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These were the times of Basel II, when a bank was considered safe by regulators when its capital as a proportion of assets weighted by their risk, estimated by banks themselves, reached a certain level. After the crisis, regulators finally found out that in-house risk calculations were deeply flawed, to say the least. This issue is examined in detail in Cardim de Carvalho (2015a).
The G20 comprises the ten largest advanced and the ten largest emerging economies.
It may or may not be a coincidence that the break in the Keynesian consensus was made explicit in the G20 2010 Toronto summit, when the financial crisis was beginning to hit the periphery of the eurozone.
Austerity-ers also see the year as the relevant time period in which budgets have to be balanced. A more flexible approach would result from considering longer periods of time (such as, for instance, the duration of the business cycle).
The recent literature on the virtues and defects of austerity is, as one would expect, large. To mention two other works published in this journal dealing with similar issues, we should point to Truger (2013) and Blyth (2016). The present paper largely shares Truger's views as to the effects of austerity, although it does not dwell on the results of policy focusing. Blyth (2016), following his influential book (Blyth 2015), emphasizes redistributive aspects of austerity policies from a political point of view, which are not explored in this paper either.
One should not assume that it was the position only of the Conservative Party, even though the source here is Winston Churchill, then Chancellor of the Exchequer. It would be more accurate to say that it was the view of the civil service. Labour governments at that time shared the same view. Even some liberal critics, such as Hubert Henderson, Keynes's co-author of Can Lloyd George Do It?, seemed to accept it, at least when facing Keynes's implicit criticisms of the Treasury View in The General Theory of Employment, Interest and Money (1936). Henderson in fact became an implacable critic of The General Theory because of its policy implications.
Churchill also offered a more general summary of the Treasury View: ‘The classical doctrines of economics have for nearly a century found their citadels in the Treasury and the Bank of England. In their pristine vigour these doctrines comprise among others the following tenets: Free imports, irrespective of what other countries may do and heedless of the consequences to any particular native industry or interest. Ruthless direct taxation for the repayment of debt without regard to the effects of such taxation upon individuals or their enterprise or initiative. Rigorous economy in all forms of expenditure whether social or military. Stern assertion of the rights of the creditor, national or private, and full and effectual discharge of all liabilities. Profound distrust of State-stimulated industry in all its forms, or of State borrowing for the purpose of creating employment. Absolute reliance upon private enterprise, unfettered and unfavoured by the State’ (quoted in Clarke 1988: 29). Most, or all, of these points, however, are too general in nature to be useful for the present discussion.
Skepticism about the intrinsic adjustment properties of monetary economies to nominal shocks such as the one represented by the return to gold at an overvalued exchange rate was manifest in Keynes's famous pamphlet The Economic Consequences of Mr Churchill, where he predicted the difficulties the British economy would face if the decision to return to gold under those conditions prevailed. The British experience in the late 1920s described in the pamphlet, included in volume 9 of Keynes's Collected Writings, seemed to have inspired Keynes's arguments against the reliance on automatic adjustment mechanisms in The General Theory.
Some officials did believe in Say's law, most notably perhaps Otto Niemeyer, one of the few professional economists in the Treasury's staff. Others were less orthodox, such as Ralph Hawtrey.
Churchill's quote, above, authorizes this interpretation.
To this day this remains a point of contention among Keynesian economists as well as among economic historians. Again, this is not the place to explore this issue, but a possible explanation for the difficulty of understanding Keynes's point was the peculiar sense in which he used the word finance. Middleton (1985), for instance, considers that by the end of his exchange with Bertil Ohlin in The Economic Journal about the determination of the interest rate, Keynes had accepted loanable funds theory. For an examination arriving at the exactly opposite conclusion, see Cardim de Carvalho (2015b: ch. 6 cit.). A discussion starting from different methodological assumptions, arriving at the same conclusion, is Lindner (2015).
‘In the considered view of the authorities, Keynes was judged unrealistic on the scope and schedule of public works; over-optimistic on the scale of secondary employment and the likely savings on the dole; and insufficiently mindful of the effect on international confidence of efforts to finance such a programme’ (Clarke 1988: 293).
The argument was sort of a cliché among Treasury officials, although the empirical basis for such a claim was not once presented, at least in the documents collected in Peden (2004). One should note, anyway, that in the absence of macroeconomic theories that could explain what all the occurrences of large-scale unemployment had in common it was necessarily the particularities of each situation that would attract attention.
Treasury officials, in fact, seemed to be remarkably ignorant of the actual impact of President Roosevelt's policies on the US economy, even though they referred to it frequently. It may be interesting to contrast the diagnosis offered by the British Treasury to the Public Works Administration experience in the first two years of President Roosevelt's first term in office. A large share of public works financed by the federal government was actually decided and realized by local authorities. At least in some areas, the program was considered to be quite successful. See, for example, Williams (2013) for an extensive examination of New Deal building works in New York City, and Smith (2006) for a detailed examination of the public works initiatives of the New Deal.
The view that allowing fiscal deficits to emerge once, even if for good reasons, would open the door for fiscal irresponsibility by politicians is an old warhorse of conservative criticism of Keynes's policy proposals. See, for example, Buchanan (1987: 142): ‘The Keynesian policy model seemed to offer an intellectual–moral argument for expanded public spending financed by debt (or money). But ordinary politics fails almost totally when the other side of the Keynesian policy norms is required for macroeconomic purpose. Political decision makers cannot increase taxes so as to generate compensatory budgetary surpluses. The bias toward deficits emerges directly from the most elementary application of public choice of principles. In this context, the net contribution of the whole Keynesian half century must be evaluated negatively. It is represented best by the regime of massive and continuing budgetary deficits that we observe, deficits that bear no relationship to any alleged macroeconomic purpose, and that are almost universally acknowledged to have adverse consequences for the economy as well as for the moral bases of modern society. These deficits emerged because the Keynesian impact was to dislodge almost totally the precept of budget balance from the effective fiscal constitution.’ Notice that a similar inflationist bias is frequently denounced as characteristic of Lerner's Functional Finance approach.
For economy of space, we will use the acronym BMF in the rest of the paper to refer to the positions defended not only by the German Federal Ministry of Finance, but by the German government as a whole, more clearly since 2010. Other members of the German government also defended the policies described below, even if less frequently or forcefully, including Chancellor Merkel and the Minister of Economic Affairs and Energy, Social Democrat Sigmar Gabriel. The policy was also supported by Bundesbank officials and European Commissioners and officials, and by the German Council of Economic Experts (GCEE). It is noticeable that while the Bundesbank and the GCEE tend to defend more liberal (in the European sense) views as to how a social market economy should work, relying on private markets that are as free as possible, the Ministry of the Economy and Energy, headed by Mr Gabriel, defends redistributive measures as an integral part of the government's overall strategy and the concept of the social market economy itself. But while there are divergences around the degree of social protection that the social market economy should provide to workers and pensioners, no fundamental disagreement seems to exist in regard to the centrality of fiscal consolidation and structural reforms defended by the Federal Ministry of Finance.
One referee warns me that in fact by this time Germany was still resisting joining the short-lived ‘Keynesian’ consensus of the G20 and it was only in early 2009 that the country agreed to pursue some fiscal stimulus policies.
In a sense, all debt in the eurozone is ‘foreign’ debt since it is denominated (and redeemable) in a currency that is not under the control of each country's authorities.
The IMF used to demand fiscal and monetary austerity from the members benefiting from rescue packages. In the case of the eurozone, monetary policies were decided by the European Central Bank, so that borrowing governments could only take responsibility for fiscal austerity. Structural conditionalities were a later addition to the Fund's conditionalities. They were introduced after the collapse of the Bretton Woods fixed exchange rate system in the early 1970s, when only developing countries still appealed to the IMF to manage balance-of-payments crises. The Fund judged that balance-of-payments crises in developing countries occurred not only because they adopted inadequate macroeconomic policies but also because they were structurally unfit to recover and sustain external stability. As a result, the IMF began to demand structural reforms as conditionalities. Mostly, structural conditionalities referred to institutional reforms to be introduced in labor, product, and financial markets. These markets were believed to be uncompetitive because of excess regulations, the existence of state monopolies, and other barriers to the free adjustment of prices according to supply and demand. Structural reforms generally consisted of liberalization measures in all three markets. Demands for structural reforms reached their zenith in the Asian crises of the late 1990s and the Fund was severely criticized for its excess of zeal. Structural reforms were toned down afterwards but they staged a strong return in the troika's rescue packages for eurozone members. On the performance of the IMF in the Asian crises, see Cardim de Carvalho (2000).
Despite his frequent references to the expression ‘social market economy,’ Erhard seemed to have a somewhat fuzzy understanding of the concept. Most of the time it seemed to combine the emphasis on free competitive markets (which should mean not only keeping governments out of markets as much as possible, but also curbing private monopolies) with some measure of social protection to those at the basis of the social hierarchy. At times, Erhard added more characteristics to define the concept, such as admitting some measure of economic planning to reduce uncertainties for the private sector, but the core features seem to be free markets and focused social safety nets. An interesting source of Erhard's ideas is the collection of speeches and press articles, Erhard (1963), which informed this section of the present paper.
Erhard (1963) contains only one reference to Keynes: ‘The misunderstood Keynes doctrine is just as much out of date now as the early liberal conception which forbade the intervention of the state in things economic’ (ibid.: 274). In that text, Erhard did not elaborate on what was the nature of the ‘misunderstanding’ surrounding Keynes's doctrine but he made clear that Keynesianism was not a real threat: ‘The real danger – and I cannot say this too often – comes from the social planners and romantics, who believe that the complex life of a nation can be reduced to a blueprint, who see the intricate process of free co-operation in purely mechanical terms and who start out with romantic ideas of a social system in which man, as God created him, is a mere abstraction’ (ibid.).
One prominent German economist, Herbert Giersch, a long-term member and head of the Council of Economic Advisors, identified Joseph Schumpeter as one of the inspirations for the policy strategy. Another former member of the Council, Ernst Helmstädter, also defended the priority given in the policy model to innovation, arguing that a particular kind of Say's law applied to innovations (in these cases, he argued, supply would create its own demand). See Giersch (1993: chs 2 and 8) and Helmstädter (1988: 416).
Right after the monetary reform of 1948, Erhard stated that ‘the stability of the new money can never be threatened so long as we settle down to systematic public budgeting and, by means of an equally systematic monetary and credit policy, see to it that our commodity production and our purchasing power remain in harmony’ (Erhard 1963: 47). Later, in 1952, Erhard stated that ‘the Federal Government is firmly resolved to maintain a balanced budget at all costs. The German people's experience of the tragedy of inflation was such that no one is likely to deviate from the straight and narrow path and risk a recurrence of such a dangerous development’ (ibid.: 121–122).
As the Financial Times correspondent in Germany observed in late 2014, ‘even on the left of the ruling coalition, there are no demands for domestic growth-boosting policies. Klaus Barthel, the SPD deputy chairman of parliament's economics committee, told the FT: “we are on the right lines”’ (Wagstyl 2014).
The material on which this section is based is different from what we used to characterize the Treasury View. Access to the Ministry of FInance's internal documents is not possible as was the case with the Treasury View. Of course, the difference is a matter of temporal proximity. British Treasury documents for the 1920s and 1930s were released to the public a long time ago. In contrast, when dealing with the Federal Ministry of Finance we are interested in events that are still developing. We should not, therefore, expect the same facility of access to the current financial policies of the German government or of the European Commission as is possible with the Treasury Views of the 1920s. This forces us to give much more weight to the pronouncements of authorities such as Minister Schäuble than we did to the views of, say, Winston Churchill. Like Mr Churchill, Mr Schäuble is not a professional economist, but this in itself should not pose a particularly serious problem. We are not directly interested, in this paper, in the academic economists’ debates on fiscal austerity, as important as they certainly are. One consequence, of course, is that many arguments raised by authorities may rely on theoretically fragile foundations or may be insufficiently developed and thought through. As suggested by one of the referees to this article, perhaps one should not dignify the BMF's view by calling it a ‘strategy.’ On the other hand, Mr Schäuble has been most insistent and forceful in his defense of fiscal austerity in his frequent speeches, interviews, and press articles, presenting his views on the basis of arguments that clearly suggest familiarity with the relevant economic theory. Moreover, they seem to be politically effective at least with the German public.
It is interesting to remember that President Roosevelt himself refused to consider multiplier effects of investments in public works in his budget proposals. This explained his preference for relief initiatives over spending on public works in the first years of the New Deal. See Stein (1990: 57–60) and Smith (2006: 96).
These limits, however, proved not be as constraining as the writers of the treaty expected, and were violated by no less than Germany and France, the two most important founders of the Union.
Ludger Schuknecht, the Chief Economist of the BMF, has recently lamented that in fact ‘[m]ost Western governments stopped pursuing policies of budget consolidation for the time being,’ which, he also seemed to lament, ‘many leading Keynesian economists think [to be] a good idea’ (16 June 2016, URL: http://www.bundesfinanzministerium.de/Content/EN/Standardartikel/Topics/Public-Finances/Articles/2016-06-16-public-finances-at-a-crossroads.html).
As was exemplified by France during the first three years of Mitterrand's presidency.
Monetary accommodation, however, would entail an increase in indebtedness by those countries needing financial cover for current-account deficits. As we will see below, this alternative would violate one of the cardinal principles espoused by the German Federal Ministry of Finance: that increasing debts may be an evil in themselves, quite independently of the reasons why they may be increasing.
In one of his most important speeches, Minister Schäuble left no doubts about the need for all eurozone members to share the three-pillar BMF strategy of fiscal consolidation, structural reform, and investment stimulus. See http://www.bundesfinanzministerium.de/Content/EN/Reden/2015/2015-04-15-columbia-university.html.
Germany performed its own structural reforms with Chancellor Schröder's Agenda 2010, in 2003. A summary of Schröder's reforms is given at http://www.eurofound.europa.eu/observatories/eurwork/articles/chancellor-proposes-agenda-2010-to-revive-economy.
In fact, Germany itself seems to fallen prey to moral hazard recently. At least, such is the view expressed by the GCEE in its 2016 report: ‘The reform track record of the current government is disappointing. From the point of view of the German Council of Economic Experts (GCEE), the economically successful period – which was partly a result of past reforms – was not used sufficiently to prepare the German economy for future challenges. In view of decreasing innovation and disruptive technological changes, the Federal Government should have aimed much more at strengthening market forces and promoting structural change through suitable reforms’ (GCEE 2016: 7). The Council is especially critical of the raise in minimum wages and pensions decided by the Merkel government.
Minister Schäuble has been very insistent on the importance of considering moral hazard in the policy-making process. Pressures should be maintained on crisis countries, because relief would break their will to promote reforms. In a speech to the Bundestag, Schäuble stated that: ‘But, ladies and gentlemen, there is something we need to understand, because it's true: People – I mean people like us, societies, especially in democracies – do not like to make changes when things are going well; we only accept changes when we have to, when there is no other way, when there is a crisis. That is something I've had occasion to realise in the past. In that respect, perhaps it is not an easy time for far-reaching reforms, because we are still so well off. But we mustn't accept that as the final word’ (cf. http://www.bundesfinanzministerium.de/Content/EN/Reden/2016/2016-09-26-Accept-challenges-maintain-stability-security.html). The manifest opposition of the German authorities to the creation of European bonds is inspired by the same concern with moral hazard: ‘Any mutualisation of liability would actually weaken competitiveness – whether we're talking about eurobonds or collective liability for banks’ legacy assets. It would create the wrong incentives and give the impression that state support is guaranteed in every case’ (cf. http://www.bundesfinanzministerium.de/Content/EN/Reden/2014/2014-03-27-bruges.html). Pointing to moral hazard has been a central point of BMF rhetoric, and is repeated continuously by Minister Schäuble and other authorities. On at least one occasion, the Minister in fact attributed the global crisis to moral hazard: ‘A lot of people underestimate the problem of moral hazard. But if you separate decision-making power from accountability, and if you separate opportunity from risk, you cannot succeed. That was the main cause of the financial crisis’ (cf. http://www.bundesfinanzministerium.de/Content/EN/Reden/2015/2015-04-17-brookings-washington.html).
In other words, the toughness of rescue conditionalities in the case of eurozone members may be inspired, at least in part, by the objective of maintaining pressures on borrowing countries to reform their structures and balance their budgets as quickly as possible rather than by actual adjustment requirements. As Minister Schäuble wrote in a 2011 op-ed article for the Financial Times, ‘[t]he recipe is as simple as it is hard to implement in practice: western democracies and other countries faced with high levels of debt and deficits need to cut expenditures, increase revenues and remove the structural hindrances in their economies, however politically painful’ (Schäuble 2011).
Cf. MEE (2015). The report, in fact, goes beyond the reference to the importance of innovations as the main competitive weapon in modern market economies, to express priorities that seem taken directly from Schumpeter's (1980) Theory of Economic Development. For instance, MEE officials expect that start-ups will be the main promoters of innovation. There is a concern with the financing of start-ups that reflect directly Schumpeter's thinking of the entrepreneurial function as independent from the functions of both capitalists and managers of existing concerns.
Cf. http://www.bundesfinanzministerium.de/Content/EN/Reden/2014/2014-03-27-bruges.html. The point is repeated in many other speeches and press articles. Even Chancellor Merkel, after stating how much bigger Europe's contribution to world output is than its population share, and how large is the area's contribution to world social spending, concludes ‘[t]hat shows the magnitude of the challenge facing us. That is why innovation capacity and competitiveness are key issues for Europe’ (cf. https://www.bundesregierung.de/Content/EN/Reden/2014/2014-02-19-oecd-merkel-paris_en.html).
Cf. http://www.bundesfinanzministerium.de/Content/EN/Reden/2015/2015-03-26-structural-reforms.html. The minister added at the end of the speech: ‘To cut a long story short: There is no trade-off between fiscal consolidation and structural reforms, particularly labour market and welfare reforms. On the contrary, they typically complement each other.’
Cf. http://www.bundesfinanzministerium.de/Content/EN/Reden/2011/2011-09-27-berlin.html. The same theme, with some variations, was repeated on other occasions. See, for example, http://www.bundesfinanzministerium.de/Content/EN/Reden/2010/2010-06-24-handelsblatt.html; http://www.bundesfinanzministerium.de/Content/EN/Reden/2011/2011-09-27-berlin.html; http://www.bundesfinanzministerium.de/Content/EN/Reden/2015/2015-03-27-bundesbank.html; and http://www.bundesfinanzministerium.de/Content/EN/Reden/2015/2015-04-17-brookings-washington.html. Blaming Keynesian anti-cyclical policies for the crisis was not consensual, however. Commissioner Olli Rehn, for one, seemed to disagree, pointing out that, with the possible exception of Greece, fiscal weakness was the result, not the cause of the crisis in the eurozone. Cf. Rehn's speech of 5 May 2012, URL: http://ec.europa.eu/economy_finance/articles/governance/2012-05-05-oli-rehn_en.htm.
As reported by The New York Times in 2014, one of the three main arguments made by Berlin was that ‘[t]he eurozone's economic problem is largely one of supply rather than of demand’ (Taylor 2014). In the same spirit, Minister Schäuble stated that ‘the problem [of unemployment] resides more with finding qualified workers and with bottlenecks in the planning procedures at the regional and communal levels’ (cf. http://www.bundesfinanzministerium.de/Content/EN/Reden/2016/2016-06-10-swiss-austrian-conference.html). The notion that the way out of the crisis was to be found through supply rather than demand policies was shared in other quarters. In 2013, in an interview for Le Monde, Philippe Aghion, an advisor to François Hollande at the time, stated that ‘it is necessary to replace the welfare state by the strategist state that invests in human capital, innovation and the strengthening of professional careers. A state that manages the cycle through supply rather than through demand, helping businesses and individuals to maintain the innovative character of their investments in times of recession: instead of Keynesian, it is necessary to become Schumpeterian’ (Kahn/Escande 2013).
‘Treasury officials’ criticism of Keynes were often motivated by determination to defend a system of what they conceived to be sound public finance. They had inherited a tradition, going back to Sir Robert Peel and William Gladstone, whereby, at least in theory, the state should be politically neutral as between different economic interests, and should interfere with market forces as little as possible’ (Peden 2004: 3).
The fallacy is to miss the fact that while a family's expenditures are unlikely to affect their own income, the opposite happens with government expenditures. By spending, the government is able to increase aggregate income and, thus, tax revenues.
One is not denying the importance of confidence. Nevertheless, recognizing the relevance of confidence does not take us very far in the understanding of how can it be obtained. The now apparently closed debate around the possibility of ‘expansionary fiscal consolidations’ relied on the idea that budget discipline would increase private agents’ confidence and thus their willingness to increase consumption, investment, etc. Guajardo et al. (2011) showed that it did not work that way. Fiscal consolidation has been contractionary, as expected by Keynesians. Even one of the original proponents of the notion of expansionary fiscal consolidation has already acknowledged that the hypothesis was falsified in all the experiments under which it was tested (Perotti 2011; 2014).
As stated by a conservative newspaperman: ‘In the end, you are either a big-state person, or a small-state person, and what big-state people have about austerity is that its primary purpose is to shrink the size of government spending. … The bottom line is that you can only really make serious inroads into the size of the state during an economic crisis. This may be pro-cyclical, but there is never any appetite for it in good times; it can only be done in the bad’ (quoted in Eichengreen 2015: 366).
‘It is now clear what are the advantages of an upswing stimulated by means of securing a surplus in foreign trade. It is worth mentioning that the “natural” upswing based on the automatic increase in investment activity does not enjoy these advantages, and if there is no influx of foreign capital, it will be confronted with the same balance of payments difficulties as the upswing based on “domestic exports” [by which Kalecki meant government expenditures]’ (Kalecki 1971: 25).