Wolfgang Schäuble is a German who really loves austerity

Sam Seitz

In the wake of the 2008 Crisis, there was much debate over what type of economic response the United States and other advanced economies should pursue to minimize the impact of the financial crisis. At first, America and Europe pursued fairly aggressive monetary policies. However, while the United States continued to pursue stimulative measures – adding fiscal stimulus measures through Obama’s controversial stimulus package – Europe embraced strict fiscal austerity, slashing government spending in an effort to “live within their means.” Now, eight years later, we are able to compare which policy was more effective. While there is certainly mixed evidence both ways, the empirical and scholarly consensus heavily supports the idea that during times of severe economic malaise, austerity is an awful strategy.


Going into the crisis, there existed two major schools of thought. The first school – Neo-Keynesianism – argued that increased government spending and money printing was the best strategy to prop up the failing economy. The second school – the Austrian School – argued that governments should cut spending in order to prevent ballooning debts. This approach argued that crises are simply caused by poor investments, and by cutting government spending and allowing poor-performing sectors to fail, the market would correct itself. Both schools of thought sounded theoretically plausible, so there was no strong consensus at the outset.

Neo-Keynesian arguments rely on a number of theories. The first is the Phillips Curve – a model that predicts a correlation between higher inflation and higher employment. This model is based on the concepts of “sticky wages” and “sticky prices.” “Sticky wages” is the idea that firms don’t increase wages exactly with inflation. As inflation rises, wages stagnate, at least for a short period. Thus, companies actually end up paying less in terms of real wages, granting them more money to invest in R&D or strategic restructuring. “Sticky prices” argues that, like wages, prices don’t rise with inflation. Therefore, the real cost of goods and services decrease, granting consumers more spending power. This allows consumers to stimulate growth by buying and investing more than they otherwise would. By using aggressive monetary policy to increase inflation levels, central banks are, in theory, able to mitigate a major economic contraction. Neo-Keynesians argue that this effect can be further magnified by coupling aggressive monetary policy with tax breaks and increased government spending – two policies that further increase cash flow in the economy. In theory, at least, the government is able to fill-in for a decline in spending and consumption, cushioning the impact of a major economic calamity.

Neo-Keynesians also argue that Austrian approaches are a bad idea because by cutting government spending, governments actually increase the debt/GDP ratio. While this sounds counterintuitive at first, it actually makes a lot of sense. Government spending contributes a lot to GDP. From R&D to government acquisition programs, the public sector has a meaningful impact on economic growth. By slashing federal spending, therefore, the government is actually hurting overall growth levels. The debt, however, still exists because spending cuts only impact deficits. Thus, Neo-Keynesians argue that by embracing austerity, countries are essentially prolonging economic recovery while simultaneously increasing the national debt relative to the size of the economy. Neo-Keynesians also warn that intense austerity measures can trigger a liquidity trap – a situation in which frightened consumers hoard money because they fear further market collapse and potential unemployment. Liquidity traps can’t be fixed by monetary policy alone because merely printing more money doesn’t do anything if people refuse to spend it. Thus, Neo-Keynesians argue that governments must initiate large-scale spending projects during periods of intense economic downturns to stimulate the flow of money through the economy.

Austrians counter with a number of powerful arguments of their own. First, they argue that by embracing massive government intervention, the market becomes distorted. This is certainly true. For example, if one just draws a simple aggregate supply-demand curve, one notices that stringent government intervention can make up for a fall in demand, but it also permanently distorts prices. Moreover, Austrians argue that bailouts and stimulus packages can create a moral hazard because firms realize that no matter how risky their investments are, the government will always be there to backstop them in the case of a disastrous outcome. This is the classic “too big to fail” argument. Austrian economists are also skeptical of the stimulative effects of easy money. In particular, they argue that because consumers know the money will have to be given back eventually through taxes, most people will simply hoard the money or invest in low-risk ventures that don’t meaningfully stimulate the economy. This belief that consumers internalize government budget constraints is known as Ricardian Equivalence.

Austrians also point out a number of problems with the Neo-Keynesian worldview. First, by spending vast amounts of money to stimulate the economy, governments increase their debt level. This can potentially prove catastrophic because it can undermine investor confidence and lead to a bond sell-off. After all, the more indebted a country becomes, the higher the risk that it will be unable to service its debts, making potential investors less willing to invest in bonds. As demand for risky bonds falls, governments are forced to hike interest rates to attract investors, thus making it even more difficult to pay back the debt. In essence, loose monetary policy can quickly generate a dangerous debt spiral. Austrians also argue that overly aggressive government intervention can crowd out private sector enterprises, as innovative but struggling firms fight a losing battle against government enterprises with near limitless access to capital. The argument goes that with innovative industries stifled by government intervention, it actually becomes harder to recover from economic downturns because the free market is disrupted by unsustainable government competition.

Historical Record

As you can see, both Austrian economics and Keynesian economics seem to be theoretically plausible. They both make powerful arguments and offer compelling criticism of each other. Fortunately – or, rather, unfortunately – history is replete with economic shocks and crises with which we can test the relative merits and demerits of these theories. Both Keynesianism and Austrian-based austerity measures have been tested throughout the 20th and 21st Centuries. For the purposes of this post, however, we will only be looking at the Great Depression and the Great Recession.

The Great Depressions causes are still widely debated. Nevertheless, it is safe to say that high levels of debt, poor stock market regulation, and poor industry growth all contributed. At the onset of the Great Depression, the United States and many European countries embraced austerity. Moreover, they actively restricted trade and access to capital through intense protectionist measures like trade tariffs. Herbert Hoover, the president at the onset of the Great Depression, never seemed to fully embrace either a full laissez-faire solution or a full Keynesian solution. He dallied, and he increased U.S. protectionism. This cost the U.S. economy dearly, as unemployment reached highs of up to 25%. Hoover also insisted on trying to maintain balanced budgets, a policy which ultimately prevented the government from effectively stimulating the economy. Moreover, the U.S. was hamstrung by its adherence to the gold standard, a policy which prevented the U.S. from manipulating its currency to boost manufacturing competitiveness.

Roosevelt soundly defeated Hoover in the 1932 election and implemented an aggressive stimulus program in the form of the New Deal. This aimed to massively increase government works projects in an effort to stimulate the economy and boost employment levels. This series of programs was largely successful, and they meaningfully improved the economic situation of the United States. However, Roosevelt did not go far enough in his stimulus measures. In 1937, the U.S. economy slumped again. The exact reason for why this second recession occurred is still heavily debated, but two compelling theories are that the Fed tightened monetary policy too quickly and that cuts to federal spending in the 1937-1938 fiscal year meant that stimulative measures were cut off too quickly. The economic malaise continued until World War Two, a period in which U.S. spending skyrocketed. This suggests that it was not too much government that prevented economic recovery, but that it was insufficient government intervention coupled with inane trade protectionism that led to the prolonged economic calamity that was the Great Depression.

The Great Recession (aka the 2008 Crisis) also presents a fascinating case study. The reason is that the U.S. and Europe took polar opposite approaches to addressing the crisis. At first, their responses were similar. Loose monetary policy from both the Fed and European Central Bank (ECB) was used to try to ameliorate the market contraction caused by the housing bubble. However, by 2010, the policy response had changed. While Europe slashed government spending, the U.S. passed Obama’s “Stimulus Bill,” massively increasing federal spending. Thus, while the Europeans used only monetary policy to stimulate their economy, the U.S. used monetary and fiscal policy to stimulate its economy. The data seems to unambiguously support America’s decision. The United States’ economy is in significantly better shape than almost every European economy, and the American recovery happened far quicker than Europe’s. Indeed, certain parts of Europe still face extreme debt levels and severe unemployment. Greece and Spain, for example, have suffered even more than America did during the Great Depression due to their acceptance of austerity measures. To be fair, there are certainly European outliers. Ireland was able to recover despite an incredibly harsh austerity regimen, and some of the Baltic states have also been able to return to relatively high levels of economic growth despite embracing Germany’s harsh austerity demands. Nevertheless, the aggregate data suggests that austerity failed.

Take Away

The two biggest financial crises in modern history were both resolved through aggressive stimulus programs, not stringent austerity measures. While there will always be a few contrarian economists who disagree, I think it is safe to say that austerity is an absolutely awful and inane solution to economic downturns. Fortunately for you, you don’t have to take my word for it. Just read economic journal article after economic journal article, and you will see that the majority of economists agree. Keynes was right. Hayek was not.