YIaNNIS KItrOMIlIDES

Deficit reduction, the age of austerity, and the paradox of insolvency

Abstract: The European debt crisis in 2010 resulted in the adoption of fiscal austerity measures in many European economies, and produced demands for the adoption of similar policies in the United States. This paper examines whether the implementation of immediate fiscal austerity during a fragile economic recovery is justified and whether it is the best means of achieving deficit reduction. The paper points out that although the austerity strategy can lead to deficit reduction and prevent insolvency in the case of an indebted individual, this may not necessarily be the outcome in the case of national indebtedness. The problem is accentuated when austerity measures are replicated in many interdependent economies. The paradox is in general valid when it is assumed that fiscal policy is effective and that fiscal multipliers are positive, assumptions that the New Consensus Macroeconomics theoretical framework that underpins the austerity strategy, inappropriately, rejects. The overall conclusion is that synchronized fiscal austerity cannot solve the problem of ballooning public debts that need to be tackled in conjunction with attempts to reform the international banking and financial system. Key words: austerity, deficit reduction, fiscal policy, insolvency, public debt.

In the course of 2010, a number of European countries with large budget deficits adopted the strategy of imposing the age of austerity as a means of achieving rapid fiscal consolidation. Even countries such as France, without pressing deficit issues, and Germany, with a current account surplus, have adopted measures of fiscal austerity. What is striking and remarkable about the adoption of this strategy is its timing. It was adopted one year after the G-201 countries agreed at their april 2009 meeting in london to implement the opposite policy of coordinated fiscal expansion
Yiannis Kitromilides is a senior lecturer in economics, Westminster Business School, University of Westminster, london. He is grateful to two anonymous referees for helpful comments. 1 the G-20 consists of argentina, australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, russia, Saudi arabia, South africa, republic of Korea, turkey, the United Kingdom, and the United States.
Journal of Post Keynesian Economics / Spring 2011, Vol. 33, No. 3 517 2011 M.E. Sharpe, Inc. 01603477 / 2011 $9.50 + 0.00. DOI 10.2753/PKE0160-3477330306

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in order to combat the threat to the global economy posed by the financial crisis that began in late 2007. the strategy of fiscal consolidation, already adopted by European countries, received official endorsement from the G-20 countries at their June 2010 meeting in toronto, where it was stated in the official communique that advanced economies have committed to halve deficits by 2013 and stabilize debt-to-GDP (gross domestic product) ratios by 2016. Japan, among the advanced economies, was excluded from this commitment but not, presumably, the United States. the apparent U.S. commitment to the toronto targets, however, needs to be seen in light of the equal weight given in the communique to the risks that the global economy faces from synchronized fiscal adjustments, and therefore the need to take these risks into account when attempting to meet the fiscal targets. although there is no firm official commitment by the United States to the strategy of immediate fiscal austerity following the toronto meeting, there appears to be a significant policy shift and an emerging consensus in U.S. policy-making circles in favor of the austerity strategy. the main aim of this paper is to consider this policy reversal and to examine, first, whether the objective of immediate and rapid deficit reduction during a fragile economic recovery is justified, and second, whether the imposition of the age of austerity is the best means of achieving this objective. these questions will be discussed mainly in the context of recent policy debates in Europe and the United States and with reference to recent and not so recent theoretical and empirical arguments concerning public indebtedness. Controversy about budget deficits and public debt is not, of course, new in economics. Some aspects of the issue of public indebtedness have been debated in economics since the time of ricardo (1951) and Smith (1957). Smith (ibid.) devoted a whole chapter in The Wealth of Nations on public debt. He acknowledged that during times of national emergency, such as a war, public borrowing was inevitable because war expenditure could not be financed entirely from current taxation. He was, however, concerned about the burden of public debt and was dismissive of the suggestion that the payment of interest on public debt was like the right hand paying the left hand because some of the national debt of Great Britain was owed to foreigners, such as the Dutch. Even without foreign borrowing, Smith (ibid.), not surprisingly, thought that public debt was pernicious because of the ability of governments through various juggling tricks (such as inflation) to reduce the value of the debt. this, according to Smith,

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occasions a general and most pernicious subversion of the fortunes of private people; enriching, in most cases, the idle and profuse debtor, at the expense of the industrious and frugal creditor; and transporting a great part of the national capital from the hands which were likely to increase and improve it, to those who are likely to dissipate and destroy it. (ibid., p. 770)

It is worth noting that moralizing about indebtedness, describing debtors as idle and profuse and creditors as industrious and frugal, is not an entirely modern phenomenon in economics, as will be discussed later in this paper. the Napoleonic Wars produced a huge deficit in Great Britain, which led ricardo (1951) to develop an interest in public debt, and in particular an interest in the question of whether tax finance and borrowing are equivalent. It was, however, Keynes (1936) who ignited a major controversy in macroeconomics concerning the impact of deficit spending on income and employment, which continues in various guises to the present day. this paper considers the relevant aspects of both theories, and it proceeds as follows. the next section provides some background information not only on the European debt crisis and the European austerity measures but also on the effect of the debt crisis on the U.S. policy debate about budget deficits and public debt. the third section considers the crucial theoretical and empirical question concerning the nature of the relationship between deficit reduction and the continuation of the economic recovery. In the fourth section, the logical basis of the austerity strategy is assessed. the policy debate, of course, extends beyond narrow technical disagreements in macroeconomics. In the fifth section, the political economy aspects of the austerity debate are examined and some moral and ethical controversies over austerity and indebtedness are reviewed. the sixth section summarizes and draws some conclusions. The debt crisis in Europe and the timing and scale of fiscal austerity policies Fiscal austerity in Europe was precipitated by the Greek debt crisis, which spread quickly to the rest of Europe when other countries of the eurozonenotably Spain, Portugal, Italy, and Irelandalso came under market scrutiny and market pressure for exceeding in varying degrees their own self-imposed rules on government finance. the rules, known as the Maastricht criteria, stipulated that total government debt must not exceed 60 percent and total budget deficit must not exceed 3 percent of

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GDP at the end of the fiscal year. these market pressures led to fears of contagion, potentially threatening the stability of the euro. the implementation of tough fiscal austerity measures in Greece was a condition for the provision of assistance from the European Union and the International Monetary Fund (IMF). the adoption of these measures in Greece acted as a catalyst for the spread of fiscal austerity policies throughout the eurozone. the debt crisis also had a huge impact on policy debate beyond the eurozone. In counties such as the United States and the United Kingdom, which had Greek-style deficits, there were soon demands for Greek-style austerity measures in order to prevent a Greek-style tragedy. In the United States, Federal reserve Chairman Ben Bernanke (2010), in a speech to the National Commission on Fiscal responsibility and reform set up by President Barack Obama for the purpose of producing ideas on deficit reduction, argued that a deficit reduction plan needed to be put in place urgently in order to maintain the U.S. governments credibility in financial markets. Bernanke insisted that failure to act soon may result in tougher and more disruptive measures later. the same argument was reiterated by the Congressional Budget Office (2010): to restore market credibility, much tougher measures will be required if fiscal adjustments are made later rather than earlier. Flynn also advocated the early introduction of austerity measures, and concluded that the European debt crisis provides a cautionary tale that it is always best to take action to shore up budget deficits before market forces demand it (2010, p. 20). the same logic informed policy making in the United Kingdom where, following the formation of the first coalition government for 70 years, a program of accelerated deficit reduction, mainly through deep public expenditure cuts, was agreed and announced by the coalition partners in May 2010. the argument that the implementation of fiscal austerity policies is necessary in order to appease the financial markets raises important issues of democratic accountability and national sovereignty. the undemocratic nature of this subordination of public policy making to market sentiment is a very important constitutional issue, a detailed examination that is beyond the scope of this paper. the general claim, however, that accelerated deficit reduction by means of fiscal austerity is necessary and unavoidable and constitutes the most urgent policy priority requires further scrutiny. the elevation of concern over budget deficits to the top of policy priorities is similar to the position taken by governments on both sides of the atlantic in the early 1930s regarding the primacy of balanced budgets as a policy objective. In the United States, President Herbert Hoover as

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well as the leadership of both parties in Congress regarded balancing the budget as the top policy priority. During the 1932 presidential campaign, the Democratic Party championed fiscal conservatism and vigorously supported balanced budget policies.2 Similarly, in the United Kingdom in 1931, after the resignation of the government over the issue of public expenditure cuts, a National Government was formed under Prime Minister ramsey MacDonald with the specific objective of balancing the budget. In the United States, of course, President Franklin D. roosevelt soon abandoned the preelection rhetoric in support of balanced budgets and adopted a policy of increased public expenditure and deficit spending. reduction in unemployment replaced balanced budgets as the top policy objective.3 By contrast, in the United Kingdom, the national government continued with its balanced budget policies, which, according to Skidelsky (1992), led Keynes to declare despairingly at a meeting of a group of members of the UK House of Commons in 1931: Stop housing, roads, telephone expansionsimply insane. Flagellate ourselves so that foreigners will say at any rate these Briton take their problems seriouslywe might lend them some money (ibid., p. 396). the above comments by Keynes regarding the policy stance of the UK National Government in 1931 might also be appropriate for the austerity policies adopted in Europe and advocated for the United States in 2010. It could be argued that savage public spending cuts in the face of an uncertain global economic outlook constitute self-flagellation undertaken, at least partly, in order to establish market credibility so that the markets will say that policymakers in countries that adopt fiscal austerity take their problems seriously. Is the age of austerity strategy equivalent to self-flagellation, or is it a prudent measure necessary in order to prevent even more painful future fiscal adjustments? Deficit reduction and economic recovery the central theoretical and empirical question in the policy debate about the age of austerity is the relationship between deficit reduction and economic recovery. Is rapid fiscal consolidation a help or a hindrance to a fragile economic recovery? Put differently, is a policy of accelerated deficit reduction a precondition for maintaining the recovery or in conflict with the aim of maintaining the recovery? It would be a precondition if the implementation of immediate and deep cuts helps to maintain the
2 3

See Kimmel (1959) for a detailed account of U.S. budget policy during the 1930s. See Kimmel (1959).

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governments market credibility and prevents a rise in interest rates, which helps the continuation of the recovery. Moreover, implementing austerity measures may bolster the recovery directly by boosting confidence in the private sector about the future prospects of the economy, which leads to higher private investment. On the other hand, the objectives of reducing the deficit through savage public spending cuts and maintaining the recovery may be in conflict if cuts that are too much, too soon have a significant deflationary effect on the economy and therefore produce the opposite effect on private-sector confidence. this may abort the recovery and possibly cause a double-dip recession. In any case, an aborted recovery, either due to an adverse market reaction to the absence of deep public expenditure cuts or a double-dip recession resulting from the deep cuts, does not help the cause of rapid deficit reduction. Which outcome is more likely? Is the economic recovery under greater threat from implementing or not implementing fiscal austerity? the remainder of this section addresses these questions and turns our attention to an assessment of the theoretical and empirical basis of the strategy of imposing, as a matter of urgency, draconian fiscal austerity measures at a time when the world economy is recovering from the worst recession of the postwar period. We will appraise three related arguments supporting the age of austerity strategy. the first argument relies on the proposition of the New Consensus Macroeconomics (NCM) theoretical framework that discretionary fiscal policy is ineffective as a tool of stabilization policy (arestis, 2007). What this means is that a change in fiscal stance has no impact on aggregate demand, and the traditional Keynesian multiplier effect is close to zero or even negative. this conclusion is justified using theoretical arguments and empirical evidence based on the pre-Keynesian idea known as crowding-out and is reinforced by the ricardian equivalence theory as reformulated by Barro (1974): deficit spending by governments cannot have an expansionary effect on aggregate demand due to simultaneous offsetting reductions in private-sector demand. First, there is a fall in private investment demand caused by higher interest rates (crowdingout), and second, a fall in private consumption because rational, forwardlooking consumers increase their savings in anticipation of higher future taxes (ricardian equivalence). Similarly, a reduction of budget deficits due to fiscal tightening will not affect aggregate demand for analogous reasons: the contractionary impact on the aggregate demand of public spending cuts and tax increases will be offset by increases in investment demand and consumption demand stimulated by lower interest rates and lower savings in anticipation of lower taxes. this essentially is the

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modern version of the treasury view opposed by Keynes (1936) in the 1930s: deficit spending in a recession is rejected because it has no expansionary effect on aggregate demand; fiscal tightening during a fragile recovery is acceptable because it has no contractionary effect on aggregate demand. the theoretical and empirical basis of these conclusions has recently come under considerable criticism. arestis, after reviewing recent theoretical developments and empirical evidence, concluded that the downgrading of fiscal policy in the NCM is not justified, and that there are very little theoretical and empirical grounds to suggest that fiscal policy should not be used as an instrument of stabilization policy (2009, p. 19). at the theoretical level, the relaxation of some of the ricardian equivalence assumptions produces stronger results for fiscal policy. For instance, the introduction of the overlapping generations models in the tradition of Blanchard (1985) and Weil (1989) implies that intertemporal consumption smoothing is not possible. also, the introduction of the liquidity-constrained household by Botman and Kumar (2006), whereby a significant proportion of households do not have access to capital markets means that fiscal policy changes that affect disposable income could have significant real effects. at the empirical level, studies by Briotti (2005), Hemming, Kell, and Mahfouz (2002), Hemming, Kell, and Schimelpfenning (2002), and Wren-lewis (2000) found little evidence of either direct or indirect crowding-out, full ricardian effects, or zero fiscal multipliers. an important contribution is by Eggertsson (2006), who provides evidence that suggests that under fiscal and monetary policy coordination, fiscal multipliers are higher than when no policy coordination prevails. In fact, they are bigger than those found in the traditional Keynesian literature. the fiscal multipliers reported in Eggertsson (ibid.) under fiscal and monetary policy coordination are 3.4 in the case of the real spending multiplier, and 3.8 in the case of the deficit spending multiplier. When there is no policy coordinationthat is, when the central bank is goal independentthe real spending multiplier is unchanged while the deficit spending multiplier is zero (see arestis, 2009). therefore, if fiscal policy can be effective and fiscal multipliers are generally positive, as most of the above studies seem to conclude, it cannot be assumed that the age of austerity would not have a significant deflationary macroeconomic effect. Even less plausible is the claim that deep public expenditure cuts could have an expansionary effect. the second argument in support of the fiscal austerity strategy relates to the cumulative effect of budget deficits on the total public debt as a percentage of GDP. What is the relationship between total debt and economic growth? Is there a level beyond which debt accumulation can

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have a negative effect on economic growth? In a recent study, reinhart and rogoff (2009) claim that once the debt-to-GDP ratio exceeds 90 percent, economic growth is reduced by at least 1 percent. Indebted economies, therefore, need fiscal austerity measures in order to prevent debt accumulation from reaching or exceeding this threshold with its adverse effects on economic growth. In 2009, three eurozone countries exceeded the 90 percent threshold: the total debt-to-GDP ratio was 115.8 in Italy, 115.1 in Greece, and 96.7 in Belgium. another three eurozone countries had ratios approaching the 90 percent threshold: the debt-toGDP ratio was 77.6 in France, 76.8 in Portugal, and 73.2 in Germany. Outside the eurozone, the United Kingdom had in 2009 a ratio of 68.1 percent.4 In the United States, the equivalent ratio for 2009 was 83.29 projected to rise to 94.27 for 2010.5 If we compare the current size of public debt with the reinhart and rogoff (2009) threshold, it seems that alarm bells should be ringing for those economies that have exceeded or are rapidly approaching this target ratio. However, it should be noted that in the immediate postWorld War II period, the debt-to-GDP ratios in both the United States and the United Kingdom had significantly exceeded the 90 percent threshold without adverse effects on economic growth, while more recently Japan was able to combine debt-to-GDP ratios of nearly 200 percent with low interest rates. Furthermore, Nersisyan and Wray (2010) criticize the reinhart and rogoff (2009) results for failing to distinguish in the data between sovereign and nonsovereign countries. Sovereign are countries with their own floating-rate currency, such as the United States and the United Kingdom, and nonsovereign are countries without their own currency or on the gold standard or other fixed-exchange rate system, such as the countries of the eurozone or the United Kingdom before abandoning the gold standard or the United States before 1973. Nersisyan and Wray (2010) conclude that because sovereign countries face different debt constraints from nonsovereign countries, the aggregation of different types of debt over different periods renders the reinhart and rogoff correlations irrelevant at least for sovereign countries such as the United States and the United Kingdom. Furthermore, Nersisyan and Wray (ibid.) maintain that for sovereign countries, the direction of causation could be reversed, with low growth causing rather than being the result of public deficits. In any case, the reinhart and rogoff (2009) thesis, if accepted, is essentially an argument supporting the case for long-term fiscal consolidation rather than a policy
4 5

See http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home. See www.whitehouse.gov/omb/budget/fy2011/pdf/hist.pdf.

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of urgent and accelerated deficit reduction during a fragile economic recovery. rogoff (2010), however, disagrees with this assessment and insists that urgent measures are needed because the reaction of markets to debt accumulation can be sudden, unpredictable, and severe. He claims that the evidence generally suggests that the response of interest rates to debt is highly non-linear. thus, an apparent benign market environment can darken quite suddenly as a country approaches its debt ceiling (ibid.). therefore, gradual fiscal consolidation is, according to rogoff (ibid.), a risk not worth taking. Immediate fiscal tightening is needed. the prospect of dark clouds gathering in the market environment as a result of growing public indebtedness brings us neatly to the third major argument, already briefly mentioned in the previous section, supporting the speedy adoption of the age of austerity strategy. record peacetime budget deficits and record peacetime debt accumulation make global financial markets extremely nervous. Governments therefore need to calm market nerves by formulating and adopting policies that the markets find credible. It is, indeed, the financial markets, particularly the bond markets and the credit-rating agencies, that need to be convinced and that ultimately determine whether the deficit reduction plan of a democratically elected government is credible or not. What the markets actually want is by no means always clear, unambiguous, or fixed. Generally, the markets expect governments to adopt policies that show they take their problems seriously. Usually this means a readiness to adopt fiscal austerity measures. However, in a globalized financial system, the concerns and anxieties of global market investors that determine market sentiment are often affected by several complex, interconnected, and interacting factors. One factor that may affect market sentiment is undoubtedly the state of public finances; another factor is the stability of the banking system. there may clearly be an interaction between these two factors. For instance, the need, as was the case during the financial crisis that began in late 2007, to preserve a stable global banking system under threat of systemic collapse inevitably affects the borrowing needs of governments and the state of public finances. Increased public indebtedness combined with uncertainties over the ability of governments to deal with future banking emergencies can create further nervousness in the market, which can feed back on the borrowing ability of sovereign states, which in turn can create further doubts and uncertainties over the stability of the banking system, and so on, in a potentially vicious spiral. trichet (2010) points out that according to calculations by the European Central Bank, the total volume of taxpayer risks earmarked to support the financial system in the course of the financial crisis that began in late 2007 amounted, on both

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sides of the atlantic, to a staggering 27 percent of GDP. Governments were able to provide this commitment and prevent a financial meltdown because of credible public finances. Fiscal consolidation, therefore, is essential, according to trichet (ibid.), in order to restore credibility in the ability of governments to cope with future emergencies and threats of financial meltdown. this argument, however, can backfire. If the markets form the view that the age of austerity strategy is counterproductive, this may strain further rather than calm down market nerves, and change perceptions of what constitutes a credible government policy to deal with ballooning deficits. the debt problem and the problem of reforming the international banking and financial system therefore must be tackled together. at the moment, they are not. What the markets actually demand, at the most basic level, is quite simple. the markets, like any lender, need reassurance that borrowers will be able to repay their debts. When debts become too big, lenders get nervous and demand from borrowers a deficit reduction plan that typically involves cuts in spending and increased revenue generally referred to as austerity measures. the bigger the deficit, the bigger the austerity demanded by lenders. the bigger the austerity adopted, the happier the lenders feel about the prospect of debt repayment. When dealing with situations of individual insolvency, the logic of a plan that involves a combination of spending cuts and increased revenue is, of course, impeccable. It can also legitimately be taken as a healthy sign that the indebted individual is taking the problem of indebtedness and possible insolvency seriously. Can the same logic be applied in the case of national indebtedness? Can the age of austerity dispel the dark clouds hanging over the market environment of heavily indebted economies? The logic of establishing market credibility: from the paradox of thrift to the paradox of insolvency It was, of course, Keynes (1936) who warned us about the pitfalls of the logical fallacy of composition in formulating macroeconomic policy: what is true for the part is not necessarily true for the whole. the most famous example, of course, is the case of an individual household budget and a government budget: while it is sensible to counsel an individual household faced with economic difficulties, such as unemployment, to balance its budget by cutting down spending and living within its means, it is not a sensible advice to a government when the economy as a whole faces unemployment. In fact, the solution to the countrys unemployment problem is the opposite to that of an individual house-

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holds. What is needed in a recession is not a balanced, but an unbalanced, public budget. this is the simple Keynesian message in support of deficit spending in a recession, largely ignored by policymakers in the early 1930s and dismissed more recently by the NCM theoretical framework as unimportant. thankfully, the simple Keynesian message was accepted by the G-20 governments in 2009, thus possibly preventing a 1930s-style global depression. For a brief moment, faith in the NCM theoretical framework was suspended and the whole world became Keynesian and agreed on a coordinated program of deficit spending and global fiscal expansion. a similar lesson, based on the same basic logic, was supposedly learned with regard to global protectionism and the futility of beggarthy-neighbor policies. One country can protect its domestic industries but not if all countries try to protect their domestic industries at the same time. However, a year later, the economic policy-making environment has been spectacularly transformed. a general Keynesian commitment to continued fiscal expansion has given way to a pre-Keynesian obsession with fiscal consolidation. During 2010, in dealing with the problem of public deficit reduction, whether in Greece and other countries of the eurozone or in the United Kingdom and the United States, the simple Keynesian warning concerning the fallacy of composition appears to have been forgotten in macroeconomic policy-making circles. Yet the same basic principle that was relevant and, in all likelihood, effective in fighting the prospect of a global depression, continues to be relevant in dealing with the problem of public indebtedness. It is undoubtedly true that an individual faced with mounting personal debts and pressures from lenders to repay the loans can avoid insolvency by putting in place a personal austerity plan. It should be emphasized that not all highly leveraged households or firms necessarily face pressures from lenders to reduce the deficit. If borrowing is used to finance productive investment, the deficit will be eliminated through the flow of higher future incomes without the need for austerity measures. If, however, for whatever reason there is a real or perceived pressure from lenders for deficit reduction in the short run, a personal austerity plan may be the only option to prevent individual insolvency. the plan may involve savage and unpleasant spending cuts and, ideally, an attempt to augment individual income through increased work effort. In principle, such a plan, however unpalatable and painful, can eventually achieve its objective of reducing or even eliminating the deficit in due course, thus avoiding personal insolvency. It is true that the choice facing a single individual attempting to reduce indebtedness is, unless bailed out by friends and relatives, between the pain of austerity

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and the disaster of insolvency. the same is not true for the economy as a whole. Enduring the bitter medicine of austerity does not necessarily reduce indebtedness and prevent the disaster of insolvency. the reason is quite simple. In the case of a single individual, the mere fact of cutting down spending in order to repay debts does not affect an indebted individuals ability to maintain or seek an increase in his or her income, thereby facilitating the repayment of the debt. the ability of the economy as a whole, however, to maintain or increase its income will, in all likelihood, be affected by the very act of trying to deal with the problem of public indebtedness through fiscal tightening. By cutting down spending and increasing income, an individual will eventually reduce the deficit. the same plan imposed on an indebted economy is not necessarily tenable. Public spending cuts and tax increases may, paradoxically, fail to reduce the budget deficit and public debt as a proportion of GDP if they cause a slowdown or even a fall in GDP. reducing the numerator does not reduce the ratio if the denominator is reduced by the same or even greater amount. the well-known Keynesian insight, known in economics textbooks as the paradox of thrift, is the counterintuitive idea that an attempt by one individual to increase saving may succeed, but attempts by all individuals to increase saving may fail to increase total saving. the policy implication of this paradox is that governments need not act in the same way as a single individual in dealing with macroeconomic problems. the policy of coordinated fiscal expansion adopted by the G-20 governments in 2009 was based on this basic Keynesian insight. In dealing with the problem of public deficit reduction, a related concept, which may be termed the paradox of insolvency, must also be considered when formulating public policy: deficit reduction measures that can achieve deficit reduction and prevent insolvency in the case of an indebted individual may not necessarily achieve the same result in the case of national indebtedness, especially if replicated across many countries with fiscal deficits. a global deflationary spiral is not going to help improve public finances anywhere. The political economy of deficit reduction policy the policy debate about the age of austerity is not simply a technical dispute between opposing schools of thought in macroeconomics and another example of economists advocating diametrically opposite solutions to policy problems. there is a much wider debate about the respective roles of the public and private sectors of the economy. In

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this wider debate, an attempt is made to persuade the public to accept a smaller public sector by accepting the age of austerity. In the battle to win over public opinion, a great deal of what Krugman (2010) calls fiscal scare tactics are being deployed. Part of this fear-mongering is the claim that austerity is the appropriate policy for preventing both individual and national insolvency. as Davidson points out, [n]o economic topic encourages more political demagoguery than the unsustainable national deficits (2010, p. 663). the public of countries with unsustainable deficits is being bombarded with frightening images and dark comparisons between individual and national insolvency, as if countries are indebted individuals facing a visit from the bailiffs or a long term in a Dickensian debtors prison unless they accept the lesser of the two evils, which is savage austerity. Million of citizens are warned by politicians and media pundits to prepare for an age of austerity and to accept the bitter medicine of savage cuts in public expenditure in order to avoid the disaster and national humiliation of having the bailiffs around. the message that there is no alternative, either for an individual or a country, but to accept the age of austerity, which is, indeed, a powerful message that is reinforced when moral and ethical implications regarding the causes and consequences of indebtedness are added. at the ethical level, excessive indebtedness is often viewed as a sign of moral weakness, and its absence a sign of moral strength. the recent media war of words between Germany and Greece and more generally between Northern and Southern Europe on the subject of the EU bailout plan is a testimony of the type of moral indignation and controversy that the subject of indebtedness can cause. It has echoes of Smiths (1957) descriptions, quoted in the introduction of this paper, of the industrious and frugal creditors who are likely to increase and improve national capital as opposed to the idle and profuse debtors who are likely to dissipate and destroy it. the mass media had a field day contrasting the hard-working, disciplined, and prudent Northern Europeans with the imprudent, undisciplined, and dishonest siesta states6 of Southern Europe who, like the unemployed in the 1930s, are responsible for their own misfortune, unworthy of any support. the popular anxiety about indebtedness, whether at the practical or ethical level, is to a large extent based on a comparison between the reality of individual indebtedness and the reality of national indebtedness. Such a comparison is, of course, natural, but in many respects misleading. the problems and challenges faced by a country with massive debts appear
6

the term siesta states was used by liddle (2010).

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to be the same as those faced by an individual with massive debts. there are, however, fundamental differences between individual and national indebtedness, two of which are worth emphasizing.7 First, indebtedness is less of a problem for a country than for an individual because a national debt does not have to be repaid in full over a finite period. One generation can, and generally has done for many generations, roll over the debt of a previous generation without disastrous consequence. Indeed, as Davidson reminds us, the fear of increasing national indebtedness can cause greater harm than its absence:
we have nothing to fear about running big government deficits when government is the only spender that can increase market demand for the products of our industries and thereby maintaining a profitable entrepreneurial system. For government to spend less in the hope of keeping down the size of the national debt would mean causing market demand to remain slack and thereby impoverishing both our business and our workers. (2009, p. 63)

Second, and equally pertinent to the current debate, even if the aim is simply to reduce rather than eliminate the level of national indebtedness, there is a basic asymmetry in the process of individual and national deficit reduction. What constitutes a solution to the problem of indebtedness at the micro level may not be a solution at the macro level. an individual is always able to reduce indebtedness by cutting spending; a government may not always be able to do the same. the imposition of immediate and draconian fiscal austerity, therefore, may not only be painful and unpalatable but also ineffective. this possibility is not seriously entertained by proponents of the new pre-Keynesian orthodoxy. there is a great deal of wishful thinking that the process that was described above as the paradox of insolvency is invalid and that there are no significant differences in the process of individual and national reduction in indebtedness. It is claimed that there is no significant risk of a double-dip recession that will derail national deficit reduction plans because resources released from the overblown public sector will be absorbed by a rejuvenated and full of optimism private sector. the source of such optimism is expectations brought about by the paradigm shift or regime change in policy making, of lower public spending, lower interest rates, lower inflation, and above all, lower taxes made possible by a lower public debt (assuming, of course, that taxpayers will not be asked to foot the bill of another banking collapse). In recent years, austerity
7 For a more complete discussion of the differences between individual, household, or firm and national indebtedness, see Nersisyan and Wray (2010).

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measures have succeeded in reducing deficits in several countries such as Mexico in 1995, South Korea in 1998, turkey in 2001, and Brazil in 2002. the bright and shining example of this process, however, is the Canadian model of deficit reduction. In Canada, a budget deficit of 9.1 percent of GDP in 1993 was transformed into a small surplus in 1996. this was achieved mainly through savage budget cuts, no tax increases, by a government that had just been elected with a huge majority. above all, it was achieved at a period, 199396, when the United States, Canadas major trading partner, was experiencing rapid economic growth. Countries adopting the austerity model of public deficit reduction faced an entirely different global economic environment in 2010. Not only the United States but also other advanced economies are slowly recovering from the worse recession in decades. If the fragile recovery is destroyed and the global economy is pushed back into recession by the age of austerity policies, the private sector, despite all the optimistic prospects that fiscal austerity is supposed to generate of lower interest rates, lower inflation, and lower taxes, may not be in the mood to absorb all the resources released by the public sector that will remain unemployed. It is not inconceivable that employment in the private sector may also contract. If that were to happen, even the financial markets, whose nerves these policies were designed to calm, might eventually realize that these measures, especially when replicated in a number of countries, represent too big a gamble after all. Indeed, at least in the case of Greece and Ireland, the imposition of the age of austerity proved to be only a temporary tranquilizer and sedative, not a long-term cure for market jitters regarding budget deficits and public debt. the same markets that have been clamoring for savage austerity in Greece soon woke up to the fact that with projected negative economic growth rates in Greece, these plans could not prevent Greek default. In June 2010, a survey of global investors revealed that approximately 75 percent of investors believed that Greek default on sovereign debt was inevitable.8 On July 19, 2010, despite the fact that savage austerity measures were in place, the credit rating agency Moodys downgraded Ireland on the same grounds. Spain and Portugal also received similar treatment. In fact, countries that have dutifully taken the bitter medicine of austerity are, in fact, making the markets more, not less, nervous, and instead of being rewarded for their pains, they get even more punishment from the
8 See, the quarterly Bloomberg Global Poll, conducted June 23, 2010, available at www.bloomberg.com/news/2010-06-08/greek-default-seen-by-almost-75-in-poll-ofinvestors-doubtful-on-trichet.html.

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markets. In a way this is to be expected because, ultimately, what the markets want is deficit reduction not austerity measures per se. In other words, at some point, the markets start taking on board the insolvency paradox and actually stop treating the deficit reduction process of a country in the same way as that of a single individual or firm: it is surely not reassuring for a lender to know that a borrower has an austerity plan in place if, at the same time, the borrower is about to lose his or her job or is being forced into part-time work. therefore, the unavoidable painful measures may not only fail to promote growth but also, and as a consequence, fail to placate the markets that, paradoxically, were the initial justification for the accelerated deficit reduction strategy. In the battle to win over public opinion, accelerated deficit reduction and austerity measures are presented not only as an economic necessity but also as a moral obligation. the tendency to moralize over indebtedness, individual or national, was present in the discipline, as we saw in the introduction to this paper, since adam Smith (1957). It was, however, Keyness paradox of thrift and his radical view of saving and deficit spending that raised the stakes in terms of the moral debate on indebtedness. as Skidelsky points out, Keynes did for economics what Nietzsche did for morals. He transvaluated values, so that thriftiness becomes (under the most usual circumstances) pathology, not a sign of health, and virtue brings catastrophe to the societies that practice it (Skidelsky, 1992, p. 544). In fact, the Keynesian paradox of thrift was, according to Skidelsky, the central point of his assault on the evangelicised economics of the Victorians (ibid., p. 499). Keynes, of course, was well aware but dismissive of the effect that his views had on Victorian values, especially the view expressed in the penultimate chapter of the general Theory, that saving was a public vice. Keynes writes,
No wonder that such wicked sentiments called down the opprobrium of two centuries of moralists and economists who felt much more virtuous in possession of their austere doctrine that no sound remedy was discoverable except in the utmost of thrift and economy both by the individual and by the state. (1936, p. 362)

If we substitute the utmost of thrift and economy with deficit reduction, the above quotation could easily be an apt description of the views of some of todays moralists and economists or deficit hawks. they not only have no other sound remedy than to promote deficit hysteria but they also feel virtuous in possession of their austere doctrine that the only solution to the problemand the only redemption from the

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sinof national indebtedness is to impose the age of austerity and prolonged unemployment on millions of people. What is so virtuous and moral about that? Summary and conclusions Support for the age of austerity strategy is based on three major arguments. First, fiscal policy is ineffective, there are no traditional Keynesian multiplier effects, and therefore fiscal stimulus or fiscal contraction has no macroeconomic effects; second, current wartime levels of public indebtedness are unsustainable, and they pose a threat to economic growth and price stability; and third, financial markets, like any lender, are anxious and nervous about ballooning fiscal deficits. Because markets can suddenly lose their patience with devastating consequences for the borrowers, governments with big deficits, like individuals with big debts, must implement austerity measures now in order to convince the lenders that they are serious about dealing with their debt problems. Critics of the strategy question the validity of all three arguments. Contrary to the claims of the NCM, fiscal policy can be effective and fiscal multipliers are generally positive; it is an unproven assertion that there are universal, in time and space, thresholds of public indebtedness that reduce, when exceeded, economic growth; and finally, austerity measures that are appropriate in reducing individual indebtedness and preventing individual insolvency are not necessarily appropriate in dealing with problems of national indebtedness. If fiscal policy is ineffective and fiscal multipliers are zero, as claimed by the NCM theoretical framework, then the paradox of insolvency is invalid and fiscal austerity can, in fact, achieve deficit reduction because there will be no net deflationary effect. Furthermore, the austerity measures may even have an expansionary effect in the long run if optimistic expectations inspired by the measures stimulate private-sector growth sufficiently to neutralize any deflationary effect of savage public spending cuts. However, after examining the relevant theoretical arguments and evidence (arestis, 2009), we do not find this argument plausible and it does not invalidate the general conclusion of this paper that a deficit reduction plan that is appropriate in the case of an individual debt may not be appropriate in dealing with government debt, especially when there is synchronized fiscal austerity. With regard to the fear-mongering that the markets will react adversely to the absence of immediate and savage fiscal austerity, the markets themselves appear to be providing a different answer. at least in the case

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of Greece, Ireland, Spain, and Portugal, it appears that the markets are not pacified by the imposition of the age of austerity because there are serious doubts whether the age of austerity will, in fact, achieve the intended outcome of rapid fiscal consolidation. the problem of ballooning public debt is a long-term problem requiring long-term solutions. the solution to the problem should not be based on a short-term reaction to market jitters. It is, above all, a problem that is inextricably connected with the problem of reforming the global banking and financial system. the two problems need to be tackled together not separately. In the battle to win public acquiescence for the age of austerity, the analogy between individual and national indebtedness, however inappropriate and misleading, is indeed very useful, particularly when combined with scare-mongering and moralizing about indebtedness: it helps to conceal the real objective of this austere doctrine, which is not deficit reduction but reduction of the public sector whatever the cost in terms of unemployment. REfEREncES
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