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Understanding austerity

There is a general confusion in Pakistan, whereby austerity policies are taken as belt-tightening in terms of prioritising against less important expenditures or reduction in expenditures with regard to running of government. While these are indeed important steps that should be taken, with all the more focus in times of acute stress on fiscal space as currently is the case for the country, austerity in economics literature means taking steps that reduce aggregate demand, may that be through cutting down government’s development expenditure, or making it harder to invest by increasing the cost of capital or, in other words, interest rate.

Taken in this correct sense, austerity should be discouraged, since it not only reduces economic activity, hurts aggregate supply, increases unemployment, it also has enhancing effects on poverty and inequality. Worst of all it perpetuates the capacity of elite capture to influence public policy towards strengthening their extractive economic institutional design. Noted economist, Clara E. Matai in her 2022 book ‘The capital order: how economists invented austerity and paved the way to fascism’ pointed out the dangers of austerity on both economic activity, and in strengthening the link between austerity and elite capture. She indicated in this regard: ‘If one subscribes to the argument that austerity is a tool for managing a capitalist economy, as Keynesian economists did and do, then one might believe that a continued deployment of austerity across societies and economies is a form of political irrationality – a wrong economic policy based on wrong economic theory that has never succeeded in achieving its stated ends. …Against its promise to stabilize the world economy, the austerity project of the 1920s was a spectacular failure: its reduction of aggregate demand… is cited by many as a cause of the Great Depression… austerity’s capacity to impose and reinforce class structure is the true measure of its efficacy; it was a servant to, and indeed the primary safeguard of, capital order.’

Moreover, in the current context of inflation being mainly driven by global supply shock, mainly at the back of Covid pandemic, and the war in Ukraine, reducing inflation through austerity measures has instead likely increased inflation through diminishing impact on aggregate supply of over-board policy rate increases, in basically both developed and developing countries. Economics Nobel laureate Joseph E. Stiglitz in his recent interview to ‘Democracy Now’ to a question by the interviewer that among other things indicated ‘…as we look at international economic crisis, soaring inflation, devalued currencies, nations across the globe confronting catastrophic debt crisis…’ pointed out in this regard ‘Well you’ve described it. What concerns me right now, is that all of this is being made worse by monetary policies. The Federal Reserve raising interest rates when the problem is not excess aggregate demand. The problem is supply side interruptions, demand shifts caused by the very forces that you described – the war, the pandemic. Let me be frank, raising interest rates designed to slow the economy down, increase unemployment, is going to be not the right policy for addressing the inflation that we face.’

In reducing economic activity, austerity in fact has diminished domestic resource mobilization in not just lesser economic exchange, but also greater economic misery through higher inflation and unemployment, decreases the space for political activism, which is needed to push public policy to bring the rich under the tax net, who otherwise have strong stranglehold on tax policy. Hence, for International Monetary Fund (IMF) to ask government to tax the rich more, and for government to be more pushed to unshackle elite capture requires less, not more, austerity. It is ironic that the lessons of austerity are being lost on both IMF and recipient countries of the IMF programmes.

Instead, the IMF should strengthen public voice through greater economic empowerment, which comes from non-austerity, counter-cyclical measures – like keeping policy rate at a lower rate with greater push on government to manage inflation through more creative measures on the fiscal side that protect much-needed spending, pushes up supply, and brings greater export competitiveness – by bringing in greater special drawing rights (SDRs) for developing countries, and in turn enabling them to have needed fiscal space to create debt repayment capacity, among other beneficial outcomes, like spending towards sustainable green and inclusive economic transition.

Noted economist Isabella M. Weber, in her interview recently to the programme ‘60 Minutes Australia’ pointed towards the serious limitedness of fighting inflation through over-reliance on policy rate, especially given the current supply-determined nature of inflation mainly. She indicated: ‘I think it is a very painful way of fighting inflation, and I think there are alternatives. It’s a way of fighting inflation that often makes the people, who have suffered from inflation, suffer once more. The idea of using interest rate to tackle inflation is a very roundabout way of going about it. It’s a bit like as if you had a fire in your kitchen, and you were going to flood your whole house. So, therefore, I think given the nature of inflation that we have been observing, it will be better to choose more targeted measures, rather than to simply rely on interest rate hikes. …Due to the enormous pain that is being induced by interest rate hikes, I think governments should step up, and should be creative, and try to devise surgical tools to deal with the kind of inflation that we are facing today.’

To bring greater force to this non-austerity effort, policies of expenditure rationalization should be put in place, along with policies that allow moving towards an entrepreneurial state where government is not seen from the yardstick of either small or big, but rather smart, and not just as a facilitator to the private sector, and just relying on taxes to bring public welfare, but as an equal partner in economic development, and market outcomes so that public interest is watched through contracts that protects their interests, and also by government also earning a share in profits – in turn to be used as investment into public welfare, in addition to taxes – in economic activity.

Similarly, rich, advanced countries both through direct bilateral support, and also through multilateral platforms like the IMF, in general, could support developing countries in their effort to create a more resilient and green economy by creating non-austerity, expenditure efficient programmes, rather than wrongly pushing them to manage their debt repayment capacity, and inflation through austerity measures.

Here, it needs to be pointed out that a significant extent of research has indicated that SDRs provision is non-inflationary, and capacity to fund developing countries is not as much limited, as otherwise thought, to tax revenues of developed countries. Renowned economist, Mariana Mazzucato, in her recent interview to BBC’s programme ‘Newsnight’ highlighted in this regard: ‘This whole notion that you run a government like you run a household, and you actually have to earn tax revenues to even be able to spend. In otherwise, you know, you have to do austerity, is a complete myth. Government create money all the time. We do that for war. I mean look at what happened in Germany recently. Overnight, they created 100 billion euros for the war effort. So, why do we have to treat our social problems, around health, around public education, public transport, climate change, as urgently as we treat climate [I think a small error, whereby instead she would have likely meant war, instead of saying climate]. And then use tax to redistribute in a progressive way, not a regressive way, and to steer the economy to be more inclusive, and sustainable.’

In that sense, for instance, developing countries should have been provided with easy finance to make debt repayments, especially given climate change impacts and pandemic weakening repayment capacities, rather than asking them to adopt austerity, the same way they are being asked to control inflation through squeezing aggregate demand, when it is much less painful, and a lot more effective to reduce inflation by enhancing aggregate supply at the back of low policy rate, and provision of much greater allocation of SDRs to reduce the impact of imported/cost-push inflation.

Dr Omer Javed, "Understanding austerity," Business recorder. 2023-03-10.
Keywords: Economics , Monetary fund , Economic policy , World economy , State Bank , Economy , Mariana Mazzucato , Pakistan , Ukraine , Germany , IMF , SDR

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