The tragic error of excessive austerity

Viv Davies:  Hello, and welcome to Vox Talks, a series of audio interviews with leading economists from around the world. I'm Viv Davies from the Centre for Economic Policy Research. It's the 5th of July, 2012, and I'm speaking with Professor Lord Richard Layard, founder and emeritus professor of the Centre for Economic Performance at the London School of Economics. We discuss his recently published Manifesto for Sound Economics, written with Paul Krugman, which aims to generate a movement of economists who are prepared to speak out against policies they know to be wrong.

Professor Layard briefly summarises the manifesto and what he considers to be the errors that have taken root in public consciousness and which have provided support for the excessive austerity of current fiscal policies in many countries.

We also discuss the role of the European Central Bank as a lender of last resort, and whether the current bank-led capitalist culture will ever be changed. I began the interview by asking Lord Layard to summarise why he thought the manifesto needed to be written.

Richard Layard:  Well, I think the majority of economists probably disagree with what is presently going on, and in particular with the assertion that the only way to get growth is to take extra action to reduce public deficits. That, of course, is getting things the wrong way round, because the deficits are not because of low growth; it's the low growth that's the cause of the deficits. We have these deficits, but not because there was irresponsible public borrowing back in 2007, because there was excessive private borrowing and lending, which led to the bust, which lead to reduced private spending. Then the reduced private spending led to reduced tax receipts, and so the lower taxes which are causing the deficits in the public finances.

So when you've got a reduction in private spending, the last thing you want to have is simultaneously a reduction in public spending, thereby cutting the total level of activity in the economy. And you don't want to have, equally, big tax rises reducing private spending.

And what is remarkable is that there is no evidence that doing these things ‑‑ which every country is being told they have to do ‑‑ will produce the growth which people assert is going to be the result. So the IMF in its latest economic outlook has a wonderful chapter where they look at 183 episodes in the past where countries have taken discretionary action to reduce their deficits, and they show that in the vast majority of cases, this led not to faster growth but to slower growth, which is what, of course, the ordinary economics textbook for a depression economy would lead you to expect.

There's another issue. If we slow growth in this way, we're having a bad effect on the future path of deficits. We're going to have higher deficits further into the future, and there's a strong argument put forward by Larry Sumners and Brad DeLong in Brookings papers that if you increase the deficit in the short run, this would have the effect of stopping unemployment becoming endemic, and thereby making it easier to have higher growth in the medium term, and therefore lower deficits in the medium term, which would more than offset the slightly higher deficits you have in the short term.

So, really, just to go on trying to cut deficits in the short term is a very counterproductive policy.

Viv:  The manifesto presents two counterarguments to your proposal. A confidence argument in that austerity increases confidence and the prospects of recovery, et cetera, and a structural argument against expanding demand in that output is constrained on the supply side by structural imbalances in the economy. Could you elaborate a little on these arguments and how you counter them in the manifesto?

Richard:  Well, the confidence argument says that if you increase the deficit, this will raise interest rates, and that will produce lower growth. There really isn't any evidence of that in the conditions we're now in. We would have significantly higher interest rates if we had a higher deficit. Because just look around. You see absolutely massive deficits in the US, Britain and Japan, and you see almost the lowest interest rates that we've ever seen. So it's just not a reasonable spectre to be raising. In fact, the confidence argument is obviously failing, because you can see that businesses are not feeling confident because of the deficit reduction policies. They're feeling, "Oh my god, where is the demand going to come from?"

This deficit reduction policy is just going to impose low growth on our countries for some years. We're not going to invest because we can't see the market. So the confidence argument isn't working. The structural argument is also invalid, because suppose that we were being inhibited from expanding aggregate demand because there were some sectors that were already operating at full capacity.

Then we would have to see some sectors operating at full capacity. We don't see that, we see in most the countries, we see excess capacity and unemployment in every part of the economy, and higher unemployment in every occupation.

It's not a plausible argument, the structural one. It was used during the Great Depression, and lo and behold when people said the American economy can't produce any more, suddenly there was the Japanese threat and from 1940 to 1942 the US GDP rose by 20%. It had been limited by demand rather than by supply.

Viv:  Within a European context, would you be in favour of the ECB acting as lender of last resort to European banks?

Richard:  Well, the European problem is a different one. I perhaps should have referred to it when we were talking about interest rates, because of course European interest rates in many countries are very high. But this is not because these countries were irresponsible in their budgetary policy in 2007. We had falling debt income ratios in Spain and Italy and some other countries in 2007. Even now, Spain and Italy have lower deficits than the US, Britain and Japan, even though they also have higher interest rates.

It's just not the case that the interest rates are caused by those deficits so much as the fact that the countries of Spain and Italy do not have a central bank behind them that will fund their deficits, whereas Britain, Japan and the States do have a central bank behind them that would in the last resort fund these deficits.

So we have to have institutional reform in Europe, and we have to have some system whereby ultimately the central bank will not only be a lender of last resort to European banks but also a funder of governments on certain conditions, of course, and that's why we have to have these much more strict arrangements for European supervision of budget deficits in the different member countries.

Viv:  So it's clear then that the global financial crisis wasn't a blip on the landscape, but what you're advocating calls for a radical and very significant cultural and political shift. Do you think banks, businesses and governments are ready and prepared to go that far? Will they ever be?

Richard:  Well, I think the public is going to demand it. And I think there are sort of very specific reasons relating to this crisis which are going to lead to much greater regulation of banks, and hopefully more government activism in getting us out of the recession. But I also think actually that there will be and needs to be a big cultural change in a different capacity. I've been a co‑founder of something called "Action for Happiness," which is a movement to encourage people, in fact all the members pledge to try to create more happiness in the world and less misery. To lead a moral life in everything they're doing, including their work life.

And I don't think we want people working in businesses unless they think that what they're doing is socially useful. I think we've got to get back to that kind of concept of a life that is dedicated to the common good in some way or other, and not simply dependent on self‑interest.

Viv:  So finally, how would you like to see economists respond to your manifesto?

Richard:  Well, I want everybody to get up and shout and write articles, send off letters, organise meetings and make sure that we stop proceeding in this way, which is bringing in so much misery to our people.

Viv:  Lord Layard, thanks very much for taking the time to talk to us today.