Felix Salmon

How austerity blooms on Keynes’s grave

By Felix Salmon
August 19, 2011

James Macdonald has an extremely valuable way of putting things into stark focus:

The markets have highlighted a fundamental shortcoming in Keynes’s ideas: He assumed that governments would always be able to borrow. If they cannot, then Keynesian economics is dead in the water.

The thesis of Macdonald’s essay is simple and scary — and, I think, correct.

We have been living through, and are now probably witnessing the end of, an era with no historical parallels: what might be described as the “great debt experiment.”

In many ways this is a good thing. We’ve relied far too much, in the developed world, on debt-fueled growth — and that kind of growth rapidly becomes unsustainable in a world where the amount of growth that can be squeezed out of every marginal dollar of debt has been falling steadily for decades.

But deleveraging,which is great from a systemic-stability perspective, has another name in the short term: austerity. And that’s something we’re only starting to get used to, and which is going to get much more painful, especially in Europe, before this cycle has played itself out.

Greece was the first Eurozone country to find itself locked out of public markets; it won’t be the last. And even now, Greece can still borrow: the ECB and Eurozone have enough faith in Keynesian principles that, for the time being, they’re willing to step in as the lender of last resort to troubled sovereigns. But Greece is small enough to save in that matter; Italy, not so much. If the public markets shut out Italy, or if the Eurozone lacks the political will to continue throwing good money after bad, then we’ll immediately enter the most severe crisis of our lifetimes.

Here’s a couple of charts from Spiegel’s excellent slideshow on the subject to put Europe’s sovereign debts in perspective; the second one should be titled “debt”, not “deficit”. But the first one is the scarier one: it just shows the debt coming due by end-2013 in the five crisis countries. We have a serious liquidity issue here, never mind the questions of solvency raised in the second chart.



The Maastricht limit, of course, is the maximum debt that Eurozone countries are allowed to have. So much for that idea. And debt in general, as we saw in 2008-9, is a treacherous and precarious beast — you never want to push it to its limits. The market will roll over a country’s debts happily and indefinitely — until it won’t. Some countries, like Japan, are relatively safe in that regard: “the market”, there, is domestic savers in a country with a high domestic savings rate. But when a country is reliant on foreign investors to buy its debt, and can’t easily fund itself domestically, it’s playing an extremely dangerous game.

Is that the case in the US? Happily, no — as you might suspect, given the 10-year Treasury yielding 2%. But you’d probably be surprised how much of America’s $14 trillion debt is money we’ve lent to ourselves in one form or another.


So the US, by rights, should be the last country onto the austerity train. We’re the happy recipient of the global flight-to-quality trade, we fund in our own currency, and we fund largely domestically. (Yes, the “public debts” includes a lot of foreign investors, and even some foreign sovereigns, but all that money being taken out of our paychecks in the form of social security contributions and the like goes a surprisingly long way — it’s forced lending to the US government, and it’s not going away.) There are serious questions about some countries’ ability to be able to continue to tap the capital markets; there are no questions at all about others. The US is, happily, in the latter category: if the Treasury ever stops borrowing, that will be thanks to Congressional edict, rather than due to any reluctance on the part of the markets to roll over debt.

That said, the US is running into enormous political problems just trying to make up with sovereign borrowing what the economy has lost in private-sector borrowing over the course of the recession. If it can’t rise to the Keynesian challenge domestically, there’s absolutely no way it will let itself be dragged into becoming a lender of last resort globally.

Which means that we’re in the final innings of the Keynesian game. If you look at the history of sovereign debt, we started with countries borrowing large sums of money from rich private-sector individuals like the Rothschilds. When those sums weren’t enough, the era of big publicly-owned banks began, and borrowing capacity rose sharply. Then we moved into domestic capital markets, and eventually international capital markets. Each move increased the amount of money available for lending to sovereigns. Finally, when sovereigns get tapped out, they can try to appeal to super-sovereigns: the ECB, the EFSF, the IMF and the like. But those funds are limited, and don’t last long. Hence the move to austerity — the only other option. Or, of course, there’s always inflation — the other way that the ECB can bail out overindebted sovereigns. But that doesn’t seem likely any time soon.

Update: Matt at Obsolete Dogma has a really smart response.

29 comments so far | RSS Comments RSS

There are four major market-rate currencies, and they are each tied to an economy that is heavily burdened with debt. There is one giant economy that has a huge surplus. Normally, that would make it difficult for the four debt-ridden economies to use deficit spending to sustain their economies, but given that the creditor economy refuses to float their currency, then there is no reason the four central banks shouldn’t print more money to drive their economies and pay off their debts.

A big reason the four economies have so much debt is because their currency has been overvalued relative to the monster creditor. If the monster creditor were to float their currency, their cost advantages would decrease, allowing the debtors to reduce their deficits. But since the creditor does not hold any debtor accountable, there is no penalty for deficit spending. Yes, the individual member states of the EU can’t print their own money; the ECB must do that for them, and distribute it. If the other three debtors don’t like it, what are they going to do? Pretty much the same thing, as they control their currency.

There is no choice but to take this approach. The distribution of income and wealth has been shifting to where it has become more heavily concentrated in a smaller segment of society, and people have tolerated this as long as they did not suffer that much. It’s kind of a social compact. The wealthy can make more money, as long as the middle class aren’t forced into poverty. But as the states are forced to assume a bigger burden, they assume more debt, and people start clamoring for austerity. If austerity shifts enough people from the middle to the bottom, the compact is breached, and there will be strife that will cost far more than the inflation that eventually comes with deficit spending.

So the four giant debtors need to print more money, and the giant creditor needs to float their currency, and the net result will be coins aren’t worth what they used to be. That happens all the time.

Posted by KenG_CA | Report as abusive

The maastricht “limit” is nonsense. It’s a ratio, so once the boom starts, you can borrow ever more, until other stuff breaks the spell.

Posted by Foppe | Report as abusive

The opening quotation is peculiar. Of course the U.S. and Europe as a whole can borrow, and cheaply; they are just stupidly refusing to do so. It seems to me that Keynes developed crucial insights as to how modern economies work, with obvious and important policy implications for situations such as now prevail. Policy makers in the United States and Europe are overwhelmingly refusing to take Keynes’ wise advice. If engineers took to designing buildings with a willful refusal to take gravity into account, would we call that a failure of Newtonian mathematics?

Posted by kenjd | Report as abusive

It seems like there ought to be another option that governments can turn to for financing their activities, just as there is for business — equity. I’m not quite sure what equity financing for a government would look like, but presumably equity holders would be residual claimants on all revenues. It would perhaps provide some market discipline since governments would want to maintain their equity valuation by (at least) good cash flow management, making sure that there was always some residual revenue to claim.

This would be similar to British Gilts, but without the guaranteed dividends.

Why don’t more governments do this? Why doesn’t the US? It would make the debt ceiling theater irrelevant.

Posted by daniellc_boca | Report as abusive

I think you’re misinterpreting some of the Keynesian postulates, namely that when there is a demand shortfall governments can borrow money for next to nothing. That is the US, Japan, Canada, and Europe (taken as a whole), areas with high unemployment.

The real problem, as I see it, is an unwillingness to transfer wealth back to people who comprise the “economy”. What’s the difference between democracy and communism? The former votes with a lever the latter with a rock.

Posted by jesse1 | Report as abusive

Why do we keep coming back to this blog? For posts like this and it hardly matters if you agree or disagree with Salmon’s take on things. Excellent brainfood.

Posted by ottorock | Report as abusive

arrgh! keynes didn’t say government should run deficits (borrow) continually (ie. reagan and bush II). keynes said government should run deficits in a liquidity trap (ie. now). get yer facts straight, felix!

Posted by arrgh | Report as abusive

Not being able to borrow from creditors in no way prevents keynsian stimulus.

1. A nation with its own currency can devalue.
2. Debt jubilee is a keynsian stimulus.
3. Total default and the creation of a new financial structure is the nuclear bomb of keynsian stimuli.

Someone like Salmon should know better.

Posted by pinko | Report as abusive

Alot of the savings accumulated thanks to reduced
tax rates of the last 30 years have been recycled
back into government spending through T-bond
purchases, at least insofar as the state’s increased
debt reflects tax decreases, with no corresponding
spending reductions.

But especially in the last 4 years,
companies not having productive ideas for spending
are collecting interest on the debt rather than creating jobs.

A simple way to implement a keynesian type stimulus would
be to increase taxes where these savings are
accumulating, and spend this revenue quickly on
infrastructure projects.

For now politics is holding the dam against such logic,
and in a short time they will be declaring that water should run uphill.

Posted by jswift | Report as abusive

Macdonald’s piece is provocative, but oddly simplifies some ideas to make them fit a thesis. Most notably, he uses ‘Keynesian’ as synonymous with ‘deficit spending.’ It’s not. Keynes advocated surplus in boom, deficit in bust (when borrowing costs are lower in any case. We haven’t done that.

And in the US, deficits are not the result of welfare programs justified by Keynesianism. Instead, they’re largely a product of Reagan-derived politics: tax cuts paired with defense spending increases, wars, and no significant domestic spending cuts. (Simply letting the Bush tax cuts expire does most of the work to ending the US debt problem, even now).

Also, Felix’s first graph – the Spiegel slide on PIIGS debt needs – seems to assume that 100% of the amount due is picked up by the Euro rescue fund. That can’t be right. Surely the PIIGS will cover much themselves, some more will be rolled over, etc?

Posted by Dilettante | Report as abusive

http://research.stlouisfed.org/fred2/ser ies/MULT

Just because you borrow and invest, doesn’t mean your investment is going to give you a positive return

Posted by fresnodan | Report as abusive

Hey Felix,

couple thoughts.

I see the real solution to the eurozone debt crisis as the entry of Turkey (after much, ironic german begging to the turkish government) into the EU. It is debatable whether eurobonds exist before or after this happens.

I see the real solution to the US debt crisis as a kinda “fyou we’re the world’s reserve currency.” I think the better solution would be the pegging of facebook credits to the dollar at a rate of 10:1 combined with a donation of 1000 fb credits to every American citizen. In short private sector stimulus, a kinda private corporation share buyback.

Posted by theinfamoush6 | Report as abusive

The era of government “stimulus” is over. Keynes recommended running surpluses during the good times to have the funds for automatic stabilizers, loss of revenue/deficits in the bad times. He suggested not raising taxes during a recession and if you are to do anything other than the above–focus on investment as it goes down in a recession and all jobs come from investment. We hardly followed any of his rules. Keynes would be upset to see what has been done under “Keynesian Theory”. Japan has built infrastructure as Keynesian stimulus for 21 years and is broke. It did not work. We borrowed Trillions and it did not work–even if it had been infrastructure it would not have been much better. We must move to a balanced budget because we have a lot of unfunded future liabilities and on the current path interest could become the largest expense in the budget. Borrowing is not the answer.
The other issue of us owning much of our own debt in social security and other trust funds is more serious than the other debt because the other debt can likely be rolled over but we must come up with cash for social security, etc. The pressure on future budgets will be even more extreme–we should have funded social security or moved to private accounts.

Posted by GASinclair | Report as abusive

This is one of your less perceptive posts. The problem with this whole post is that it misses a very fundamental, non-political reality. Predictions by the Keynesian economists have been more than 85% accurate. Predictions by the “Serious People” crowd of been –at best –perhaps 15% accurate. Not that they care. They are about as interested in empirical fact as the pope who jailed Galileo was.

Nonetheless, the Keynesian have a working model, and now, such DFH’s as Morgan Stanley are in agreement.

In one sense you are correct. Western governments WON’T borrow –even if they can –and they won’t raise taxes. The rentier class doesn’t want then to do so. It wants a new era of peasants.

Have fun while it lasts, boys. You look more and more like the Russian upper classes in –say –1913.

Nice work.

Posted by tconnor | Report as abusive

Maybe you should check the maturities of who holds what US debt. The foreigners will be at the short end and the domestic holders at the longer end. Remember also you only need to pay one cent less on one of the dozens of bonds, notes and bills out there to default.

Posted by Danny_Black | Report as abusive

Also you might want to check how much of the US liabilities are inflation linked. If your liability is to pay for medical care forever then you can’t really inflate it away.

Posted by Danny_Black | Report as abusive

So, we’ve been following monetarist policies since the 1980s yet it’s the fault of Keynesian economics we’re in this mess now? Policies in the UK and US of moving money from state to citizen in boom times, but not asking for it back in slumps was always going to create a debt crisis – and the Chinese are right to now be critical.

If Keynes had been followed instead, those boom gains would have repaid debt, not given tax breaks to the rich so in crises such as the current one debt would not have climbed so high. If the surpluses had been used to invest in making business costs cheaper through better infrastructure (as well as free, high quality and appropriate training) there could have been fewer layoffs in the slump.

Relying on a political ideology that comforts its followers that taxes can keep on going down forever are about as realistic as the idea that markets can never go down.

Posted by FifthDecade | Report as abusive

Problem with Keynes is he thought of economics and not politics.

He didn’t anticipate politicians spending on marginal voters in the run up to the election. This was the problem in the 60s mand 70s.

Then came Thatcher and Reagan and they started cutting taxes in the run up to elections (while at the same time claiming fiscal responsibility).

Both sides borrowed in the voters name to bribe the voters for votes.

The voters got what they voted for.

None of this is Keynes’ fault. The thesis that a government can’t spend into a recession when it can’t borrow is right in simplistic terms. But Keynes advocated surpluses in booms and deficits in slumps (in excess of the amounts automatic stabilisers would cause). This still holds good, but we had the boom without the surplus, now the slump comes and the deficit looks more difficult to manage.

Posted by Dafydd | Report as abusive

http://felixsalmon.tumblr.com/post/87968 88012/a-paywall-question

I believe the answer to your question is called (das) Social (network) Capital.

Social Capital is more commonly thought of charisma. In England and the US they also call it class.

by the way everyone get ready for the tech company stock buybacks, as long as their cash hordes are in dollars? who wants to digg?

speaking of which, news corp sucks, but this link is free.
http://online.wsj.com/article_email/SB10 001424053111903480904576508382675931492- lMyQjAxMTAxMDEwODExNDgyWj.html?mod=wsj_s hare_email

I saw a woman at a food truck accepting credit cards and swiping them on her ipad. She had a device from intuit, one of the few to rise (“Lazarus Asset Management, Inc. will be revered as the leader in generating well informed decisions around what’s important to the business…its assets. …”) on friday.

Posted by theinfamoush6 | Report as abusive

The WSJ article explains how html5 has enabled cookies that are written in javascript, which is surely patent protected?

client side hacking:

the news in england is that NEWS runs england. I can’t wait to be just a scottish citizen! Remember, Remember … I know of no reason why Queen Anne should be forgot…

I couldn’t use RBS PROMISSORY notes on the tube (fenglish), but I could at the sainsbury’s…

http://en.wikipedia.org/wiki/Performativ e_utterance
which is enshrined as
pretty much obviates any argument against Gay Marriage in the US.


Posted by theinfamoush6 | Report as abusive

FifthDecade, China is undergoing one of the worst lootings by insiders since the USSR was run by Yeltsin. I would bet on the US economy every single time vs the Chinese one, on both the medium and long term.

Posted by Danny_Black | Report as abusive

@Danny Black There are four stages of grief: Denial, Anger, Sadness, Acceptance. I see you are still at stage one. Strangely, you don’t seem to see the legislated looting of America’s tax coffers by the corporate rich… But anyhow, facts are facts, the US has been borrowing money off the Chinese (now their biggest creditor) for decades just to continue paying for an image underneath which the substance turns out to be less glamorous. It pains me to see this greed generated decline.

What worries me is that in this economic war not only does the US not see it as such, they continue paying money to the power that seeks to usurp them as the worlds No 1 Economic superpower. The US beat the USSR in the cold war because its enemy was basically bankrupted, the Russians ran out of money. The Chinese (who are very clever) learned this lesson well and are now applying it to the US. The US meanwhile is split and cares more about what happens in Dayton, Ohio than it does about the world picture – and to be honest it probably doesn’t care much about what happens in Dayton either.

In some cases I believe there is a case for monetary policy though, but it seems not to operate effectively in all situations. It’s like an S-shaped curve, at one end it works fine and almost looks predictably linear; then a step change takes place and a different system becomes the one to use. The trick is to accept where you are, not waste energy denying it or shooting the messenger.

Posted by FifthDecade | Report as abusive

FifthDecade, I am just about old enough to remember exactly the same nonsense being written about the Japanese. The Japanese at least were innovative when it came to some management techniques.

Posted by Danny_Black | Report as abusive

Amazingly, I believe if you listen really closely you can make out the thousands of protestors in Greece shouting the exact same thing Matt said. In unison: “Unfortunately, austerity is self-defeating here since it depresses growth; the denominator of the debt-to-GDP ratio shrinks in tandem with the numerator.”

How all those rabble rousers made it through the NYT paywall to read Krugmann remains a mystery!

Posted by melior | Report as abusive

melior, weird I thought the greeks were chanting “give us more free money from the people who didn’t spend like crazy when the times where good” along with chants of “Screw the people who lent us the money that allowed us to have the lifestyle we had without paying taxes”

Posted by Danny_Black | Report as abusive

Overspending is fundamentally a political problem. Whether it’s Pork Belly Politics, or lower retirement ages, or lower taxes, or health care for those under the poverty line, or more access to credit, politicians for ages have been most successful when following this Bread and Circuses approach to get elected for personal power; Nations and Economies however have fared less well whenever these policies are followed.

Churchill said that politics is the art of the possible, but sometimes we have to think the impossible. George Bernard Shaw observed that “The reasonable man adapts himself to the world; the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man.”

If we are to prevent stagnation, then we must not choose reasonable men as leaders, but look for those who are unreasonable for it is only by doing unpopular things that the West can be saved. Unfortunately, this is where Democracy has a problem.

Posted by FifthDecade | Report as abusive

@fifth decade, do you think fox news can influence the election of George W. Bush instead of Al Gore or did it just take the blame off jeb bush and Kathleen harris? what about banning lobbying and replacing it with the media? I mean I’m assuming in london you guys only tithe the waitress, guv’nor? #samikhedira #googlemoderator

Posted by theinfamoush6 | Report as abusive

theinfamoush6, imagine if Al Gore had been elected. Then he would have got the blame for the crash after the dot com bubble, for not doing anything about 9/11, corporate scandals like Enron and WorldCom and probably destroyed his and Clinton’s reputation. Instead he is a multimillionaire Nobel Prize winner private jetting around the world telling people to lower their carbon footprint. Will bet he thanks all the major deities at night.

Posted by Danny_Black | Report as abusive

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