstill”.
The austerity policies adopted in 1931 contributed to a long recession, and Skidelsky noted that there was never a complete recovery until the war.
Commenting on the present situation, Skidelsky wrote: “We are about to embark on a momentous experiment to discover which of the two stories about the economy is true. If, in fact, fiscal consolidation proves to be the royal road to recovery and fast growth then we might as well bury Keynes once and for all.
“If, however, the financial markets and their political fuglemen turn out to be as ‘super-asinine’ as Keynes thought they were, then the challenge that financial power poses to good government has to be squarely faced.”

*Martin Khor writes a weekly newspaper column in Malaysia. He previously headed a consumers NGO.