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Home > Blogs > Ian Fraser and Anthony Harrington > Review of 2010: Stimulus versus Austerity

Review of 2010: Stimulus versus Austerity

Global economy | Review of 2010: Stimulus versus Austerity Ian Fraser and Anthony Harrington

The theme of the World Economic Forum last January was “Improve the State of the World: Rethink, Redesign, Rebuild.” Sadly few of these lofty goals have been achieved in 2010. Things got off to a poor start when Davos’s summiteers, particularly those from advanced economies, seemed incapable of agreeing on how best to reinvent and reinvigorate the global economy in the wake of the worst financial crisis since the 1930s.

As we pointed out in our Review of 2010: The G20 and the US recovery this is partly a consequence of the sheer heterogeneity of the G20 – the group includes countries as diverse as Australia, Argentina, Indonesia, Saudi Arabia and Turkey alongside developed world stalwarts like the Germany, UK and US. Some are resource rich, some resource poor, some developed, some still considered emerging, and so on.

By February, the consensus around neo-Keynesian stimulus which had been in place since the G20’s London summit in April 2009 was starting to unravel. Different countries started pursuing their own divergent agendas, which given the economic backdrop to each, was hardly surprising. Nor was it surprising to find that the avenues chosen were sometimes narrow and protectionist in nature.

The biggest split was between the so-called neo-Keynesians and the neo-Austrians. The former included countries such as the USA and China, which put all their eggs in the basket of continued stimulus coupled with renewed bouts of quantitative easing in the hope this would restore (or sustain) economic growth. They believed this could be done in such a way as to avoid the risks this would lead to a Japan-style “lost decade”.

On the other side were the ‘neo-Austrians’ or ‘new frugalists’. Members of this group – which included Germany, Britain, Ireland, Greece and Ukraine – imposed tough austerity measures, including public spending reductions and tax rises as a means of addressing what were seen as unsustainable budget deficits. In the case of the UK, it remains unclear whether the tough medicine prescribed by the coalition government of prime minister David Cameron will restore economic growth (blog: Osborne's shock therapy).

The latter group adopted this politically challenging stance either voluntarily – out of a long-standing sense of fiscal rectitude – or through fear that if they did not they would be severely punished by the international bond markets, which would impose killing increases in debt costs.

At the extreme end, a few profligate nations had little choice other than to be dragooned into this camp. These included Ukraine, Greece and Ireland, for whom there would have been no International Monetary Fund-backed bailouts without some sharp trimming of their sails.

Whether wittingly or otherwise these countries were following the tenets of the Austrian economists (whose gurus include Freidrich Hayek and Ludwig von Mises) a school which has been out of favour for a while but which an Economist article published in November said it might be due for a comeback. This said:

"A one-paragraph explanation of the Austrian theory of business cycles would run as follows. Interest rates are held at too low a level, creating a credit boom. Low financing costs persuade entrepreneurs to fund too many projects. Capital is misallocated into wasteful areas. When the bust comes the economy is stuck with the burden of excess capacity, which then takes years to clear up ... Efficient-market theorists disliked the Austrians because they appeared to assume that businessmen could act irrationally."

There is now a full time blog criticizing the high priest of Neo-Keynesian-ism, the Nobel prize winning economist Paul Krugman – it's called Krugman-in-Wonderland. In one recent post, the author wrote:

“Economic downturns do not occur because people stop spending, as Keynesians believe. Instead, people stop spending because the economy moves into recession, and stuffing more paper money into the hands of people so they can continue to spend only makes matters worse. Why? Because the recessions are centered on malinvestments which can no longer be supported by consumer spending patterns, the factors associated with those malinvestments also must be liquidated or transferred to other uses in order to allow a real economic recovery to begin."

Alan Meltzer, a distinguished monetarist economist whose viewpoint will be in QFINANCE early in 2011, is on the side of the Austrians. He said:

"Is Britain suffering a Great Depression because the government is making deep spending cuts? No. The economy is doing okay and sterling has appreciated. Is the German economy about to tank because they announced spending cuts? Not at all; it seems to be doing rather well and the euro has appreciated. What Krugman is saying is simply untrue. I’m constantly surprised that the media take him seriously.…"

Krugman, however, has been robust in his own defence, and in the defence of neo-Keynesianism. In a quote featured on’s webside, Krugman derided the Republican cry of “This will cut jobs!” when the US government talks about defense cuts.

"What’s so wonderful is watching Republican congressmen saying: “But this will cut jobs!” The very same Republican congressmen who were denouncing the stimulus, saying government spending never creates jobs now claim that cutting defense spending (government spending if ever there was any – our note) cuts jobs. It’s wonderful…”

The jury is still out, and will probably remain out for a good while yet, on which school of economic thinking has more of the right on its side. About the only thing that us more humble beings can be certain of is that there will be a lot more economic pain to go around before we see boom times again, especially in the developed world – and maybe next time we’ll be wiser…. (you think?)

Tags: economic recovery , fiscal stimulus , G20 , international differences , Ireland , Japan , sovereign debt , US
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  1. Anonymous Comment says:
    Wed Jun 20 14:52:12 BST 2012

    Your story was really informative, thanks!
  2. Anonymous Comment says:
    Wed Jun 20 14:50:06 BST 2012

    AFAIC that's the best awsner so far!
  3. chris-cook says:
    Mon Dec 27 00:53:21 GMT 2010

    I have to take issue with some of the Pro-Austrian comments quoted.

    "Low financing costs persuade entrepreneurs to fund too many projects. Capital is misallocated into wasteful areas."

    Firstly, very few entrepreneurs are able to use bank credit to finance their projects. But capital was indeed allocated into wasteful areas, because far from new productive assets being created, banks created and lent enormous amounts of new credit to buy existing asset, and in particular land/property, resulting in the property bubble.

    "and stuffing more paper money into the hands of people so they can continue to spend only makes matters worse"

    This is complete nonsense. The money being created by government is NOT finding its way into the hands of the general public, either as earned income or through borrowing. It is getting no further than the small minority of investors who are bidding up the prices of all assets, income-bearing or not..

    The truth is that for the last 30 years the rewards from productivity increases have gone almost exclusively to owners of capital, while real incomes stagnated. the result is that 90% of the populations of the Uk and and US are in debt to the other 10% who own all the unencumbered assets. The toxic combination of compounding debt and private property - particularly in land - has done what it has always done for thousands of years and concentrated wealth unsustainabl;y in the hands of a minority.

    Mr Meltzer must know in making his comments that the spending cuts have yet to take effect, and so the fact that these economies are ticking over is due to past action, not present cuts. Latvia, ad Ireland are a measure of the true effect of applying leeches to a patient bleeding internally.

    In ny view Austrian economics shares with Keynesian economics a fundamental misunderstanding as to the nature of money and credit..

    Firstly, a monetary misconception. Credit creation in fact precedes deposits, and not vice versa. There is no such thing as 'fractional reserve banking' any more. The credit which banks create, and the matching demand deposits, are based upon an amount of capital specified by the Bank of International Settlements in Basel, and is therefore constrained by capital not by reserves.

    Secondly, a fiscal misconception: public credit creation and spending precedes taxation, and not vice versa.

    'Tax-payers' money' is a myth. The credit created by central banks on behalf of Treasuries and spent into existence has never been anywhere near a tax-payer.

  4. wwfranklindo says:
    Wed Dec 22 23:02:27 GMT 2010

    Frederic Von Hayek said that all forms of collectivism lead to serfdom. We see it ourselves in the Land of the Fee and Home of the Slave.

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