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Can Austerity Work?

posted 30 Sept 2012, 10:17 by heiko khoo

 by Michael Roberts      

The people of Spain, Greece and Portugal have been on the streets to oppose more 'austerity' as a solution to the economic crisis in these countries.  Yet the Spanish government is proceeding to impose yet another round  of austerity measures in its 2013 budget announced this week.  The French 'left' government has also done something similar and the Greek coalition is struggling to reach agreement on yet another round of cuts in government spending demanded by the EU and the IMF.              

Austerity is (correctly) conceived by the majority as trying to destroy their living standards now and in the future.  But the Keynesian left also tells us that austerity won't work anyway in creating economic recovery. As Paul Krugman put it in his blog only this week ( "The straight economics of the situation suggests that Spain doesn’t need more austerity. It shouldn’t throw a party, and, in fact, it probably has no alternative (short of euro exit) to a protracted period of hard times. But savage cuts to essential public services, to aid to the needy, and so on actually hurt the country’s prospects for successful adjustment."

So what is the point of austerity?  Why do so many governments of the major capitalist economies persist in policies to reduce public sector spending, raise taxes and lower budget deficits at a time when their economies are in recession? Are they mad? Krugman thinks so ("Europe's austerity madness").  And so does Larry Elliot, the Keynesian business editor of the UK's Guardian newspaper, "Austerity mania is sweeping Europe" (

The Keynesians see this policy of austerity not only as wrong-headed, but also ideological.  It's true that there is an ideological aspect to austerity.  There is a built-in antagonism to any sector of the economy that is not capitalist and could threaten the dominance of capitalist production, by taxes on profits, 'excessive' welfare benefits, more regulation and 'interference' with free markets.

But that is not the main reason for governments pursuing policies of austerity. The main purpose of austerity is to restore the profitability of the capitalist sector of national economies after the Great Recession and resulting decline in profits.  Capitalism in the major G7 economies has experienced a secular decline in the rate of profit since the 1960s and despite a relative recovery in the 1980s and 1990s, profitability peaked and started to slide in the last decade (see my paper, A world rate of profit (roberts_michael-a_world_rate_of_profit.).   This decline was counteracted by a massive expansion of credit (fictitious capital) in the 2000s.  But that eventually collapsed into the Great Recession.  Now profitability needs to recover.  The policies of austerity are designed to help do that.  In the US, labour's share is at a record low, pushing profitability back up.  As a result, US economic growth has been relatively better than in Europe.

But the Keynesians argue that the problem is not profitability, they say, but a lack of 'effective demand'.  To boost demand, we need cheap money from the central banks, an injection of liquidity through the printing of money and more government spending, not less. To cut spending and even consider raising interest rates at this time is suicidal for capitalism and economic recovery.

As Elliot puts it: "The austerity programmes come with pledges of economic reforms. Put simply, the idea is that too many eurozone countries have been feather-bedded for too long and now need a chill blast of reality to wake them up. Budget retrenchment will ensure that countries live within their means while deregulation, privatisation and more flexible labour markets will make them leaner and fitter. Before too long a revitalised Europe will be punching above its weight in the global economy.  All of which is total moonshine.  Not one of the objectives set by Hollande, Mariano Rajoy in Spain or Antonis Samaras in Greece is likely to be met. The first goal is that budget deficits will come down rapidly as a result of austerity. All the evidence so far is that targets will be missed because demand will be sucked out of already pitifully weak economies, with the effects magnified because so many countries are acting in the same way simultaneously.

But the targets for budget deficits and debt levels would be met if European capitalism restored economic growth.  The question is: how can that be done?  The Keynesians say policies of austerity will not do it.  But will Keynesian policies restore economic growth either?  Under the capitalist mode of production, the purpose is not raise GDP or increase household consumption.  That may be a by-product, but the purpose is to make profits.  And profitability is still too low to encourage capitalists to raise investment sufficiently to reduce unemployment and wage incomes and thus 'effective demand'.  A policy of raising wages would reduce the share of profit in GDP; and a policy aimed at expanding government spending would be damaging to profits, just when capitalists are trying to 'deleverage' their 'dead' and unusable capital and reduce costs.

Sure, some capitalist sectors benefit from extra government spending through the procurement of government services and investment from the capitalist sector e.g. military weapons and equipment; roads, schools and hospitals etc. Mainstream economists often claim that government does not "produce anything",  it does not "create wealth". What the mainstream really means is that government does not create new value (profit).  It merely redistributes existing value, often against the interests of the capitalist sector as a whole.  Government can thus be damaging to capitalist investment especially if taxes are diverted to welfare spending, workers pensions and public sector wages.  And if government gets too large, it could even reverse the dominance of the capitalist mode of production.

So the Austerians see the need to keep government spending down, reduce the 'size of the state' and cut sovereign debt not as ends in themselves, but as part of the effort to revive profitability in the capitalist sector by cutting the costs of taxation and welfare.  Indeed, from this light, the most important policies of austerity are not really the control of government spending but the accompanying 'supply-side' reforms that aim to 'liberalise labour markets' (cut jobs,public and private), reduce wages (public and private), lower pensions (public and private) - in other words,  lower the cost of variable capital (labour) and drive up the rate of surplus value (profit to wages ratio).  If the capitalist sector is also 'deleveraging' by destroying the value of its constant capital and financial debt (by liquidating it or paying it down), then both measures will raise profitability and set the scene for a new round of capitalist investment.

Austerity can work.  But there are two problems.  The first is that the majority of people may not put up with it and remove governments who implement it.   The other problem is that it can take a very long time.  The long depression of the late 19th century that swept across the major economies started in 1873 and did not really end until 20 years later.  In my book, The Great Recession (Chapter 13), I show how Marx's law of profitability operated during that period in the most important capitalist economy then, the UK.  The UK rate of profit began to fall from early 1870s and stayed around 25% lower throughout until the early 1890s.  It took a long time for capital value to be destroyed sufficiently.

In a previous post (The Great Depression and the war, 6 August 2012), I have shown that the Great Depression of the 1930s was not reversed until the second world war broke out, when capital was destroyed physically as well as in value terms and the capitalist mode of production was temporarily 'suspended' by state direction of (military) investment and control of wages.  So austerity could well last a long time in this current Long Depression.  But eventually, unless labour revolts against it,  profitability will recover and capitalist investment will revive enough.  From this perspective, Keynesian policies will only delay the process and the lengthen the time before recovery.

The Austerians like to cite the example of the Baltic states as showing that their policies will work much better than the Keynesians in quickly restoring capitalism.  Yet another report justifying this has been released by the right-wing UK think tank, the Centre for Policy Studies (Estonia: a case study: how and why Estonia embraced austerity (  Head of research, Ryan Bourne at CPS argues that "Estonia proves that a turnaround through swift, sharp austerity is possible for a country provided ... it is willing to undertake radical supply-side reform alongside curbing spending ...What is needed are an end to "excessive borrowing, unstable welfare states, high debt burdens, unreformed and illiberal labour markets, excessive regulation etc".

Bourne attacks Krugman for claiming that austerity has not worked because Estonia's real GDP is still some 9% below its peak in 2007, having fallen over 17% from peak to trough.  He says that this is unfair because Estonian unemployment has fallen back from 20% in early 2010 to just (!) 10% now and the economy grew at over 8% in 2011.  So austerity worked. But Krugman is right to point out that Estonia's real GDP is still way below where it was in 2007 and more important, Estonia will never return to the trend growth it has before 2007 - the value of that output has been lost forever.

Bourne sweeps past the reason for Estonia's high growth before the global financial collapse, namely a humungous credit boom where private sector debt exploded to 100% of GDP, generating a current account deficit of 18% of GDP, with inflation peaking at 11% a year.  So much for untrammelled capitalism providing a steady and sustainable economy.  Bourne's claim that 'internal devaluation' through policies of austerity adopted by the Estonian government had succeeded 'quickly' is also open to question.  The government cut public spending but also slashed pensions, reduced sick pay and health benefits for all workers.  The huge slump brought imports screeching to a halt and so the trade deficit was reversed as a result. The real success of austerity has been a sharp fall in real wages and cuts in corporate taxes - namely raising the share of profit.

But if austerity has worked in Estonia, the main reason is one not mentioned by Bourne at all: emigration.  The Estonian labour force has been decimated as thousands left this tiny country to seek work elsewhere in Europe.  The Estonian version of the British Tory cry to the unemployed of "get on your bike" to seek work was to get on the train or plane westwards for fill up the reserve army of labour in Germany etc. The money earned abroad also came back to families ameliorate the hit to living standards at home.

And there were two other factors not available to larger capitalist economies.  Estonia's banks are wholly owned by Swedish ones, who made sure they were bailed out and there was no collapse when the credit bubble burst.  And second, tiny Estonia received over €3.4bn in EU structural funds to finance infrastructure spending. (For more on this, see my post, Keynes, the profits equation and the Marxist multiplier, 13 June 2012.)   So small capitalist economies may well be able turn things round through austerity if the majority of working people are prepared to pay the bill for capitalism (as it seems the Estonian electorate has been - although they are a lot smaller in number than in 2007!).

Greece is not tiny like Estonia, but it is a relatively small capitalist economy, dependent on trade (including services like tourism).  The troika (EU, IMF, ECB) is demanding even more austerity to drive down labour costs.  It is demanding more wage and pension cuts (already cut 40%) and a six-day week for all Greeks as normal!  This is the most blatant attempt to hike the rate of exploitation. The Greeks already work the longest hours in Europe (see my previous post, Europe: default or devaluation?, 16 November 2011).

The interesting thing is that austerity in Greece is supposed to be aimed at the public sector.  The reality is that it is private sector workers that have been hit the most.  Public sector employment shrank by some 56,000 from 2009 to 2011, a 7.8% drop.   But private sector employment (a much larger share of the labour force) is down 13%. And labour costs are down 18.5%.  This is the real target of austerity.  And it is beginning to have an effect.  In Greece, unit labor costs rose 33.7% between 2000 and 2009, while in Germany they rose just 0.6%. But this gap between German and Greek unit labor costs has already dropped to less than half the 2009 peak.  Indeed, on current trends, Greek unit labour costs will be lower than Germany’s by early 2015, as Greek costs drop by over 40% and German costs rise by 10%. Greek capitalism is becoming ‘competitive’, but taking around eight years of hell to do so!

I made a (crude) measure of the rate of profit in the Greek economy over the last ten years.  The rate of profit peaked in 2007 some two years before the crisis really hit Greece.  Investment then plummeted 50% from 2007 to now.

The key result of austerity has been to drive up the rate of surplus value by 25% since 2009.  Unfortunately, Greek capitalism still has not been able to get rid of its dead capital through bankruptcies, mergers and privatisations sufficiently to reduce the organic composition of capital and raise profitability.  So investment is not yet recovering.

So austerity is working to some extent in Greece, but without the destruction of the value of much more Greek capital, it will take a long time. And the rest of capitalism could enter a new global recession before Greek capitalism gets out of its pit, so destroying the prospects of recovery through more exports and tourism.

If it is still very difficult for small capitalist economies that depend on low unit labour costs and exports (like Ireland) to turn things round, it is even more difficult for larger capitalist economies (UK) or giant ones (US, Japan), where profits still depend mostly on domestic markets and the unemployed labour force cannot be transported to the rest of the world to relieve the burden on the state.  The UK economy is the largest one where the government claims that austerity is the best (only) policy that will work (see my post, UK economy: no Plan B,18 July 2012).  So far, it is failing.  Far from the budget deficit coming down, it will be larger this current fiscal year to April 2013 than last year and the public debt to GDP is heading towards 100% of GDP.  Government tax revenues are just not meeting targets because the UK economy is teetering on recession.

Even worse, there is no contribution to GDP growth from an improving trade account, as there is for Estonia, Greece and even Spain.  The UK's external deficit is widening, not narrowing.

British exporters are finding that the global recession and falling costs in Europe and elsewhere is pricing them out of trading markets at a truly horrendous rate

And most important, unlike the US, UK profitability has not recovered since the Great Recession.  And that is keeping business investment well down.

The Austerians in the government conclude that the UK needs more austerity, or 'supply-side' reforms.  The Labour opposition is also wedded to the idea of austerity, if the latest comment of the opposition finance spokesman, Ed Balls, is anything to go by: "The public want to know that we are going to be ruthless and disciplined in how we go about public spending," Daily Telegraph, 28 September.  The Keynesian left want Plan B, with more government spending.

Austerity or Keynesianism?: neither policy will succeed until profitability is restored.