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The Case Against Austerity

Demonstrators block a police car on the parking lot of the Madrid transport bus company during the general strike held in whole Spain in Madrid as unions launched a 24-hour general strike all around Spain to protest tough government labor reforms and austerity measures.
Josep Lago | AFP | Getty Images
Demonstrators block a police car on the parking lot of the Madrid transport bus company during the general strike held in whole Spain in Madrid as unions launched a 24-hour general strike all around Spain to protest tough government labor reforms and austerity measures.

The companion piece to my earlier Case for Austerity— in light of today's dismal economicdata from the UK.

Perhaps the strongest argument in favor of fiscal stimulus—and against austerity—is history itself: Specifically, the double dip ravages of the worst economic crisis in living memory—The Great Depression.

The argument comes to us from Christina Romer, the former chairwoman of Barack Obama's Council of Economic Advisers, in her guest article in The Economist Magazine, from late 2009.

Romer begins with a history primer:

"The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth."

And then the fiscal spigots were turned off:

"However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. One source of the growth in 1936 was that Congress had overridden Mr. Roosevelt’s veto and passed a large bonus for veterans of the first world war. In 1937, this fiscal stimulus disappeared. In addition, social-security taxes were collected for the first time. These factors reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure."

In a word: 'Austerity'.

Federal spending was curtailed. Taxes were raised.

And the result was a return to economic contraction.

After the implementation of the New Deal, unemployment had dropped rather dramatically— from 1932-33 levels of 25 percent to 14 percent. But fears of ballooning deficits were the new order of the day: Deficits had risen from 16 percent of GDP in 1933 to 40 percent of GDP by 1936.

Hence the pressure to cut spending and raise taxes.

Romer concludes:

"The 1937 episode provides a cautionary tale. The urge to declare victory and get back to normal policy after an economic crisis is strong. That urge needs to be resisted until the economy is again approaching full employment. Financial crises, in particular, tend to leave scars that make financial institutions, households and firms behave differently. If the government withdraws support too early, a return to economic decline or even panic could follow."

One wonders if Britain—in its push for austerity—has fully internalized that lesson.

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