Austerity vs. Stimulus in the Current World Recession - Assignment Example

Austerity vs. Stimulus in the Current World Recession The financial crisis of 2008-09 and the ensuing recession the world has encountered after it has spared no one from its effects. The rich and the poor, the employer and the employee, the producer and the consumer, all have been swept under the carpet of world recession as an aftermath to the great financial crisis. The government, too, was deeply affected by the events that led up to the crisis and using its power to implement policy, introduced measures that they hoped would introduce stability to the depressing scenario. While there was a consensus on the fact that the government should intervene and introduce policies that improve the situation, there existed a wide range of opinions and arguments as to what policy should be adopted. While one group was in favour of expansionary economic policies, the other became a vocal advocate of promoting contraction economic policies. In the simplest of all terms, the debate boils down to one that lies within the opposite poles of austerity and stimulus. Stimulus meant to introduce policies that encourages consumer spending while austerity became synonymous to lowering the level of consumption within the economy. What these terms have meant for the world in the aftermath of the financial crisis can be gauged by not only the increased attempts to understand them, but also through the active criticisms both sides of the debate have been receiving over the past five years. There has been a mirage of opinion based articles in leading newspapers debating over the austerity vs. stimulus dilemma, and it is useful to look at them to gain a deeper understanding of the issue. Even so, the leading lessons learnt from the aftermath of the financial crisis and the current world recession all point to one fact: that stimulus in times of recession can lead to a worsening situation for the already staggering economy. Such a claim serves to negate the traditional Keynesian approach that it is stimulus that sets things right when economic activity is suffering. John Maynard Keynes is without doubt one of the most influential contributors to the field of economics, especially that of public policy making. In the backdrop of the financial crisis and the eventual years of recession, Keynes theories and words rang true for many. Keynes theory is applied in the concept of the business cycle, which implies that economic activity follows a natural cyclical trajectory. This means that after every economic boom, an economic slump becomes inevitable and that every economic slump paves the way for an eventual economic boom. An economic slump, or recession, is identified by a low aggregate demand, which in turn results in a reduced output, which further serves to bring about low incomes in the economy. The low incomes of households result in a low demand on the part of consumers, which thus completes the cycle from where it started off. Unemployment is also a predominant feature of such times. However, since demand is low, the price mechanism of the free market determines a low price, which in turn encourages producers to enter the industry and produce. The entry of new firms to the industry results in increased output, increased output gives rise to increase incomes, which in turn serves to push up the demand within the economy. Employment increases as well, thus the economy is pulled out of recession and set forth on the path of a economic recovery. The year 1936 was the year Keynes book THE GENERAL THEORY OF EMPLOYMENT, INTEREST AND MONEY came out. Interestingly, it coincided with the Great Depression, which had the characteristic features of unemployment, low output, income and demand. Under such circumstances, the solution presented by Keynes was seen as relevant to the financial crisis. The same ideas were looked up to when the financial crisis struck again in 2008, however by then, the fatal flaws in Keynesian theory had been identified. It was foolish to follow his proposed solutions in such a scenario. The case of countries like Greece which promoted stimulus as proposed by Keynes can be seen as opposed to countries that followed austerity in tough times, e.g., Latvia. The economic conditions in the era Keynes wrote can be used to draw parallels with the depression of 2008-09. The ensuing policy debate therefore, is also highly relevant to our times, where policy makers are grappling, struggling and striving to control factors that are well out of their control. Before launching into a critique of the failure of Keynesian theory as a solution to the current world recession, it is first imperative to understand what exactly the theory entails. Although Keynes presented a number of pioneering ideas and economic concepts in his book that received attention worldwide, the multiplier theory even today, stands out as the most impactful of all. According to the multiplier theory, if the income generated through economic activity is reinvested in the economy, the subsequent income generated will be a multiplied proportion of the original investment. In other words, spending and investing back in the economy is the fuel for an economy. Jacob Kushner agrees with this idea in his article published in the Alaska Dispatch (Kushner, 2012). As opposed to this, an economy that saves instead of spending is in effect losing out on its chance of generating a multiplied and increased income. Keynes not only saw this as a general working mechanism for economic activity and income generation, but also implied that the multiplier effect can be used to bring an economy out of a period of depression. Spending in an economy that is facing a financial crisis gives it the stimulus it needs to get back on its feet. Keynesian thought also proposes that since the producers and consumers are directly affected by the declining economic conditions, it is the government that should step in and bring about a change that will positively affect both the price levels as well as the level of employment. Keynes puts this forward in the following words, that “the total employment caused by (e.g.) increased public works will be ten times the primary employment provided by the public works themselves” (Keynes, 1936, pg 116-117) in the case that the community in question spends 9/10th of the income generated by the government’s expenditure. Spending is the basis of the expansionary stimulus that is, according to Keynes, the solution to recession. Henry Halzitt in his book criticizes the Keynesian multiplier theory. He argues that there is no reason for policy makers to assume that a community’s propensity to consume has an effect of increasing future income. He says that under the Keynesian school of thought, “this ‘functional’ and purely formal or terminological relationship is confused with a causal relationship” (Hazlitt, 1959, pg 139). It is by no means proven that encouraging spending and discouraging saving will lead to an improved economic scenario. Laura D'Andrea Tyson, a professor at the University of California, has recently written an article for the New York Times (Tyson, 2013). She puts forward the idea that neither stimulus nor austerity is inherently harmful for an economy. If the need arises, stimulus can benefit an economy, while a policy of austerity can prove fruitful under different circumstances. She identifies that due to the growing public deficit in America, the American government under President Obama. She gives statistics of the current interest rate being near zero in the United States. This means that individuals have lesser incentive to save and more incentive to spend. Encouraging spending did bring positive results for the country’s economy in the first year of its implementations after the financial crisis. However, the fact that the interest rate is persistently lower may mean a bad omen for the economy since too much stimulus and no austerity may cause the economy more harm than good (Sloman & Garratt, 2013). Indeed, Keynesian theory suffers from a fatal flaw by assuming that stimulus in the economy is the only trajectory that is capable of bringing an economy out of recession. Anders Aslund in an article written for the Bloomberg gives the example of Northern and Southern Europe, and how one has recovered from the financial crisis and the other hasn’t. he credits Northern Europe’s austere policies to their successful emergence from the crisis, while the “half-hearted austerity” and “fiscal stimulus” is seen as the cause of the Southern Europe’s failure to do so. Bringing the relevance of the Keynesian theory in the analysis of the current financial crisis, he writes “The predominant Keynesian thinking has been tested, and it has failed spectacularly.” (Aslund, 2013). Aslund too thus sees the failure of the multiplier theory in forming the basis of economic policies in the aftermath of the financial crisis of 2008. Hence, stimulus in a recession may actually end up bringing about negative effects not only for the present situation of the economy, but also for the future. Bibliography ASLUND, A. (2013) "Why Austerity Works and Stimulus Doesn’t - Bloomberg." Bloomberg - Business, Financial & Economic News, Stock Quotes. http://www.bloomberg.com/news/2013-01-07/why-austerity-works-and-fiscal-stimulus-doesn-t.html (accessed June 7, 2013). HAZLITT, H. (1959). The failure of the "new economics": an analysis of the Keynesian fallacies. Princeton, N.J., D. Van Nostrand Co KEYNES, J. M. (1936). The general theory of employment, interest and money. New York, Harcourt, Brace. KUSHNER, J. (2012) "The Multiplier Effect: Driving Haiti’s recovery by spending aid dollars locally | Alaska Dispatch." Alaska News, Politics, Outdoors, Science and Events | Alaska Dispatch. http://www.alaskadispatch.com/article/multiplier-effect-driving-haiti-s-recovery-spending-aid-dollars-locally (accessed June 7, 2013). SLOMAN, J., & GARRATT, D. (2013). Essentials of economics. Harlow, England, Pearson. http://lib.myilibrary.com?id=459561. TYSON, L.D. (2013) "Lessons on Fiscal Policy Since the Recession - NYTimes.com." The Economy and the Economics of Everyday Life - Economix Blog - NYTimes.com. http://economix.blogs.nytimes.com/2013/05/03/lessons-on-fiscal-policy-since-the-recession/ (accessed June 7, 2013). Read More