That G20 meeting marked the moment when the rediscovery of Keynesian economics that had informed state responses to the global financial crisis since 2009 gave way to an economically more orthodox, and austere, reading of events. The G20 communiqué called for an end to re-flationary spending under the guise of something called “growth friendly fiscal consolidation,” which is a fancy way of saying “austerity.”

The opportunity to get into more detail and flesh out the argument, the academic rationale, was still there. Both the reasons given for why we all have to be austere (we have spent too much, etc.) and the logics expounded for the supposed positive effects of austerity as a policy—that cuts lead to growth—are, as we shall see, by and large dangerous nonsense. Yet they remain the governing ideas of the moment. By the time the book is published this may no longer be the case, but in the meantime, these ideas will have wrought tremendous damage.

I grew up in (relative) poverty, and there were times when I really did go to school with holes in my shoes. My upbringing was, in the original sense of the word, quite austere. Household income was a government check, namely, a state retirement pension, plus occasional handouts from my manual-worker father. I am a welfare kid. I am also proud of that fact.

Today I am a professor at an Ivy League university in the USA. Probabilistically speaking, I am as an extreme example of intragenerational social mobility as you can find anywhere. What made it possible for me to become the man I am today is the very thing now blamed for creating the crisis itself: the state, more specifically, the so-called runaway, bloated, paternalist, out-of-control, welfare state. This claim doesn't pass the sniff test. Because of the British welfare state, threadbare though it is in comparison to its more affluent European cousins, I was never hungry. My grandmother's pension plus free school meals took care of that. I never lacked shelter because of social housing. The schools I attended were free and actually acted as ladders of mobility for those randomly given the skills in the genetic lottery of life to climb them.

So what bothers me on a deep personal level is that if austerity is seen as the only way forward, then not only is it unfair to the current generation of "workers bailing bankers," but the next "me" may not happen. The social mobility that societies such as the United Kingdom and the United States took for granted from the 1950s through the 1980s that made me, and others like me, possible, has effectively ground to a halt. Youth unemployment across the developed world has reached, in many cases, record levels. Austerity policies have only worsened these problems. Cutting the welfare state in the name of producing more growth and opportunity is an offensive canard.

Austerity is a form of voluntary deflation in which the economy adjusts through the reduction of wages, prices, and public spending to restore competitiveness, which is (supposedly) best achieved by cutting the state’s budget, debts, and deficits. Doing so, its advocates believe, will inspire “business confidence” since the government will neither be “crowding-out” the market for investment by sucking up all the available capital through the issuance of debt, nor adding to the nation’s already “too big” debt.

As pro-austerity advocate John Cochrane of the University of Chicago put it, “Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both.” There is just one slight problem with this rendition of events: it is completely and utterly wrong, and the policy of austerity is more often than not exactly the wrong thing to do precisely because it produces the very outcomes you are trying to avoid.

This is doubly odd since the cause of the anticipated slowdown, the debt-ceiling agreement of August 1, 2011, between Republicans and Democrats in the US Senate that sought $2.1 trillion in budget cuts over a decade (austerity), was supposed to calm the markets by giving them the budget cuts that they craved. Yet this renewed commitment to austerity instead signaled lower growth due to less public spending going forward in an already weak economy, and stock markets tanked on the news. As Oliver Blanchard, the International Monetary Fund’s (IMF’s) director of research, put it with a degree of understatement, “Financial investors are schizophrenic about fiscal consolidation and growth.”

Austerity policies were likewise supposed to provide stability to the Eurozone countries, not undermine them. Portugal, Ireland, Italy, Greece, and Spain (the PIIGS of Europe) have all implemented tough austerity packages since the financial crisis hit them in 2008. Greece’s bloated public-sector debt, Spain’s overleveraged private sector, Portugal’s and Italy’s illiquidity, and Ireland’s insolvent banks ended up being bailed out by their respective states, blowing holes in their debts and deficits. The answer to their problems, as with the US debt-ceiling agreement, was supposed to be austerity. Cut the budget, reduce the debt, and growth will reappear as “confidence” returns.

So PIIGS cut their budgets and as their economies shrank, their debt loads got bigger not smaller, and unsurprisingly, their interest payments shot up. Portuguese net debt to GDP increased from 62 percent in 2006 to 108 percent in 2012, while the interest that pays for Portugal’s ten-year bonds went from 4.5 percent in May 2009 to 14.7 percent in January 2012. Ireland’s net debt-to-GDP ratio of 24.8 percent in 2007 rose to 106.4 percent in 2012, while its ten-year bonds went from 4 percent in 2007 to a peak of 14 percent in 2011. The poster child of the Eurozone crisis and austerity policy, Greece saw its debt to GDP rise from 106 percent in 2007 to 170 percent in 2012 despite successive rounds of austerity cuts and bondholders taking a 75 percent loss on their holdings in 2011. Greece’s ten-year bond currently pays 13 percent, down from a high of 18.5 percent in November 2012.

Austerity clearly is not working if “not working” means reducing the debt and promoting growth. Instead, in making these governments’ bonds riskier (as seen in the interest rate charged), the policy has indirectly made big European banks that hold lots of them (mainly in Germany, France, and Holland) riskier in the process. This was recognized by global investors when pretty much all private-sector lending to the European banking sector disappeared in the summer and fall of 2011, the response to which has been emergency liquidity provision by the European Central Bank (ECB) in the form of the so-called long-term refinancing operation (LTRO), the ancilliary emergency liquidity assistance program (ELA), and of course, demands for more austerity.

The United Kingdom was supposedly spared this drama by “preemptive tightening,” that is, by adopting austerity first and then reaping the benefits of growth once confidence returns. Again, this approach hasn’t turned out quite as planned. Despite the fact that the United Kingdom’s bond yields are lower than many of its peers’, this has less to do with pursuing austerity and more to do with the fact that it has its own central bank and currency. It can therefore credibly commit to backing its banking sector with unlimited cash in a way that countries inside the Euro Area cannot, while allowing the exchange rate to depreciate since it still has one.

But it is also a dangerous idea because the way austerity is being represented by both politicians and the media—as the payback for something called the “sovereign debt crisis,” supposedly brought on by states that apparently “spent too much”—is a quite fundamental misrepresentation of the facts. These problems, including the crisis in the bond markets, started with the banks and will end with the banks. The current mess is not a sovereign debt crisis generated by excessive spending for anyone except the Greeks. For everyone else, the problem is the banks that sovereigns have to take responsibility for, especially in the Eurozone. That we call it a “sovereign debt crisis” suggests a very interesting politics of “bait and switch” at play.

Before 2008 no one, save for a few fringe conservatives in the United States and elsewhere, were concerned with “excessive” national debts or deficits. Deficit hawks in the United States, for example, pretty much disappeared in embarrassment as, under the banner of fiscal conservativism, the Bush administration pushed both debts and deficits to new heights while inflation remained steady. Even in places where fiscal prudence was the mantra, in the United Kingdom under Gordon Brown, or in Spain and Ireland when they were held up as economic models for their dynamic economies—really—deficits and debt did not garner much attention. Italian public-sector debt in 2002 was 105.7 percent of GDP and no one cared. In 2009, it was almost exactly the same figure and everyone cared.

The cost of bailing, recapitalizing, and otherwise saving the global banking system has been, depending on, as we shall see later, how you count it, between 3 and 13 trillion dollars. Most of that has ended up on the balance sheets of governments as they absorb the costs of the bust, which is why we mistakenly call this a sovereign debt crisis when in fact it is a transmuted and well-camouflaged banking crisis.

The Greeks may well have lied about their debts and deficits, as is alleged, but as we shall see in chapter 3, the Greeks are the exception, not the rule. What actually happened in Europe was that over the decade of the introduction of the euro, very large core-country European banks bought lots of peripheral sovereign debt (which is now worth much less) and levered up (reduced their equity and increased their debt to make more profits) far more than their American cousins.

Being levered up, in some cases forty to one or more, means that a turn of a few percentage points against their assets can leave them insolvent. As a consequence, rather than being too big to fail, European banks, when you add their liabilities together, are “too big (for any one government) to bail,” a phenomenon that the euro, as we shall see, only exacerbates.

This is a banking crisis first and a sovereign debt crisis second. That there is a crisis in sovereign debt markets, especially in Europe, is not in doubt. But that is an effect, not a cause. There was no orgy of government spending to get us there. There never was any general risk of the whole world turning into Greece. There is no risk of the United States ever going bust anytime soon. There is no crisis of sovereign debt caused by sovereigns' spending unless you take account of actual spending and continuing liabilities caused by the rupture of national banking systems. What begins as a banking crisis ends with a banking crisis, even if it goes through the states' accounts. But there is a politics of making it appear to be the states' fault such that those who made the bust don't have to pay for it. Austerity is not just the price of saving the banks. It's the price that the banks want someone else to pay.

But austerity intuitively makes sense, right? You can't spend your way to prosperity, especially when you are already in debt, can you? Austerity is intuitive, appealing, and handily summed up in the phrase you cannot cure debt with more debt. If you have too much debt, stop spending. This is quite true, as far as it goes. But thinking this way about austerity neither goes far enough nor asks the important distributional questions: who pays for the reduction in the debt, and what happens if we all try to pay back our debts at one time?

Economists tend to see questions of distribution as equivalent to Bill Gates walking into a bar. Once he enters, everyone in the bar is a millionaire because the average worth of everyone in the bar is pushed way up. This is at once statistically true and empirically meaningless; in reality, there are no millionaires in the bar, just one billionaire and a bunch of other folks who are each worth a few tens of thousands of dollars, or less. Austerity policies suffer from the same statistical and distributional delusion because the effects of austerity are felt differently across the income distribution. Those at the bottom of the income distribution lose more than those at the top for the simple reason that those at the top rely far less on government-produced services and can afford to lose more because they have more wealth to start with. So, although it is true that you cannot cure debt with more debt, if those being asked to pay the debt either cannot afford to do so or perceive their payments as being unfair and disproportionate, then austerity policies simply will not work. In a democracy, political sustainability trumps economic necessity every time.

We tend to forget that someone has to spend for someone else to save; otherwise the saver would have no income from which to save. A debt, we must remember, is someone’s asset and income stream, not just someone else’s liability. Just as we cannot all hold liquid assets (cash), since that depends upon someone else being willing to hold less-liquid assets (stocks or houses), we cannot all cut our way to growth at the same time. For someone to benefit from a reduction in wages (becoming more cost-competitive), there must be someone else who is willing to spend money on what that person produces. John Maynard Keynes rightly referred to this as “the paradox of thrift”: if we all save at once there is no consumption to stimulate investment.

As we shall see, if one starts from the premise that investment and growth flow from confidence, then one misses this point rather completely. What matters is a “fallacy of composition” problem, not a confidence problem, in which what is true about the whole is not true about the parts. This runs counter to common sense and much current economic policy, but it is vitally important that we appreciate this idea since it is the third reason austerity is a dangerous concept: we cannot all be austere at once. All that does is shrink the economy for everyone.

One of the odd things about periods of inflation is that they are practically the only time that people far up the income distribution express solidarity with the poor en masse. Whenever inflation rears its head, we hear that it “mainly hurts the poor” since their incomes are low and they are more affected by price rises. This is at best half the story because inflation is perhaps better thought of as a class-specific tax. When “too much money” chases “too few goods”—an inflation—it benefits debtors over creditors since the greater the inflation, the less real income is needed to pay back the debt accrued. Since there are usually more debtors than creditors at any given time, and since creditors are by definition people with money to lend, democracy has, according to some, an inflationary bias. The politics of cutting inflation therefore take of the form of restoring the “real” value of money by pushing the inflation rate down through “independent” (from the rest of us) central banks. Creditors win, debtors lose. One can argue about the balance of benefits, but it’s still a class-specific tax.

In contrast, deflation, what austerity demands, produces a much more pernicious politics, since any person’s first move of self-protection (taking a pay cut to stay in a job, for example) is actually zero-sum against everyone else’s move (since doing so lowers that person’s consumption and shrinks demand for everyone else). It’s that fallacy of composition again. There are no winners, only losers, and the more you try to win, the worse the outcomes, as the Eurozone periphery has been proving for the past several years.

This problem is especially pernicious under a policy of generalized austerity because if a country’s private and public sectors are both paying back debt at the same time (deleveraging), then the only way that country can grow is by exporting more, preferably with a lower exchange rate, to a state that is still spending. But if everyone is trying the same strategy of not spending, as is happening in Europe today, it becomes self-defeating. The simple story of “too much debt, cut it now” becomes surprisingly complex as our own commonsense actions produce the very outcomes we are trying to avoid, and the more we try to cut, as Greece and Spain are proving to the world, the worse it gets. We cannot all cut our way to growth, just as we cannot all export without any concern for who is importing. This fallacy of composition problem rather completely undermines the idea of austerity as growth enhancing.

As we shall see in detail below, there have been a very few occasions when austerity has worked for states, but that has happened only when the fallacy of composition problem has been absent, when states larger than the one doing the cutting were importing, and massively so, to compensate for the effects of the cuts. Sadly, for the vast majority of countries, this is not the world we inhabit today.

John Quiggin usefully terms economic ideas that will not die despite huge logical inconsistencies and massive empirical failures as “zombie economics.” Austerity is a zombie economic idea because it has been disproven time and again, but it just keeps coming. Partly because the commonsense notion that “more debt doesn’t cure debt” remains seductive in its simplicity, and partly because it enables conservatives to try (once again) to run the detested welfare state out of town, it never seems to die. In sum, austerity is a dangerous idea for three reasons: it doesn’t work in practice, it relies on the poor paying for the mistakes of the rich, and it rests upon the absence of a rather large fallacy of composition that is all too present in the modern world.

Other commentators, such as Paul Krugman, take a more relaxed view, arguing that large debts can be accommodated quite cheaply by running a balanced budget in a positive growth environment, so that real GDP grows faster than the debt, which shrinks the debt stock in real terms over time.

We can, of course, raise issues with each position. To name but an obvious few: low growth could equally lead to more debt, so the solution would be to increase growth, not cut debt. Any savings that could be made through cuts now could simply be given away as yet another tax cut in the near future without any corresponding payoff to coming generations. A refusal by the United States to recycle foreign savings could be just as deleterious to the global economy as the excessive borrowing of foreign money, since the ability of the rest of the world to run a surplus against the United States, necessary because of its export-led growth models, would be compromised. Finally, financial repression, what Krugman implicitly advocates, does have some costs as well as benefits.

If the United States ever gets to the point that it cannot roll over its debt, the supposed big fear, we can safely assume that all other sovereign debt alternatives are already dead. The United States prints the reserve asset (the dollar) that all other countries need to earn in order to conduct international trade. No other country gets to do this. Regardless of ratings agency downgrades, the US dollar is still the global reserve currency, and the fact that there are no credible alternatives (the Europeans are busy self-immolating their alternative, the euro) tilts the balance even more in favor of the United States. US debt is still the most attractive horse in the glue factory, period.

Why, then, are we so worried about US government debt if it is still the best of all the bad options; the deficits that generate it are mainly cyclical; and, as we shall see later in the book, its level pales in comparison to the private debt carried by the citizens and banks of many other states? The answer is that we have turned the politics of debt into a morality play, one that has shifted the blame from the banks to the state. Austerity is the penance—the virtuous pain after the immoral party—except it is not going to be a diet of pain that we shall all share. Few of us were invited to the party, but we are all being asked to pay the bill.

The highest-earning 1 per cent of Americans doubled their share of aggregate income (not including capital gains) from 8 per cent in 1980 to over 18 per cent in 2007. The top 0.1 per cent (about 150,000 taxpayers) quadrupled their share, from 2 per cent to 8 per cent. Including capital gains makes the increase in inequality even sharper, with the top 1 per cent getting 23 per cent of all income by 2007. During the seven-year economic expansion of the Clinton administration, the top 1 per cent captured 45 per cent of the total growth in pre-tax income; while during the four-year expansion of the Bush administration the top 1 per cent captured 73 per cent. … This is not a misprint.

If you reside in the middle or the bottom half of the income and wealth distribution, you rely on government services, both indirect (tax breaks and subsidies) and direct (transfers, public transport, public education, health care). These are the transfers across the income distribution that make the notion of a middle class possible. They don't just happen by accident. Politics makes them happen. Americans did not wake up one morning to find that God had given them a mortgage-interest tax deduction. Those further up the income distribution who have private alternatives (and more deductions) are obviously less reliant upon such services, but even they will eventually feel the consequence of cutting state spending as the impact of austerity ripples back up the income distribution in the form of lower growth, higher unemployment, withered infrastructure, and an even more skewed distribution of resources and life chances. In essence, democracy, and the redistributions it makes possible, is a form of asset insurance for the rich, and yet, through austerity, we find that those with the most assets are skipping on the insurance payments.

Austerity is, then, a dangerous idea because it ignores the externalities it generates, the impact of one person's choices on another person's choices, especially for societies with highly skewed income distributions. The decisions of those at the top on taxes, spending, and investment prior to 2008 created a giant liability in the form of a financial crisis and too big to fail and bail financial institutions that they expect everyone further down the income distribution to pay for. “We have spent too much” those at the top say, rather blithely ignoring the fact that this “spending” was the cost of saving their assets with the public purse. Meanwhile, those at the bottom are being told to “tighten their belts” by people who are wearing massively larger pants and who show little interest in contributing to the cleanup.

In sum, when those at the bottom are expected to pay disproportionately for a problem created by those at the top, and when those at the top actively eschew any responsibility for that problem by blaming the state for their mistakes, not only will squeezing the bottom not produce enough revenue to fix things, it will produce an even more polarized and politicized society in which the conditions for a sustainable politics of dealing with more debt and less growth are undermined. Populism, nationalism, and calls for the return of “God and gold” in equal doses are what unequal austerity generates, and no one, not even those at the top, benefits. In such an unequal and austere world, those who start at the bottom of the income distribution will stay at the bottom, and without the possibility of progression, the “betterment of one's condition” as Adam Smith put it, the only possible movement is a violent one. Despite what Mrs. Thatcher reportedly once said, not only is there something called society, we all live in it, rich and poor alike, for better and for worse.

As we shall see, its intellectual history is both short and indirect. Austerity is not a well worked-out body of ideas and doctrine, an integral part of economic, or any other, theory. Rather, it is derivative of a wider set of beliefs about the appropriate role of the state in the economy that lie scattered around classical and contemporary economic theory.

Chapter 6, “Austerity’s Natural History, 1914–2012,” looks at austerity in practice. Noting that it’s not until you get states that are big enough to cut that you really get debates about cutting the state down, we begin with the classical gold standard and how cuts were built into the script of its operation, with calamitous results.

We examine six cases of austerity from the 1930s: the United States, Britain, Sweden, Germany, Japan, and France, and note how austerity in these cases mightily contributed to blowing up the world—literally—during the 1930s and 1940s.

While this story satisfies some, the moral failings of individuals are irrelevant for understanding both why the financial crisis in the United States happened and why austerity is now perceived as the only possible response, especially in Europe. However, you could have replaced all the actual bankers of 2007 with completely different individuals, and they would have behaved the same way during the meltdown: that’s what incentives do.

The crisis is overexplained in that there are so many possible suspects who can be rounded up and accused of being “the cause” that authors can construct convincing narratives featuring almost any culprit from Fannie and Freddie to leverage ratios to income inequality—even though the meltdown obviously was a deeply nonlinear and multicausal process. The crisis is overdetermined in that, being a nonlinear, multicausal process, many of these supposed causes could be ruled out and the crisis could still have occurred.

I hope to add to these accounts one simple thing: the idea that this crisis is first and foremost a private-sector crisis. In each episode we examine in this book, in the United States, the European Union, and Eastern Europe, we shall see that the crisis was generated by the private sector but is being paid for by the pubic sector, that is, by you and me. We can establish this by thinking counterfactually. One might ask the question, could we have had the crisis if the income distribution had been less skewed, if regulators had been more independent, and if finance had been less powerful? I believe we could. These were important factors—they turbocharged the problem—but they were not essential to it in and of themselves.

In what follows, I focus on four elements that I believe you cannot remove counterfactually and still explain the crisis. These are the bare essentials that made it possible, and they all lie firmly in the private sector. They are—and we shall unpack them in plain English as we go—the structure of collateral deals in US repo markets, the structure of mortgage-backed derivatives and their role in repo transactions, the role played by correlation and tail risk in amplifying these problems, and the damage done by a set of economic ideas that blinded actors—both bankers and regulators—to the risks building up in the system. Again, I stress that these are quintessentially private-sector phenomena. I do this so that I can ask one more question as a setup. If all the trouble was generated in the private sector, why do so many people blame the state for the crisis and see cuts to state spending as the way out of a private-sector mess?

What happened in 2007 and 2008 was a bank run through this repo market. A bank run occurs when all the depositors in a bank want their cash back at the same time and the bank doesn’t have enough cash on hand to give it to them. When this happens, banks either borrow money to stay liquid and halt the panic or they go under. The repo market emerged in the 1980s when traditional banks lost market share because of a process called “disintermediation.” Banks, as intermediaries, traditionally sit in the middle of someone else’s prospective business, connecting borrowers and lenders, for example, and charging fees for doing so. Before disintermediation, banks engaged in what was often called “3-6-3 banking”: they would borrow at 3 percent, lend at 6 percent, and hit the golf course by 3 p.m. It was safe, steady, and dull. But as financial markets became more deregulated in the 1980s, large corporations began to use their own cash reserves, lending them to one another directly—they disintermediated—bypassing banks and squeezing bank profits.

The old 3-6-3 model presumed that the bank that issued a loan to a customer held the loan until it was paid off, with profits accruing from the interest payments it received. But what if these loan payments could be separated out and sold on to someone else? What if many such loans, mortgages for example, could be bundled together as a pool of mortgage payments and sold to investors as an income-generating contract called a mortgage-backed security? That way, the bank that issued the loan could borrow cheaper and make more loans because the risk of the loan not being paid back was no longer on its books, and the borrower would get better rates.

What was wrong was that the risks inherent in these loans never really disappeared: they just got pushed elsewhere. Indeed, the process of selling on loans inadvertently concentrated those risks in short-term repo markets. So, how did everyday mortgages end up in a repo market?

When you and I put our money in a bank, the Federal Deposit Insurance Corporation (FDIC) guarantees it against the failure of the bank: this default risk is covered. But there is no such insurance in the repo markets, so repo-market investors protect their cash by receiving collateral equivalent to the cash lent. If the borrower goes bust, the lender can still get the money back, so long as, and this is critical, the collateral doesn't lose value. What counts as high-quality collateral? Back in the early 2000s, it included such things as Treasury bills, of course. But increasingly, AAA-rated mortgage-debt securities began to be used as collateral, since T-bills were in short supply, which is how mortgages ended up in the repo markets.

In the case of Bear Stearns, as house prices fell and mortgage defaults increased, the value of its investments fell, and its "collateral calls" (what the people it borrowed from would accept to continue lending to the company) rose. As a consequence, Bear Stearns' reputation fell and so did its capacity to borrow, which was a disaster given how much it was levered-up (how much debt it carried relative to its assets).

Leverage is how banks make such absurd sums of money. The Germans have a saying, “when you have two marks, spend one.” In modern banking that becomes “when you have one dollar in the bank, lend thirty or forty or more.” Leverage, the ratio of assets (loans and investments out in the world) relative to equity (reserve capital—the cushion you draw upon when things go wrong), rose precipitously throughout the 1980s and 1990s. If a major bank is running thirty times leverage, as was common in the run-up to the crisis, all it takes is a very small change in its asset values against its equity cushion to make it illiquid, if not close to insolvent. When securitized mortgages started to lose value in 2006, that very small decline became all too real, and the big banks that had funded themselves through the repo market (essentially borrowing overnight to loan for much longer periods with huge amounts of leverage on their balance sheets) saw their funding sources disappear. Liquidity, the very thing repo markets are supposed to provide, dried up, since no one was willing to lend to anyone else at normal rates. And because the banks were so levered up, they didn’t need all their funding to dry up—just enough to make them almost instantly illiquid.

Liquidity, however, does not simply evaporate like the morning dew. It burns up in a “fire sale” as a process called “contagion” takes hold. With everyone in the market knee-deep in mortgage securities and trying to raise money with the same devaluing collateral, they were trying to cash out what were essentially similar assets. And if they couldn’t sell mortgages, they sold anything else they could to raise cash and cover their losses, even supposedly high-quality assets that had nothing to do with mortgages. Because the market could not absorb the volume of securities being dumped on the market all at once, asset dumping to raise cash created the very panic everyone had sought to avoid. Prices plummeted, firms folded, and trust evaporated further.

Note here that this has nothing to do either with the state, which now gets the blame for the debt stemming from this crisis—a wonderful confusion of cause and effect—or with the individual moral failings of the bankers. You can blame regulators for being lax or negligent and politicians for caving to banking interests all you like, but this was a quintessentially private-sector crisis, and it was precisely how you get a multi-billion-dollar financial panic out of a bunch of defaulting mortgages. But it was not yet sufficient to cause a global crisis. To get there, you have to understand how the structure of these mortgage securities combined with unbacked insurance policies called “credit default swaps” (CDSs) to produce a “correlation bomb” that spread the repo market crisis into the global banking system. Again, this had nothing to do with states and their supposedly profligate spending habits and everything to do with weaknesses internal to the private sector.

Whereas an asset is property, or a claim on property or income, a derivative is a contract, a bet that pays out based on how a particular asset performs over a particular time period. That is the key distinction. Derivatives come in multiple combinations of four main types: futures, forwards, options, and swaps.

The idea is that if these different real-estate markets are already uncorrelated, then cutting them up and recombining them should make them super uncorrelated. If the house in Baltimore defaults, the equity tranche holders are wiped out, but that loss is isolated from the holders of the loans on the condominiums and the Upper East Side penthouses. Safety combined with greater returns (at least for those holding the risk) led to an explosion of demand for these securities as US housing prices nearly doubled between 1997 and 2008. They were no longer a simple equity hedge. They became objects of investors’ desire in their own right.

A CDS is basically an insurance policy you can sell on. It insures the purchaser of the CDS against the default of the bond upon which it is written. In return, the issuer of the CDS, the writer of the insurance policy, receives a regular income stream from the purchaser, just as an insurance company receives customers’ insurance premiums. The difference is that insurance companies typically rely on such measures as actuarial tables to calculate the risks they are covering, and then work out how much cash they need to have on hand to cover people cashing in their policies, as they surely will. They also build up cash reserves to pay out on the policy claims that will inevitably be made against the firm. But if the probability of default of a given entity (Lehman Brothers, for example) is considered to be extremely unlikely, and if you write a CDS contract on that entity, you won’t think you have to keep very much capital at all in reserve to cover anticipated losses because no such losses are anticipated.

With a decade of house-price increases telling everyone that house prices only go up, and with these new mortgage derivatives seemingly eliminating a correlation problem that was deemed small to begin with and was now insurable with a CDS, you could almost begin to believe that you had what bankers call a “free option”: an asset with zero downside and a potentially unlimited upside, and one that is rated AAA by the ratings agencies. The fact that many investment funds are legally required to hold a specific proportion of their assets as AAA securities pumped demand still further.

By the mid-2000s the markets couldn’t get enough of these securities, which was a problem because the banks and brokers writing these very profitable mortgages were running out of good borrowers to whom they could lend. The later batches of these securities were therefore increasingly made up of NINJA (no income, no job, no assets) mortgages collateralized by the eBay earnings or bar tips of the new mortgagers, or by purely fabricated income statements and robo-signed paperwork. Because the new mortgages coming in were of such dubious quality, the issuers of these securities increasingly didn’t want to hold any of this dubious risk on their own books and wanted them moved off-book.

But the real surprise, the amplifier, was that the design of these securities, rather than lessening correlation, actually boosted it. … What was uncorrelated in theory became extremely correlated in practice. Making matters worse were the CDS (insurance) contracts attached to the CDOs that would pay out if the security defaulted. If these insurance claims happened en masse, the insolvency of the entire system emerged as a distinct possibility. So, when the scope of CDS protection both written by and written on Lehman by firms such as AIG became apparent, not only did the markets take fright, the state for the first time began to see the problem as systemic rather than idiosyncratic, and too big to fail became a reality.

In principle, the different tranches of the CDO were isolated from each other. If they went bad, they went bad in reverse order, and it was thought that they couldn’t all go bad since different people held different parts of the bond and the underlying markets were uncorrelated. Unfortunately, it turned out that the underlying markets were quite strongly correlated. Adding Manhattan to Arizona and Baltimore in a single security made them correlated. The sheer volume of cash invested in real estate created one big market in US real estate across the world that became increasingly correlated to equities, particularly to the equities of the banks that were trading real estate. When the income streams of the riskiest (junior) part of the bond dried up as NINJA mortgagers walked away from their debts, investors in the more-secure tranches took fright and dumped their assets as part of the general search for liquidity.

In sum, a web of mispriced risks, with the price set at zero, between the “normal” banking system and the shadow banking system was created through the unseen links between mortgage bonds and CDSs that amplified the grossly underestimated existing correlation between assets. A problem that began in the repo market in 2007 was no longer confined there. The crisis spread globally as investors sought the protection of liquidity but failed to find it. Just as one country’s exports depends upon another country’s imports, so one bank’s liquidity depends upon another bank’s willingness to be illiquid. And at that moment, no one wanted to be illiquid.

So, why didn’t anyone see this coming? Queen Elizabeth asked the British economists assembled at the London School of Economics in 2009, who, like analysts everywhere, had failed to see the crisis coming. The answer lies in the way banks measure and manage risk, the third of our seemingly unrelated elements that together generated the crisis and that are quintessentially private-sector, not public-sector failings. Repo runs can start it, and derivatives can amplify it, but to be truly blindsided by a crisis of this magnitude you need to have a theory of risk that denies that catastrophic events can happen in the first place, and then leave it entirely to the self-interested private sector to manage that risk. Unfortunately, almost the entire global financial system worked with just such a theory of risk management.

The first and most basic risk-management technique in finance is called “portfolio diversification,” which tries to ensure that your portfolio of assets is not overly exposed to any single source of risk, except by conscious choice. One way to diversify is to try not to buy the same assets as everyone else. Instead, buy different assets, preferably ones that are uncorrelated or even negatively correlated to other folks’ assets. The second technique is hedging. Rather than simply rely on passive correlations that are out there in the world to ensure your safety, such as the inverse relationship that typically prevails between the USD and the euro, banks can adopt particular strategies, or trade derivative instruments with specific characteristics, so that the gains from one set of exposures covers (hedges) any losses in another.

A common refrain when the crisis first hit was that no one could have seen it coming. It was the financial equivalent of the meteor that wiped out the dinosaurs. All the diversification and hedging strategies that were supposed to keep banks from blowing up were, as David Viniar, the chief financial officer of Goldman Sachs put it, blindsided by “25 standard deviation moves, several days in a row.” This is similar to the “ten sigma event” claim reportedly made by John Meriweather when his hedge fund, Long Term Capital Management (LTCM), blew up in 1998.

What these sigmas refer to is the number of standard deviations from the mean of a probability distribution at which an outcome will, probabilistically speaking, occur, with each higher sigma (number) being increasingly less likely than the last. According to Mr. Viniar, what happened in 2008 was “comparable to winning the lottery 21 or 22 times in a row.” LTCM’s ten sigma in 1998 was, likewise, an event that should have occurred roughly three times in the life of the universe. That these two events happened a mere nine years apart shows us that such claims are nonsense. It also tells us why Nassim Taleb has a huge problem with the idea of risk management and financial engineering.

To understand why this is important, imagine that we have sampled the height of 10,000 randomly selected adults. We find out that most people are between five and six feet tall, that far fewer people are either seven feet or three feet tall, and that no one in our sample is outside that range. Knowing this, we can figure out the probability of any one person of a given size being close to the mean of the distribution. Under a normal distribution, a one-sigma deviation means that there is a 68 percent chance that person is close to the mean height. Two sigmas translates into a 95 percent chance of being close to the mean, and so on, out into the (very) thin tails, where no one is ever eight feet tall. As the numbers get bigger, the probability of encountering someone of such an extreme size gets exponentially smaller. The chance that someone will fall completely outside the sample becomes so unlikely that you can basically forget about it.

What VaR does is generate a figure (a VaR number) for how much a firm can win or lose on an individual trade. … What was the worst that could have happened to the US housing market in 2008? As in the height example, the answer depends on a data sample that calibrates the model. Prior to 2007, the worst downturn firms had data on was the result of the mortgage defaults in Texas in the 1980s, when houses lost 40 percent of their value. Take this data as the parameter limit, or how far out the tail goes before the sigma becomes too large to be imaginable, and you will conclude, given the assumption of a normal distribution of events, that the probability that all the mortgages in your portfolio would lose more than 40 percent of their value at once is ridiculously small.

Key here is the issue of observational experience. If you haven’t been around for a third of the life of the universe (ten sigma), then how can you know what is possible over that time period? It’s the assumed distribution that tells you what is possible, not your experience. To return to the height example, just because your model estimates that an eight-foot-tall person does not exist, it doesn’t follow that she doesn’t actually exist and that you will not run into her. In Taleb’s example, all swans were white until Europeans went to Australia and found black swans. Their exhaustive, multiyear, multisite sample of all known swans had convinced Europeans that all swans were white—until they were not. Nothing in their prior sample, no matter how complete it was, could have told them that a black swan was coming. How, then, do you hedge against risks that are not in your sample? How can you know that which is unknowable until it happens? The answer is, basically, you can’t, and if you think you can, you are setting yourself up for a fall.

One way to think about the problem is to imagine playing a game of Russian roulette. Most people would prefer not to play this game when offered the option because the risk-reward ratio is too high, which is correct if we assume the classic “one bullet and six chambers in the gun” setup. But what if I have information you don’t have, derived from a mathematical model called Brains at Risk (BaR), that tells me the gun has over a billion chambers and only one bullet, and that I can figure out where the bullet is by sampling (pulling the trigger millions of times)? Let’s also say that each time I pull the trigger I receive $100. I click once and am $100 richer, so I click again. By lunchtime, I am a millionaire and have grown confident. In terms of estimating the risk that I face, each “click without a bang” is a piece of information about the probability distribution. As I sample (click) more, I grow more confident about the shape of the distribution. I think that I am generating a more accurate prediction of where the bullet is with each piece of information (click), right up until the moment when I blow my brains out. I have just run into a black swan: a low probability (given the sample and assumed distribution) and (very) high-impact event.

Note once again how none of this has anything to do with the state's spending habits or individual morality. The causes are once again systemic and arise out of the interaction of the parts to produce an outcome that is irreducible to them. Why would people have such faith in a technology that hides risk rather than measures it? To answer that question, we need to address the deepest cause of the crisis—the other reason no one saw it coming: the theories of a generation of economic thinkers who only ever saw markets as good and the state as bad, which takes us back to economics as a morality tale, albeit of a different type.

We tend to think of economic theory as the instruction sheet for running the economy. Like the instructions that come with an IKEA dining table, the theory says that the box marked “the economy” contains X items that fit together in Y order. Ignore the instruction sheet and your economic IKEA dining table will not come out too well. This view sees economic theory as what philosophers call a “correspondence theory” of the world. Whatever the instruction sheet (theory) says about the table (reality) is true about all tables (states of the world) regardless of where and when the information is applied. But what if economic theories are less than these perfect correspondences of the world? What if our knowledge of the economy becomes less relevant over time as the world changes while the theory stays the same? Our theory would then correspond less over time, becoming in the process a less reliable instruction sheet.

Economic theory, for better or worse, provides us with the blueprints for the rules and institutions that we build to run the economy. For example, if you believe that VaR provides an adequate model of risk management, then you might argue that banks should be allowed to manage their own risks with their own models, as the so-called Basel II capital adequacy rules governing bank reserve capital requirements, which were largely written by the banks themselves, argued, and governments dutifully implemented. Or, if you think that the number-one economic problem is always and everywhere inflation, you will probably champion independent central banks to tie the hands of so-called time-inconsistent politicians who, mistakenly, tend to listen to the folks who elected them. But if those institutional blueprints are faulty or those rules are mistaken because the theory they are drawn from differs from how the world actually behaves, then our instruction sheets may produce institutions that are much more fragile than we appreciate.

Finally, economic theories are also partial and rival insofar as different economic ideas contain within them justifications for different distributions of resources. For example, as we shall see in chapter 4, both contemporary neoliberal and classical liberal economic theory focus on the microlevel supply-side of the economy; that is, on how saving leads to investment, which leads in turn to employment and to the wages that buy the products made by the workers themselves, which leads in turn to profits reinvested in the firm. No supply of investment, no demand and no consumption. Keynesian economics, in contrast, argues that consumption drives investment, not saving. For Keynesians it is the macro world of aggregates (income, consumption) and the demand-side of spending that matters. In a Keynesian world, consumers, not investors, are the heroes because consumers’ demands determine what investors supply. No demand, no supply of investment. Given these “rival views of market society,” as the economist Albert Hirschman once put it, who should get, for example, a tax cut? The Keynesian wants to give it to the poor so they will consume now to boost demand and consumption. Meanwhile, the neoliberal wants to give it to the rich to invest wisely. Different economic theories therefore empower, and disempower, different political and economic constituencies.

Economic theory is, then, both much more and much less than an instruction sheet. It is more because it is causally important in the world, and not just a correspondent reflection of it—it is, in the language of economics, endogenous to it. Different theories tell us which rules to pick, which policies to follow, and how to design institutions, providing different payoffs to different groups, in the process changing the world that the theories purport to map. But economic theory is also much less than an instruction sheet because of the partial nature of various theories and how incompletely they map onto the world they strive to describe.

The new instruction sheet, which came to be known as “neoclassical,” or more popularly, “neoliberal” economics, was quite technical, but basically it started from the premise that individuals were not the shortsighted, animal-sprit, driven businessmen lampooned by Keynes, but were instead supersmart processors of information. The new approach distrusted anything bigger than the individual, insisting that accounts of the behavior of aggregates such as “financial markets” had to be based in prior accounts of the behavior of the individuals (investors, firms, funds) that made them up, and that any theory of the behavior of aggregates must be generated from the two main assumptions of this new neoclassical economics, that individuals are self-interested agents who maximize the pursuit of those interests, and that markets clear.

According to this new view, the Keynesian instruction sheet must, in some sense, see individuals as being deluded all the time by government policy; otherwise, they would see the policy coming and anticipate it in their decisions, thus cancelling out its effects on real variables—so-called expectations or “Ricardian equivalence” effects. For example, if I know that the Democrats like to spend money, and that the money they like to spend is my taxes, I will change my spending decisions in advance of the Democrats coming to power to protect my money. Thus, if individuals do invest in being correct, as this new theory suggested, then chronically error-prone individuals would be eliminated from the market, which creates a world in which all the players in the market share the same true model of the economy. Consequently, government can’t do much at all except screw things up by getting in the way. Left alone with common and accurate information, such individuals’ expectations about possible future states of the economy will converge and promote a stable and self-enforcing equilibrium.

As John Eatwell noted a long time ago, these ideas, formalized as the efficient markets hypothesis (EMH) and the rational expectations hypothesis (RATEX), are just as important politically as they are theoretically, for taken together they hold that free and integrated markets are not merely a good way to organize financial markets, they are the only way. Any other way is pathology. Indeed, you may have noticed in this account that the state, along with the business cycle, booms, slumps, unemployment, and financial regulation, is nowhere to be seen. To the extent that the state has a role, it devolves to “doing nothing” since doing something will only produce price distortions that will upset market efficiency.

The problem with the new instruction sheet was that by seeing only equilibrium and efficiency arising out of the trading decisions of supersmart actors, it ignored the possibility of a crisis arising from any source apart from moral hazard or some large exogenous and usually state-induced political shock. It simply could not imagine that the meshing of elements that were each intended to make the world safe, such as mortgage bonds, CDSs, and banks’ risk models, could make the world astonishingly less safe.

The flaw in the logic was once again the expectation that the whole cannot be different from its component parts, that the denial of fallacies of composition haunts us once again. The neoclassical insistence on grounding everything in the micro suggested that if you make the parts safe (individual banks armed with the right risk models), then you make the whole (banking system) safe. But it turned out that the whole was quite different from the sum of its parts because the interaction of the parts produced outcomes miles away from the expectations of the instruction sheet, a sheet that was quite wrong about the world in the first place.

The deep crisis was, then, a crisis of the ideas that had made these instruments and institutions possible. If you believed the new instruction sheet, shadow banks served the real banks by augmenting liquidity and assisting risk transfer. Derivatives made the system safe by making it possible for individuals to sell risk to those willing to buy it, who were presumed to be best suited to hold it by virtue of wanting to purchase it. And the banks themselves, those with skin in the game, were assumed to be the best people to judge the risks they were taking using models they designed themselves, even if it turned out after the fact that the problem was precisely that the banks didn’t have skin in the game since they were moving everything they could off book into SIVs.

The crisis, then, was, much more than the stagflation that discredited Keynesianism, a crisis of ideas. It was a crisis of the instruction sheet of the past thirty years. The claim that the prices at which financial assets traded represented the true economic fundamentals was, when the boom was exposed as a bubble, off by orders of magnitude. The rational expectations of sophisticated investors turned out to be shortsighted and bubble chasing, as irrational exuberance on the upside gave way to runaway pessimism on the downside, just as Keynes had warned about eighty years ago. Viewing moral hazard as the only policy problem led to the decision to let Lehman Brothers fail, which suddenly exposed the global banking system to the risk posed by unbacked CDS contracts.

But most of all, what we couldn't see coming was something that the instruction sheet said was irrelevant, a form of risk that wasn't reducible to the sum of individual risks: systemic risk. Systemic risk is ever present as a residual: it's the risk you cannot diversify away. But it is also emergent from within and amplified by the interlinking of individual agents' decisions in a way that is not predictable from knowledge of those individual decisions. Systemic risk, the risk that cannot be foreseen, the bullet in the chamber of the gun, is what the different elements discussed here combined to produce. Systemic risk blew the efficient market down.

Again, and especially at this level, the crisis had nothing to do with either personal morality or state profligacy. The state had been written into irrelevance beyond providing courts, weights, measures, and defense goods. Just as it didn't start the run on the repo, amplify the crash, or cause risk blindness, so the state had nothing to do with the design of the new instruction sheet. Indeed, the new instruction sheet was designed to keep the state as far away from market processes as possible. Morality was present to be sure, but it was an upturned morality where the naked self-interest of financial market actors was taken to be the most positive virtue because its pursuit led to optimal outcomes despite moral intention.

But what mattered fundamentally was the failure of a set of ideas that justified finance doing whatever it liked because whatever it did was by definition the most efficient thing that could be done. These ideas were supposed to be "the way the world works." So when it turned out that the world didn't work that way, it was hardly a surprise that the rest of the edifice based on them came crashing down. Not to put too fine a point on it, these ideas were battered by a single event that to date has cost, once lost output is included, as much as $13 trillion and, on average, a 40 percent to 50 percent increase in the debt of the states hit by the crisis. That seems to be a very large price to pay to save something that was too big to fail and that wasn't meant to fail in the first place, especially when you and I are expected to pay for it.

Moreover, we must remember that these secondary costs have not gone back to the banks as a bill to be paid for the damage caused. Certainly, a lot of the bailout money has been paid back in different countries, but again, as IMF figures show, the net cost still far outweighs the sums recovered. By late 2010, nearly a trillion dollars remained unrecovered by the states that bailed out their banks. To get a true handle on how much this all cost, however, you would have to factor in the costs of output foregone because of the crisis and add this to these figures.

Lost output from 2008 through 2011 alone averages nearly 8 percent of GDP across the major economies. In some cases, such as Greece and Ireland, the losses are multiples steeper. But the drop in state tax revenues that comes with the crisis is perhaps even more significant because it compounds the loss in GDP. Both GDP loss and lost revenue end up being reflected in, first, the immediate budget deficit, and second, in the increase in government debt needed to plug the shortfall. As the so-called automatic stabilizers kick in, transfers such as unemployment benefits going up at the same time that revenues decrease, the public sector expands its budget as the private sector shrinks. Add to this the discretionary stimulus added by these countries to avoid even further collapses in GDP and revenue, and the net result is the most immediate mechanism for the transformation of bank debt into state debt. Again, according to the IMF, of the near 40 percent average increase in debt across the OECD countries expected by 2015, half has been generated simply replacing lost revenues when tax receipts from the financial sector collapsed. To put it bluntly, the state plugged a gap and stopped a financial collapse. It did not dig a fiscal ditch through profligate spending.

In the United Kingdom, in particular, this collapse in tax receipts was especially alarming since nearly 25 percent of British taxes came out of the financial sector. Little surprise then that Britain's debt ballooned. Of the rest of the increase in government debt, some 35 percent is the direct cost of bailing out the banks. Meanwhile, that antistate whipping boy for the growth in the debt, the fiscal stimulus, amounts to a mere 12 percent of the total. So if you want to blame the stimulus for the debt, you are going to try to account for the missing 87.5 percent of the effect.

A shorthand way of thinking about the decision to bail US banks rather than let them fail is to consider that there are 311 million people in the United States. Of these, 64 percent are aged 16 or over; about 158 million people work. Seventy-two percent of the working population live paycheck to paycheck, have few if any savings, and would have trouble raising $2000 on short notice. There are, as far as we can tell, about 70 million handguns in the United States. So what would happen if there was no money in the ATMs and no paychecks were being paid out? That was the fear. But what was the reality? Was the US financial system, comprising shadow banks, opaque instruments, bad risk models, and flawed blueprints, actually too big to fail?

By the third quarter of 2008, the height of the crisis, the top six US banks, Goldman Sachs, JP Morgan, Bank of America, Morgan Stanley, Citigroup, and Wells Fargo, had a collective asset-to-GDP ratio of 61.61 percent. They ran leverage ratios (assets/equity) as high as 27 to 1 (Morgan Stanley) and as low as 10 to 1 (Bank of America). Compare this to Lehman Brothers' footprint. Lehman was running 31 to 1 leverage on an asset base of $503.54 billion, which is equivalent to about 3.5 percent of US GDP. If that wasn't enough to send the US government running to the tool shed to stop the contagion from spreading through the CDS and repo markets, the possibility of adding just over 60 percent of GDP to the bonfire, the collective total of the banks' asset footprints, would certainly focus the collective mind on the too big to fail problem.

If you think the risk posed by hugely levered US banks that were too big to fail was terrifying, then consider the following: in November 2011 the Financial Stability Board, a coordinating body for national financial regulators, published a list of systemically important banks, in other words, the too big to fail list. Of the twenty-nine banks named, only eight were US banks; seventeen were European. The Europeans have managed to build a system that is too big to bail, which is the real reason why a bunch of putative lefties are squeezing the life out of their welfare states.

Since the 2008 crisis, banks that file with the US Securities and Exchange Commission have awarded themselves $2.2 trillion in compensation. I repeat—since the crisis. Austerity is a great policy for the banks because the people who are to pay for the mess are not the same ones who made it.

Yet today, all we hear about is the profligacy of the Greek government and work-shy and uncompetitive Greek workers as the root cause of Europe's so-called sovereign debt crisis. Again, I stress "so-called" because although the debt-to-GDP ratios of European states have grown substantially since the start of the crisis, from an average of 70 percent in 2008 to 90 percent at the end of 2012, this is the result of the financial crisis that began in the United States in 2007 hitting European shores in 2008 and pushing the European economy into recession. Just as occurred in the United States, the private debt of highly leveraged financial institutions became the public debt of states for two reasons, one already familiar and one generated by the project of European monetary union itself.

The familiar cause was the freezing up in 2008 of the global banking system, which caused the European economy to contract. As states struggled to fill these fiscal holes, public debt once again took the place of private debt as states bailed out and recapitalized their banks (in some cases) at the same time as their automatic stabilizers kicked in to undergird their economies (tax receipts fell while transfers went up in all cases). Already debt-loaded sovereigns that hadn't looked risky before—for instance, Italy's debt-to-GDP ratio was over 100 percent in 2001 and no one seemed to mind—suddenly looked much riskier as their growth slowed and as a consequence their bond yields shot up.

Once the immediate liquidity crunch of 2008 seemed to have passed, the crisis diagnosis preferred by Europe's dominant power was that the continent's problem was a crisis of state spending. The correct policy was therefore to cut the budgets of these profligate periphery states.

In late 2008, it seemed that European banks had escaped the worst of the crisis. Apart from a few German banks and a Belgian bank here or there that got in over its head, what Europe had, said German politicians in particular, was a "crisis of Anglo-Saxon banking." As German finance minister Peer Steinbrück put it, the real cause of the financial crisis was "the irresponsible overemphasis on the 'laissez-faire' principle, namely giving market forces the most possible freedom from state regulation, in the Anglo-American financial system." The European banking model, in contrast, was said to be much sounder because of its conservative practices, so there was no need for Europe to throw money at the problem as the United States and the United Kingdom had done.

There is just one problem with this diagnosis: it is wrong. The ongoing Eurozone crisis really has very little to do with the fiscal profligacy of periphery sovereigns, only one of which, as noted, was meaningfully profligate. There is a crisis in European sovereign debt markets; of that there is no doubt. But treating it as a crisis brought about by debt-fueled consumption and profligate state spending is to confuse correlation (they happened at the same time) with causation (out-of-control spending caused the crisis).

Just as we saw in the US case, the crisis in Europe has almost nothing to do with states and everything to do with markets. It is a private-sector crisis that has once again become a state responsibility. It has almost nothing to do with too much state spending and almost everything to do with the incentives facing banks when the euro, a financial doomsday machine the Europeans built for themselves, was introduced.

Europe's largest economy, Germany, saw the first signs of trouble approaching in August 2007 when IKB, a Dusseldorf-based lender, had to be rescued after suffering losses on its US subprime investments. Following this incident, it seemed for a while that German banks had avoided the crisis, until the state had to step in and rescue the Hypo Real Estate bank in 2008 when its loans to Eastern European mortgagers dried up. This sounded the alarm that other, bigger German banks were still exposed to the East through their loans to Austrian banks, which in turn lent that cash, equivalent to over 70 percent of Austrian GDP, to Eastern European mortgagers whose currencies were now rapidly losing value.

Those fears seemed justified when, in the fourth quarter of 2008, German exports contributed 8.1 percent of an overall 9.4 percent annualized decline in GDP. By mid-2009, the Bundesbank was forecasting a 6 percent GDP contraction by the end of the year. Surprisingly robust demand in Asia, however, made up for declines in the Euro Area. German exports, however, rapidly rebounded. Industrial orders rose throughout 2009, and by August investor confidence had reached its highest point in three years. Germany, it seemed, had dodged the financial bullets emanating from the United States.

The crisis may have shaken neoliberal efficient-market ideas, but to replace them all with global Keynesian stimulus was another matter entirely. Yet that seems to have been just what happened—for about twelve months.

A major reason Keynesianism now became the policy du jour was that governing neoliberal ideas denied that such a crisis was possible in the first place. So when it happened, it was bound to open up room for ideas that said such events were inevitable if you let markets regulate themselves, which is the Keynesian point. It was hard to publicly defend the logic of self-correcting markets when they were so obviously not self-correcting. Indeed, such traditional standard bearers for the neoclassical cause as Eugene Fama, Edward Prescott, and Robert Barro who had previously enjoyed public prominence found themselves confined to the opinion pages of the Wall Street Journal.

Furthermore, neoclassical policy was entirely focused on avoiding one problem, inflation, and providing one outcome, stable prices. It seemed to have very little to say about a world in which deflation was now the worry, and price stabilization meant raising, not lowering, inflation expectations.

Helping such ideas along was the fact that, as Henry Farrell and John Quiggin put it, “There was a significant Keynesian party hidden in the academy,” and it found unexpected allies. Neoclassical economists and fellow travelers who were publicly reassessing their own beliefs during the crisis, such as Martin Feldstein and Richard Posner, joined prominent Keynesian economists such as Paul Krugman and Joseph Stiglitz in the campaign for stimulus, lending Keynesian ideas a new prestige. Even international economic institutions that were famous for forcing austerity on developing countries, such as the IMF, began to argue that monetary tools were not enough to solve the crisis and that an active and coordinated fiscal policy needed to be applied. Parallel institutions that would shortly mount a counterattack against Keynesian policies and ideas, such as the ECB, largely kept out of the debate at this time, giving the Keynesians the stage. Finally, with the entire global payments system at stake and a “leave it to the market” policy that was untenable since the market was in triage, “governments quickly came to believe that monetary policy was insufficient on its own to help the real economy.”

The results were immediate and dramatic. Countries as diverse as Brazil, China, and the United States lined up to stimulate their economies and stymie the contraction of economic activity. China led with a whopping 13 percent of GDP; Spain promised 7 percent; and the United States committed around 5.5 percent of GDP. Even Germany stimulated to the tune of just under 3 percent of GDP. Whether this money was actually spent was another matter entirely, but that it was promised for its intended purpose was significant. As Keynes’s biographer Lord Skidelsky put it in a book celebrating the 2009 rediscovery of Keynes, we had witnessed “the Return of the Master.” The only problem was that by the time the master returned, some very important folks had already left the building: the Germans, followed by the British and the Canadians. The global return of Keynes was to last only a year from start to finish.

German inflation in the 1920s was not the result of a policy of monetary stimulus by the German central bank and treasury trying to stave off a recession. First of all, inflation didn’t just happen to Germany. Other Mittel-European countries, such as Austria, Hungary, and Poland, experienced hyperinflationary episodes at the same time, and none of these episodes was due to the enactment of Keynesian policies. Their common origins lay instead in the fact that World War I had been financed through debt rather than through taxes, which lowered postwar exchange rates and made imports more expensive, which in turn fostered inflation. The inflation pent-up from that earlier period ebbed and flowed for almost a decade.

Yet, it seems an odd argument to make when the classic case of hyperinflation haunting the policy memory of Europe's most powerful country was singularly not caused by a deliberate monetary stimulus attempting to arrest an economic slump.

A second, subtler, ideological argument that pushes in the same direction is that German policy makers are "ordoliberals" (literally, order liberals) rather than neoliberals. … Rather, the German ordoliberal tradition stresses the importance of state provision of the Ramenbedingungen (framework conditions) within which markets can operate. … In short, regulation to make the market possible, rather than regulation to police its rough edges, becomes, along with strong budgetary discipline, the core of a Sozialmarktwirtschaft (social market economy), where the state regulates but doesn't stimulate or experiment, especially with the budget. Ordnungspolitik, a politics of order and stability, especially financial stability policed by a strong independent central bank, is the result.

Its strength was, and still is, based on the export of high-quality manufactures to the rest of the world. This not only made it rich, it enabled what was then West Germany to buy an entirely bankrupt country, East Germany, integrate it into its own economy, and then go on to reduce labor costs, regain competitiveness, brush off the recession following the financial crisis with a shrug, stabilize its banks, and return to export-led growth in 2009, while the rest of Europe fell off a financial cliff.

German policy makers and voters believe the story. The policy lesson learned by the most powerful (and solvent) European state was that policy failures by governments, not financial markets, make crises. Consequently, the policy "success" of 2008—the return of the master and his stimulus measures—was seen by the Germans and their allies at the ECB as a policy disaster waiting to happen whose consequences would only become all too apparent in future inflation. Present debt increases were just the canary in the coalmine. Given this, the Germans were not about to sign on to any more stimulus efforts, regardless of pressure from the United States.

When the crisis hit the United States in 2007 and 2008, it was a Republican administration with an ex-CEO of Goldman Sachs at its fiscal helm that invented the $700 billion Troubled Asset Relief Program (TARP) and engineered the bailout of the US financial system. Putatively Keynesian economists, such as Larry Summers, who were part of the Obama economic team in 2008, merely continued the work of their Republican predecessors. The new team may have been intellectually more attuned to a compensatory logic by virtue of being Democrats, but it was, we should remember, the Democratic administration of Bill Clinton that had balanced the US budget and "ended welfare as we know it." When the crisis hit, the United States may have been on the right ideologically, but it was very much on the left in terms of economic policy.

Europe, in contrast, was populated by left-leaning Social Democrats and center-right Christian Democrats who had spent the previous decade building a currency union that viewed monetary stability plus strict debt and deficit controls as the only policies worth bothering about. Thus, when the crisis hit, the European left (with the exception of the British under New Labour) and center-right argued and behaved in ways that we would normally expect from American Republicans: they championed financial stability, inflation control, and budget cutting as the way to get out of the crisis.

Britain's prime minister, Gordon Brown, who as chancellor of the exchequer presided over the biggest boom and bust in British history while promising financial "prudence for a purpose," spent, lent, or otherwise guaranteed about 40 percent of British GDP to save the banks and even more to stimulate the economy. When the Brown government lost the election to Conservative David Cameron in May 2010, Cameron's party had spent the last two years trying to convince voters that it would not slash social spending and would actually be better than New Labour at providing public services.

During spring 2010, with the immediate danger of financial collapse abated and the new threat of sovereign contagion yet to fully emerge, a new ideological alignment began to take shape. For the previous year the United States, along with the British under the Labour Party's Gordon Brown, had increasingly questioned Germany's commitment to stimulating its economy. Germany was attacked for essentially free-riding on other countries' stimulus efforts, a charge it denied. In fairness, when one takes into account Germany's actual stimulus measures, such as its work-time subsidy and the impact of its bigger welfare state in a downturn, the Germans had more than a point in their favor.

Days before the G20 meeting, ECB chief Trichet explicitly rejected Keynesian demand-deficiency arguments, citing the need for “a budget policy … that we would call confidence building” that centered upon the reduction of debt. Two days later, the German finance minister Wolfgang Schäuble published an extended piece in the Financial Times in which he stressed the need for “expansionary fiscal consolidation.” Invoking the specter of future inflation, he declared that “we [Germany] … are … more preoccupied with the implications of excessive deficits and the dangers of high inflation.” As such, Germany would not respond to the crisis by “piling up public debt.” By the time of the Toronto meeting, the Canadians and the British had sided with the Germans, leaving the Americans isolated. The final communiqué of the Toronto meeting repeated the meme, authored by Trichet and amplified by Schäuble, of “growth friendly fiscal consolidation.” Seen at the time as a fudge between the Keynesian and orthodox positions, what it actually signaled was the end of global Keynesianism.

Following on the heels of the G20 communiqué came the ECB’s June 2010 Monthly Bulletin, which was an unabashed restatement of neoclassical economic ideas and a call for “growth friendly fiscal consolidation” going forward. In the Bulletin, “Ricardian consumers” with rational expectations who anticipated the effects of government policies years ahead went on display, alongside inflation-averse and confidence-sensitive investors appalled at the prospect of government “crowding out” investment, future inflation, and ever-larger government debts. As Stephen Kinsella argues regarding the seemingly contradictory logic of expansionary fiscal consolidation, “Proponents of this theory argue that fiscal contraction, rather than leading to a decline in output … will result in higher output … [as] consumers and investors anticipate long run tax deductions because of cuts in expenditure [which will] offset … the contraction.” Given this version of rational expectations theory, the ECB could only conclude that austerity had to be the way forward because “the longer-run benefits of fiscal consolidation are largely undisputed.” Undisputed, that is, so long as the question is posed only in terms of this narrow rational-expectations model.

Greece had long been the problem child of the European periphery. It came out of World War II and went straight into the bloodiest civil war in modern European history. When it ended, the already poor country stagnated (as the rest of Europe boomed) inside an unstable political order that finally collapsed into a brutal military dictatorship. When Greece emerged from the dictatorship period and stabilized in the late 1970s, the European Economic Community (the EEC, as the EU was then known) provided it with much-needed external funding for infrastructure investment while its modern political party system took shape.

Greek politics in the 1980s and 1990s was dominated by the socialist Papandreou administrations that sought to increase personal income and public consumption, an understandable response to decades of instability, violence, and political polarization. These governments ran persistently expansionary policies that, given the country’s low productivity growth, resulted in increasing debts and widening deficits. (In fact, Greece hasn’t run a budget surplus in fifty years.) Debt to GDP passed 100 percent in 1994, hovered around 105 percent for a decade, and then shot up as a result of the financial crisis in 2008, reaching 165 percent of GDP in late 2011.

What made this spending possible was that having adopted the euro, Greece and the other European periphery states (Portugal, Italy, Spain, and Ireland) were effectively endowed with Germany’s credit rating on the assumption that the ECB would back all outstanding debt issued by member states since it was all in the “same” new euro currency. As such, the historically high borrowing costs of these countries fell. Greece’s borrowing costs, for example, fell from 20 percent on a ten-year bond before the introduction of the euro to around 4 percent in 2005, and in the case of Greece in particular, more borrowing was the result. Since Greece was able to borrow more easily, money became more plentiful locally, financing both consumption and investment. However, this also raised Greece’s labor costs relative to its Euro Area neighbors; its competitiveness fell, widening its current account deficit—Greece was importing more than it was exporting with the extra cash.

Greece had some special structural problems that turned these vulnerabilities into accidents waiting to happen. First, leaving aside all the often-repeated stories of endemic corruption and dubious early retirements, of which there are many, Greece has a weak tax-collection capacity and an even weaker political will to enforce collection, so revenues have never balanced expenditures. Second, government spending was notoriously uncoordinated, with the result that in October 2009 the Greek government revealed that the reported fiscal deficit of 6.5 percent of GDP was in fact closer to 13 percent of GDP. Unsurprisingly, investors regarded this as the ringing of a rather loud alarm bell over the true state of Greek public finances. The low interest rates that Greek debt had enjoyed since adopting the euro via that borrowed German credit rating shot up, which made a difficult interest-payment environment very suddenly awful. Piling on the pressure, the ratings agencies took notice and downgraded Greek bonds from A to BBB−, which compounded the debt burden by lowering prices and further spiking yields. As a result, the economy began to contract such that outstanding debt increased as GDP collapsed.

The ideal policy back in 2009 would have cost around 50 billion euros. It would have required either the ECB, or Germany as its major creditor, to buy the secondary-market Greek debt that was subject to near-term rollover risk, bury it somewhere deep in its balance sheet, and walk away. Why didn’t they do so? One answer lies in German politics. There was a regional election coming up in Germany, and it was politically easier to blame the Greeks for being feckless than it was to explain to the German public that the ECB needed to bail them out for reasons of systemic risk. The other answer lies in the ECB statutes that forbid one country to bail out another for fear of generating moral hazard. Such bailouts are, except in exceptional circumstances (the treaty in question mentions natural disasters) not allowed. Remember, the ECB only has one problem, price inflation, and one tool, the rate of interest. As such, the ECB was completely unable, and the Germans were completely unwilling to take responsibility. As a consequence, investors began to price in the risk of contagion as increasingly likely, and the yields on all periphery bonds began to rise, which is why Portugal, Ireland, Spain, and Italy got lumped together with Greece. The PIIGS collective was born in the fires of contagion risk. Unfortunately, while the collective acronym is attractive, the problem is that Ireland, Spain, Portugal, and Italy are nothing like Greece.

Unlike Greece, both Ireland and Spain were “best in class” in terms of debts and deficits going into the crisis. In 2007 Ireland’s net debt-to-GDP ratio was 12 percent, and Spain’s was 26 percent. In contrast, Germany’s debt sat at 50 percent of GDP. Why, then, did Ireland and Spain have a crisis when Germany did not? The answer, as usual, begins and ends with the banks, in this case via real-estate lending.

To fund lending on such a massive scale, Irish banks increasingly turned to wholesale funding markets in the United States (the repo markets we learned about in chapter 2), essentially borrowing overnight to fund thirty-year mortgages. The three main Irish banks’ combined asset footprint at the time of the crash was around 400 percent of GDP.

Fearing financial Armageddon, the Irish government issued a blanket guarantee for the entire banking system's liabilities, and that 400 percent of assets as GDP on the private sector's balance sheet very suddenly became the Irish public's problem. The combined result of the property-bubble collapse and the banking system implosion was "the largest compound decline in GNP of any industrialized country over the 2007–2010 period." Government debt increased by 320 percent to over 110 percent of GDP as the government spent some 70 billion euros to shore up the banking system. Meanwhile, unemployment rose to 14 percent by mid-2011, a figure that would have been higher had it not been for emigration.

Rather than having three big banks that dominate all domestic lending, as in the Irish case, Spain's largest banks are internationalized and are therefore somewhat hedged against domestic turbulence. In Spain the real problem, as became plain in the spring of 2012, lay in the regional savings banks: the cajas de ahorros.

To understand where Spain is today, you have to start from the fact that in 1979 Spain was the eighth-largest industrial economy in the world. Today, it has slipped to seventeenth place. In between, Spain effectively deindustrialized, becoming a banking, services, and tourism hub. The problem is that the income streams such a growth model relies on come primarily from outside the country: when such people stop spending and lending, you are in serious trouble. It's even more of a problem when what domestic growth you do have is debt-financed and based on little more than the swapping of houses.

According to Bank of Spain data, while Spain's ten-year headlong rush into housing produced a 115 percent increase in house prices between 1997 and 2007, the United Kingdom's bubble was bigger still at 140 percent, and Ireland topped the list at 160 percent. Why Spain matters much more than Ireland, however, is that Spanish GDP is approximately seven times the size of Ireland's; Spain is the fourth-largest economy in the Eurozone and is responsible for almost 10 percent of Euro Area GDP. As such, the popping of the Spanish housing bubble was going to matter in more than just Spain.

Where Ireland differs from Spain—apart from the magnitude of the bust—lies in the peculiar institutions of Spanish banking. As mentioned earlier, with their international portfolios the big three Spanish banks are reasonably well hedged against domestic exposures. Where, then, did this volume of credit come from? The answer was the cajas de ahorros, the regional savings banks (think US credit unions), especially the conglomerate version, Bankia, that went bust in 2012. These institutions together made nearly 50 percent of all domestic banking-sector loans. The cajas matter because their loan books are opaque (think subprime); they are undercapitalized; and most importantly, they are stuffed full of assets that are not coming back any time soon, particularly because the assets in question were so mispriced to begin with.

Add to this the fact that Spanish mortgages are recourse loans, meaning that the bank can come after the debtor for the original loan—forever—and not for just the current value of the property, and mortgagers have every incentive to sit tight and not allow the market to clear, thus making the situation worse by inches. In the United States you can walk away from a mortgage and the house is the bank’s problem. In Spain, when you walk away from the house, the mortgage debt is still your problem.

Take Ireland and Spain together and you do not have a story of profligate states, feckless workers, and all the rest. Certainly, the Spanish regional governments have a few white elephant projects that have worsened the situation, airports that have no traffic, massive opera houses with no customers, and the like; but these are symptoms, not causes. Indeed, in the Basque country, where there was more political control of the cajas, investment in property was not allowed to the same extent and the result was investment in manufacturing. The underlying crisis is, once again, one of private, not public, finance.

A Greek default would be a risk on its own, but if it spread to Ireland and then Spain, all bets would be off.

What the PIIGS all have in common was how their adoption of the euro made the interest payments on their bonds fall as core banks came to prefer their debt to even lower-yielding German and French debt. Yet, despite all the cheap money this produced in the PIIGS, Portugal was in trouble long before the crisis of 2008.

Portugal’s two main export industries, footwear and textiles, were clobbered by Asian and Eastern European competition in the 1990s. As a consequence, its trade deficits widened and its competitiveness fell while the services sector, much of which is nontradable, took up the slack. Young people increasingly went into education, temporarily lowering, at the public expense, the unemployment rate, without necessarily increasing skills. As The Economist magazine wryly noted, “The number of lawyers increased by forty-eight percent between 2000 and 2010.” Meanwhile, growth per person averaged 0.2 percent per year over the same period, while combined public and private debts reached over 240 percent of GDP by 2010.

Demography compounds these problems. Portugal is ranked 178th out of 230 countries in population growth and 195th in births. The median age of the country is forty, and 18 percent of the population is already over sixty-five years old. Before the crisis these things could be ignored because capital flows from the European core to the periphery masked the chronic lack of growth in these countries. But once those flows stopped in 2010 in a context of market worries about Greek and Irish indebtedness, what was not a problem before—long-term growth dynamics—suddenly became one. After all, if the underlying dynamics are not there to support growth, then no amount of austerity will reduce the debt accrued.

Italy is a giant version of Portugal while being in many ways the polar opposite of Spain. Italy has low private debt and massive public debt. Massive, in the sense that Italy has the third-largest bond market in the world. Let’s think about that for a moment. A southern European country with the world’s twenty-third-largest population and eleventh-largest economy has the world’s third-largest bond market. How did that happen? Look only at Northern Italy, and you see one of the most developed industrial countries in the world, with competitive exports, price-inelastic products, and high incomes. Include the south of Italy, and you see a rather different world of agricultural producers and small, low-productivity firms.

What united these two very different versions of Italy was a political system that transferred resources from the North to pay for the South while not fully taxing its citizens to make up the shortfall because of the persistence of traditional class alignments in the South. As a consequence, persistent deficits, which turned into debts that were reduced by persistent devaluations of the exchange rate, made it possible. Adopting the euro ruled out such devaluations, but the collapse in interest rates that it engendered sustained the unsustainable a bit longer. In 2000, Italian net debt to GDP was 93 percent. In 2007, it was 87 percent. Today, it is 100 percent, as the crisis and austerity policies lower the Italian economy's already sclerotic growth rate of about 1.5 percent a year (for the past twenty-five years) while the debt owed gets bigger still and rates have shot up.

As in the case of Portugal, what wasn't an issue in 2000 suddenly became one in 2010 when the markets noticed three things: Italy does indeed have the third-biggest bond market in the world; its growth rate is terrible, so its ability to pay back or even roll over its debt if interest rates go up is extremely constrained; and, its demographics are even worse than Portugal's. While Italy is ranked 158th out of 230 countries in population growth, a marginal improvement over Portugal, it is ranked 207th in births. The median age of the population is 43.5, and 20 percent of the country is already over sixty-five years old. Given that one of the few truly linear events in life is death (there are no 200-year-old people out there), over one-third of Italy's population will be over sixty-five by 2035.

If Spain is Ireland writ large, then Italy is Portugal writ large. That these states can't grow out of the debt they have accumulated is true. That there is a sovereign bond crisis involving these states is also true. But are the PIIGS really in trouble because of a crisis of government spending? In the Italian case the reliance on deficits that became debts and on devaluations that were substituted by cheap capital flows and artificially low yields once the euro came in, suggests a slow-moving fiscal train wreck, where eventually markets woke up to the fact that thirty years from now there will be no one in Italy working to pay off the interest on those thirty-year bonds since they will be too busy paying for pensions. Moreover, markets no longer view what was sustainable in 1999—running a debt-to-GDP ratio of over 100 percent—as sustainable now given the contagion risk from the other PIIGS. The perception of the risk has changed, rather than the underlying risks themselves, which have always been there.

So, is the state complicit? Yes. Did the state cause these problems? No. Not unless we are willing to say that in Italy the level of family fertility is a fiscal responsibility and thus the state’s problem. In the Portuguese case, while demographics and low productivity play their parts, Portuguese net debt to GDP in 2000 was 52 percent and in 2007, 66 percent, which is hardly evidence of a spending splurge. Rather, in both cases, what was once seen as sustainable suddenly became seen as unsustainable once the possibility of a contagion-led fire sale through the European bond markets was factored into a slow-moving growth crisis. As usual, it’s the perception of risk that matters. And again, just as we saw in the US case, there was no orgy of government spending behind all this. Why, then, keep up the fiction that the bond market crisis is a crisis of spendthrift governments?

In May 2010, Greece received a 110-billion-euro loan in exchange for a 20 percent cut in public-sector pay, a 10 percent pension cut, and tax increases,. The lenders, the so-called troika of the ECB, the European Commission, and the IMF, forecast growth returning by 2012. Instead, unemployment in Greece reached 21 percent in late 2011, and the economy continued to contract. In November 2010, Ireland needed a bailout and received 675 billion euros for a 26 percent cut in public spending. In March 2011, it was Portugal’s turn, and it received 78 billion euros in exchange for a similar packet of reforms. However, given the contraction in all these economies and the fear of contagion, yields on Portuguese ten-year debt reached 17 percent in early 2012, and their ten-year bonds were downgraded to BBB−, otherwise known as junk.

Despite these austerity binges, Greek debt is projected (if all things remain equal for the next eight years, which will never happen) to reach 120 percent of GDP by 2020. The IMF thinks 145 percent by 2020 is more likely. Just to keep things on track, democratically elected governments in Greece and Italy were deposed and replaced by unelected technocrats who promised to keep the reforms going.

It is worth noting the timing of events. Opposition to Keynesian policies intensified in spring 2010 just as the Greek crisis became newsworthy despite Greece’s accounting for only 2.5 percent of total Eurozone GDP. In the United Kingdom, Germany, and the United States, politicians in favor of austerity zeroed in on the Greek crisis as a metaphor for the perils of Keynesianism. “Becoming Greece” became a scare story to justify cutting back at home.

The offensive against Keynesianism at the global level was married to the discovery of the Greek debt crisis and amplified via the threat of contagion to establish fiscal austerity as the new policy du jour. But in doing so, cause and correlation were confused, quite deliberately, on a massive scale.

The result of all this opportunistic rebranding was the greatest bait-and-switch operation in modern history. What were essentially private-sector debt problems were rechristened as “the Debt” generated by “out-of-control” public spending. Yet, of all the PIIGS, only Greece was in any meaningful sense profligate. Italy may have been lax, but no one minded them having the third-largest bond market in the world until 2010, when contagion plus demographics gave pause to the holders of Italian debt. Portugal may have spent a fair amount on modernizing its infrastructure and built a few high-speed rail lines of dubious need, but it was hardly spending its way to oblivion. Ireland and Spain were quintessential private-sector-housing-cum-banking crises, governed by states more fiscally prudent than Germany, where the risks were socialized while the profits were privatized. In all cases, private-sector weaknesses ended up creating public-sector liabilities that European publics now have to pay for with austerity programs that make the situation worse rather than better. The fiscal crisis in all these countries was the consequence of the financial crisis washing up on their shores, not its cause. To say that it is the cause is to deliberately, and politically, confuse cause and effect.

We really should know better. Carmen Reinhart and Kenneth Rogoff, no friends of Keynesian policy, note that a banking crisis is followed by a sovereign debt crisis 80 percent of the time. Reinhardt and Rogoff stop short of using the word “cause.” However, as Moritz Schularick and Alan Taylor have shown, sovereign debt crises are almost always “credit booms gone bust.” They develop in the private sector and end up in the public sector. The causation is clear. Banking bubbles and busts cause sovereign debt crises. Period. To reverse causation and blame the sovereign for the bond market crisis, as policy makers in Europe have repeatedly done to enable a policy of austerity that isn’t working, begs the question, why keep doing it?

While it is tempting to say that neither German politicians nor ECB bankers understand fallacies of composition and both are allergic to inflation, and leave it at that, there is a more satisfying answer, and it's the same one we saw in the US case: what starts with the banks ends with the banks. To really understand why Europe has been slashing itself to insolvency, we need to embed these very real ideological and political factors within an account of how the euro as a currency enabled the development of a system of banks that is too big to bail. If the US had banks that were too big to fail, Europe has a system of banks that are collectively too big to bail. That is, no sovereign can cover the risks generated by its own banks because the banks are too big and the sovereign doesn't have a printing press. In this world there can be no bailout big enough to save the system if it starts to fail. Consequently, the system cannot be allowed to fail, which is the real reason we must all be austere. In the United States we were afraid of the consequences of the banks failing. In Europe they are terrified of the same thing, and as we shall see, they are terrified for good reason.

To get there we encounter some very familiar themes: subprime mortgage special purpose vehicles (SPVs), repo market collateral problems, and banks chasing yield in a low-interest-rate environment, as well as some unfamiliar ones such as bank resolution regimes (who has the responsibility to bail or fail banks), moral hazard trades (too big to fail as a business model), and why national debt issued in a common currency is a really bad idea. Taken together they explain why we really all need to be austere: because once again we need to save the banks, from themselves. But this time around no politician, especially in Europe, is going to admit that is exactly what is being done, which is why the bait and switch is needed.

For people and firms, it was a pain to have to change currencies to travel or trade, and having to do so reduced both. At the state level the argument was that all the different exchange rates moving together generated currency volatility that was hard to hedge against, and it created incentives for weaker currencies to seek respite by devaluing against their stronger trading partners to improve their own competitiveness, which many European states did, repeatedly. The problem with devaluation as an adjustment policy is not only that it beggars thy neighbor; it also leads to import inflation in the countries that devalue. Italy became the poster child for these problems, having devalued the lira every year between 1980 and 1987, save 1984, thereby suffering much higher-than-average inflation than the rest of Europe while effectively reducing the average Italian's real wage through the inflationary back door.

The problem with keeping up with the Germans is that German industrial exports have the lowest price elasticities in the world. In plain English, Germany makes really great stuff that everyone wants and will pay more for in comparison to all the alternatives. So when you tie your currency to the deutsche mark, you are making a one-way bet that your industry can be as competitive as the Germans in terms of quality and price. That would be difficult enough if the deutsche mark hadn't been undervalued for most of the postwar period and both German labor costs and inflation rates were lower than average, but unfortunately for everyone else, they were. That gave the German economy the advantage in producing less-than-great stuff too, thereby undercutting competitors in products lower down, as well as higher up the value-added chain.

The only way to maintain a currency peg is to either defend it with foreign exchange reserves or deflate your wages and prices to accommodate it. To defend a peg you need lots of foreign currency so that when your currency loses value (as it will if you are trying to keep up with the Germans), you can sell your foreign currency reserves and buy back your own currency to maintain the desired rate. But if the markets can figure out how much foreign currency you have in reserve, they can bet against you, force a devaluation of your currency, and pocket the difference between the peg and the new market value in a short sale.

George Soros (and a lot of other hedge funds) famously did this to the European Exchange Rate Mechanism in 1992, blowing the United Kingdom and Italy out of the system. Soros could do this because he knew that there was no way the United Kingdom or Italy could be as competitive as Germany without serious price deflation to increase cost competitiveness, and that there would be only so much deflation and unemployment these countries could take before they either ran out of foreign exchange reserves or lost the next election. Indeed, the European Exchange Rate Mechanism was sometimes referred to as the European “Eternal Recession Mechanism,” such was its deflationary impact. In short, attempts to maintain an anti-inflationary currency peg fail because they are not credible on the following point: you cannot run a gold standard (where the only way to adjust is through internal deflation) in a democracy.

Well, you can try, and the Europeans building the EU are nothing if not triers. Following the Exchange Rate Mechanism debacle, in a scene reminiscent of one in Monty Python’s movie The Holy Grail in which the king tells his son that “they said you couldn’t build a castle on a swamp, so I did it anyway, and it fell down, so I did it again, and it fell down, so I did it again, and it fell down,” the Europeans decided to go one step further than pegging to the deutsche mark—they would all become German by sharing the same currency and the same monetary policy.

The euro, the successor to the Exchange Rate Mechanism, would become a one-time internal fix of all the different European currencies in exchange for a single external floating currency, with one important difference. Rather than pegging and retaining national currencies and printing presses, after the fix the national currencies would be abolished and the printing presses would be handed over to the Germans to make sure that neither inflation nor devaluation of the currency would ever again be options. Instead, armed with a new independent central bank that had only one goal, to keep inflation around 2 percent, regardless of the output and employment costs, via control of interest rates, prices and wages would automatically adjust to the external balance. In other words, they built a gold standard in a democracy, again.

At the time of its launch, many economists predicted that the euro would fail. Martin Feldstein noted that the countries adopting the euro did not constitute an “optimal currency area,” where business cycles and the like would be strongly integrated such that efficiency gains could be realized. Paul Krugman saw trouble in the decade of recession and unemployment necessitated by the convergence criteria of the Maastricht Treaty of 1992, the precondition for adoption of the euro, where budget deficits, debts, and inflation rates all had to be cut at the same time. Both were correct, but what really caused problems was that instead of creating convergence, the introduction of the euro created a great divergence between European economies (see figure 3.1) in almost everything except their bond spreads and balance of payments.

If a picture paints a thousand words, figure 3.2 paints a million. On the left-hand side, we see what the markets used to think of sovereign bonds before the euro was introduced. Greek ten-year bond yields started out at 25 percent, fell to 11 percent, and then came within fifty basis points (half a percent) of German bonds by 2001. Similarly, Italian bonds fell from a high of 13 percent in 1994 to becoming “almost German” in 2001 in terms of yields. Yet it is manifestly obvious that neither Greece nor Italy, nor Ireland, nor anyone else, actually became Germany, so why then did we see this convergence in yields? The popular answer is that the introduction of the ECB and its unending quest for anti-inflationary credibility signaled to bond buyers that both foreign exchange risk and inflation risk were now things of the past. The euro was basically an expanded deutsche mark, and everyone was now German.

Despite the fact that national bonds were still issued by the same national governments, banks and other financial players loaded up with them, assuming that the risks we saw on the left-hand side of figure 3.2 had all been magically sponged away by adoption of the euro. This flooded the periphery states with cheap money, completely swamping local wholesale funding markets, thereby making them vulnerable to the capital flight that was to render them illiquid in 2011, while pumping up, in the case of Spain in particular, private-sector indebtedness. While the Northern lenders lent to local banks, property developers, and the like, periphery consumers used this tsunami of cheap cash to buy German products, hence the current account imbalances noted earlier.

But why did these bond buyers believe that this new and untested institution, the ECB, would in fact guard the value of their bonds, that national governments didn’t matter any more, and that Greece was now Germany? The answer was, they didn’t need to believe anything of the sort because arguably what they were doing was the mother of all moral hazard trades.

If you were a European bank back in the late 1990s seeing sovereign bond yields falling, it might have bothered you since a source of risky profits was disappearing. On the other hand, if this new ECB gizmo really did get rid of exchange-rate risk for the sovereigns issuing the debt and take inflation off the table by housing in Frankfurt the only money press in Europe, then it really was a banker’s dream—a free option—safe assets with a positive upside, just like those CDOs we saw in the United States. So you would be a fool not to load up on them, and European banks did exactly that. But as yields converged, you would have to buy more and more bonds to make any money. There was, however, a small but significant difference in yield between the bonds of Northern European sovereigns and those of the periphery after the yields converged. So, if you swapped out your low-yield German and Dutch debt and replaced it with as much PIIGS debt as you could find, and then turbocharged that by running operating leverage ratios as high as 40 to 1—higher than your US counterparts—you would have one heck of an institutionally guaranteed money machine.

Imagine that you knew Greece was still Greece and Italy was still Italy and that the prices quoted in the markets represented the bond-buying activities of banks pushing down yields rather than an estimate of the risk of the bond itself. Why would you buy such securities if the yield did not reflect the risk? You might realize that if you bought enough of them—if you became really big—and those assets lost value, you would become a danger to your national banking system and would have to be bailed out by your sovereign. If you were not bailed out, given your exposures, cross-border linkages to other banks, and high leverage, you would pose a systemic risk to the whole European financial sector. As such, the more risk that you took onto your books, especially in the form of periphery sovereign debt, the more likely it was that your risk would be covered by the ECB, your national government, or both. This would be a moral hazard trade on a continental scale.

Now, either because they really believed that the untested ECB had magically removed all risk from the system or saw the possibilities of a moral hazard trade, or both, major European banks took on as much periphery sovereign debt (and other periphery assets) as they could. Indeed, as we shall see below, these banks were incentivized by the European Commission to get their hands on as many periphery bonds as they could and use them as collateral in repo transactions, thereby upping the demand for them still further. There was, however, one slight flaw in the plan. While bank lending and borrowing may be cross-border in the Eurozone, bank resolution and bailout responsibilities (notwithstanding the 2012 proposal for an EU banking union, which does little to fundamentally address these problems) are still national. So, while any individual bank could play this moral hazard trade, if they all did it, all at once, then what was individually too big to fail became very quickly too big to bail as a whole. Once again, the dynamics of the system were different from those of the sum of the parts.

In sum, in each country, and across the Eurozone as a whole, European banks have become too big to bail. No sovereign, even with its own printing press, can bail out a bank with exposures of this magnitude. If you have signed up to a currency arrangement whereby you gave yours away, you really are in trouble. As Simon Tilford and Philip Whyte put it bluntly, the Eurozone crisis is “a tale of excess bank leverage and poor risk management in the core … [and] the epic misallocation of capital by excessively leveraged banks.”

From the start the euro was a banking crisis waiting to happen. One trigger for the crisis was Greece and the discovery that the PIIGS were pushing up yields, as detailed earlier. The other trigger was a series of events that happened, just as we saw in the United States in 2008, deep within the banking system itself and that centered upon the use of government bonds as repo collateral for funding banks. Once again, what is portrayed as a public-sector crisis is, at its core, an almost entirely private-sector (banking) problem.

Besides being funded via short-term borrowing on US markets, it turned out that those conservative, risk-averse European banks hadn’t missed the US mortgage crisis after all. In fact, over 70 percent of the SPVs set up to deal in US “asset backed commercial paper” (mortgages) we encountered in chapter 2 were set up by European banks. The year 2008 may have been a crisis in the US mortgage markets, but it had European funders and channels, and most of those devalued assets remain stuck on the balance sheets of European banks domiciled in states with no printing presses.

Recall that in the United States in 2008, the collateral being posted for repo borrowing began to lose value. As such, the firms involved had to post more collateral to borrow the same amount of money, or they ran out of liquidity real fast, which is what happened to the US banking system. The same thing began to happen in Europe. While mortgage-backed securities, the collateral of choice for US borrowers in the US repo markets, were AAA-rated, for European borrowers in London the collateral of choice was AAA-rated European sovereign debt. Just as US borrowers needed a substitute for T-bills and turned to AAA mortgage bonds, so European borrowers had too-few nice, safe German bonds to pledge as collateral since the core banks were busy dumping them for periphery debt. So they began to pledge the periphery debt they had purchased en masse, which was, after all, rated almost the same, a policy that was turbocharged by a EC directive that “established that the bonds of Eurozone sovereigns would be treated equally in repo transactions” in order to build more liquid European markets. By 2008, PIIGS debt was collateralizing 25 percent of all European repo transactions.

As investors fretted about European sovereigns, credit-ratings agencies started to downgrade those sovereigns, and their bonds went from AAA to BBB and worse. As such, you needed to pledge more and more of these sovereign bonds to get the same amount of cash in a repo. Unfortunately, with around 80 percent of all such repo agreements using European sovereign debt as collateral, when those bonds fell in value, the ability of European banks to fund themselves and keep their highly levered structures going began to evaporate.

By early 2010, Eurozone banks had a collective exposure to Spain of $727 billion, $402 billion to Ireland, and $206 billion to Greece. French and German bank exposures to the PIIGS were estimated in 2010 to be nearly $1 trillion. French banks alone had some $493 billion in exposures to the PIIGS, which was equivalent to 20 percent of French GDP. Standard & Poor’s estimated French exposures to be as high as 30 percent of GDP, all told.

Again, the vast majority of these exposures were private-sector exposures—property lending in Spain, and the like. The sovereign component of these figures was comparatively small. But what mattered was how levered these banks were and how important those sovereign bonds were for funding these banks. Once these bonds lost value, European banks increasingly found themselves shut out of US wholesale funding markets at the same time that US money markets began dumping their short-term debt. What happened in the United States in 2008, a general “liquidity crunch,” gathered pace in Europe in 2010 and 2011. It was only averted by the LTROs of the ECB in late 2011 and early 2012.

So, why, then, do European governments play the great bait and switch and then blame it all on sovereigns that have spent too much? Basically, it’s because in a democracy you can hardly come clean about what you are doing and expect to survive. Imagine a major European politician trying to explain why a quarter of Spain needs to be unemployed, and why the whole of periphery Europe needs to sit in a permanent recession just to save a currency that has only existed for a decade.

What actually happened was that the biggest banks in the core countries of Europe bought lots of sovereign debt from their periphery neighbors, the PIIGS. This flooded the PIIGS with cheap money to buy core country products, hence the current account imbalances in the Eurozone that we hear so much about and the consequent loss of competitiveness in these periphery economies. After all, why make a car to compete with BMW if the French will lend you the money to buy one? This was all going well until the markets panicked over Greece and figured out via our “kick the can down the road” responses that the institutions we designed to run the EU couldn’t deal with any of this. The money greasing the wheels suddenly stopped, and our bond payments went through the roof.

The problem was that we had given up our money presses and independent exchange rates—our economic shock absorbers—to adopt the euro. Meanwhile, the European Central Bank, the institution that was supposed to stabilize the system, turned out to be a bit of fake central bank. It exercises no real lender-of-last-resort function. It exists to fight an inflation that died in 1923, regardless of actual economic conditions. Whereas the Fed and the Bank of England can accept whatever assets they want in exchange for however much cash they want to give out, the ECB is both constitutionally and intellectually limited in what it can accept. It cannot monetize or mutualize debt, it cannot bail out countries, it cannot lend directly to banks in sufficient quantity.

Jay Shambaugh sees the euro as caught in three interlocking crises, each of which worsens the others. He sees the Euro Area's banking problem compounding the sovereign debt problem, which in turn (via austerity) hurts growth in the name of fostering competitiveness, which is undermined by deflation. … With no EU-wide fiscal authority, only a monetary one, there are no shock absorbers in the system of the type you would find in, for example, the United States. When a firm closes in Michigan and moves to Mississippi, capital flows out of one state and into another, but taxes raised in Connecticut smooth the adjustment through federal transfers. Labor is also much more mobile in the United States than in the EU, and America also lets its cities die, thus speeding adjustment. None of this happens in Europe. It turns out that cross-border borrowing in euros is, when bond markets reflect true risk premiums, just like borrowing in a foreign currency, with the result that banks increasingly want to match local loans with local assets. Although there is no exchange-rate risk to cover, if your sovereign's yields go up and your parent economy deflates, then your ability to pay back your loans declines as if you were making payments in a depreciating currency.

But what makes the situation in Europe terrible at its core aren't just these glaring holes in its institutional design or the immoral hazard posed by its banks. Rather, it's what might be termed the "epistemic hubris" behind the whole euro monetary project, which again comes down to the power of a set of economic ideas that blinds us to the effects of our institutional designs, just as it did in the US case.

No one knows the future, but we do know that it will have some shocks in store for us. We can imagine those shocks to be exogenous, and design mechanisms to compensate for them, such as well-conceived welfare states. Or, we can view them as endogenous, always and everywhere the result of our own bad policy choices. If we take the latter view, and we do not know what the future may have in store, as well as take policy tools away from democratically elected politicians, we may want to try to make the future conform to our preferences.

Imagine the future as a space of unrealized possibilities. You can accept that uncertainty and roll with it, or you can try to make the future behave within certain specified parameters, narrowing the space of possible futures. The way you do that is with rules. So long as they are clearly stated and everyone follows them, then according to this logic, the future will unfold, as you would like to see it, in accord with the rules. This is ordoliberalism gone mad, as well as the logic behind the euro. From the Maastricht convergence criteria to the Stability and Growth Pact to the promised new fiscal treaty that will solve all the euro’s problems once and for all (except that it will not), it’s all about the rules. But those rules only ever apply to sovereigns. There was of course a worry that some states may not follow the rules, so more rules were put in place. But there was never much attention paid to the possibility that private actors, such as banks, would behave badly. Yet this is exactly what happened, and the EU is still blaming sovereigns, tying them down with new rules, and insisting that this will solve the problem.

Friedrich Hayek is often seen as the father of neoliberal economics. It’s not an unfair reading, and he was certainly no fan of the state. But what he really railed against was the epistemic arrogance of the planner who assumes that he can anticipate the future better than a local actor whose knowledge is much more fine grained. Although the Hayekian critique is usually applied to postwar Keynesian planners, today it is more germane to EU planners who think that by setting up rules they can make the future conform to the probability space that they want to see. As Paul De Grauwe put it beautifully, “This is like saying that if people follow the fire code regulations scrupulously there is no need for a fire brigade.”

By looking only at inflation rates, budget deficits, and state debts, EU planners failed to see the growth of a banking system that is too big to bail. The price of their hubris is the belief among European elites that only a decade or more of unremitting austerity will suffice to prop them up, perhaps at the ultimate cost of undermining of the European political project. This may be the true price of saving the banks. Not just the end of the euro, but the end of the European political project itself, which would be perhaps the ultimate tragedy for Europe.

American policy makers can only blame the state, and occasionally the banks, but never the market. To do so is somehow un-American—as if fealty to Wall Street is the same as honoring the Constitution. Meanwhile, European policy makers seem to be trapped in a room with a monetary doomsday device, an overlevered banking system on the brink, and a German instruction sheet for defusing the thing that makes the problem worse rather than better.

Europe is at the moment undertaking a giant austerity experiment and the results, as discussed, are predictably awful. If doing the same thing over and over again is still the definition of madness, then the madness is probably going to end badly, long before austerity ever pays off, which it cannot under current circumstances.

For an idea so central to the governance of states and markets, austerity’s intellectual history is both short and shallow. There is no well worked out “theory of austerity” in economic thought that extends back in time to some foundational statements that became more systematized and rigorous over time as there is, for example, with trade theory. We have instead what David Colander has called a “sensibility” concerning the state, embedded in liberal economics from its inception, that produces “austerity” as the default answer to the question, what should we do when markets fail?

Indeed, gaining control of the state by the merchant class was a defining feature of early capitalism. With the partial exceptions of the United Kingdom and the United States (the former because it was first to make the transition to capitalism and the latter because it was geographically isolated), from Germany in the 1870s to China today, states make markets as much as markets determine the fate of states.

But from the start this liberal view of “the state versus the market” rested upon a misunderstanding: markets naturally appear when you remove the state from the equation. However, as Karl Polanyi noted at the end of World War II, there is nothing natural about markets. Turning people into wage laborers, securing the private ownership of land, even inventing capital and preserving its monetary form are all deeply political projects that involve courts, regulation, enforcement, bureaucracy, and all the rest.

As Albert Hirschman once observed, when the same arguments are repeated with almost no modification for over 300 years, regardless of any contrary facts impacting them, we should do well to hold them with suspicion. In the spirit of Hirschman’s suspicion, these chapters 4 and 5, drawing from austerity’s intellectual history, offer an answer as to why it continues to dominate the minds of today’s governing and academic classes.

In chapter 4, we investigate the prehistory of austerity, first as an absence in early liberal economic thought, and then as a definite policy in early to mid-twentieth-century economic theory. Austerity was not a policy consistently argued for from the seventeenth century onward, since the conditions of its realization—big states that spend lots of cash that can be cut—do not arise until the twentieth century. Rather, austerity emerges over time as a derivative consequence of other shared beliefs—a sensibility—concerning the nature and role of the state in economic life that sit at the core of liberal economic thought.

The relevance of these three early liberals for austerity thinking is a disposition they share that I term the can’t live with it, can’t live without it, don’t want to pay for it problem of the state in liberal thought.

The tension between these two viewpoints—can’t live with it, can’t live without it—generates a concern with how states should fund themselves, and it is this concern that creates the conditions for the emergence of austerity as a distinct economic doctrine when states become large enough budgetary entities in their own right to warrant cutting: that is, by the 1920s. When that happens, austerity appears in its own right as a distinct economic doctrine.

These ideas were, I argue, the original neoliberal ideas in that they drew on the classical liberalism of Locke, Hume, and Smith, and applied themselves anew to the policy issues of the day. I then discuss the responses that these ideas engendered, the most relevant of which are John Maynard Keynes’s refutation of austerity policies and Joseph Schumpeter’s strange abrogation of them. By 1942, it seems that the die has been cast and austerity had been sent away to the retirement home for bad economic ideas. It turned out, however, to be a premature retirement.

Austerity remained the policy for people in the developing world, however, at least until the current crisis. But even at that moment, ideas did not appear out of nowhere: they had precursors and promoters.

The analysis confirms that although a particular form of austerity that combines devaluations with large-scale labor agreements to cap wage growth does work occasionally to create expansions, these cases are vastly outnumbered by negative ones, and the conditions of those exapansions singularly do not apply to the world we happen to live in today.

Milton Friedman once argued “only a crisis—actual or perceived—produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around.” The next three chapters explain why the idea of austerity has been “lying around” in various forms for the past four centuries. Its repetition, refinement, and continual redeployment do not improve it over time. But that doesn’t stop liberals from finding it endlessly attractive and polishing it anew every time there is a crisis.

Apart from philosophizing on the rights of citizens in a commonwealth and on the limits to the power of the kings who seek to rule them, Locke was an economic revolutionary. He grounded his notion of what constitutes legitimate rule in individual property rights, without which there can be no economic liberalism, no separation of the state from the market, and no capitalism as we know it today. Locke's vision is outlined in his Second Treatise of Government (1690). To create the separation of state and market he wanted, Locke had to make several moves: naturalize income and wealth inequality, legitimate the private ownership of land, explain the emergence of labor markets, and depoliticize the invention of the device called money that made all these things possible. At base, Locke's liberalism is an economic liberalism that pits the individual against the state. Austerity's intellectual history starts here.

In the context of a country racked by war, regicide, and rebellion, this view may seem rather bloodless: unlimited inequality in property naturalized by virtue of God's lack of foresight on the issue of spoilage. But it does allow Locke to explain as inevitable, and therefore good, the creation of markets in land, labor, and capital, which happened to be the very political project that people of his class were engaged in at that moment. His next step was to protect these new institutions of the market from this emergent capitalism's nemesis: the state.

Remember that these arguments are being developed in seventeenth-century England, where public debt is the debt of kings, kings who invoke rights given by God to appropriate the property of others willy-nilly. That Locke deploys equally specious rationales for why he and his brethren in the commonwealth should have as much of the world as they want is beside the point. Rather, his point is to defend those gains from the state at all costs and to minimize the state's ability to extract further resources. It is this minimalist foundation for what the state can and should do, bequeathed by Locke, that later liberals built upon. Such a foundation has a hard time, by design, supporting any view of the state that extends beyond the protection of property. But even this narrow activity costs money, and this requires that the state raise it. Thus the liberal dilemma that generates austerity is born. The state: can't live with it, can't live without it, don't want to pay for it.

Hume's basic problem with public debt is that it has no limit, at least until the interest rates on the debt become crushing. Plus, debt is easy to levy since its costs are hidden and intergenerational, which makes states love debt. As Hume put it, "it is very tempting to a minister to employ such an expedient, as it enables him to make a great figure during his administration, without overburdening the people with taxes. … The practice will, therefore … almost infallibly be abused, in every government." Accordingly, government will issue debt at a rate that shall exceed the rate of interest that it could earn elsewhere, therefore finding ready buyers at the cost of diverting funds from industry. As a consequence, capital will become concentrated in debt securities that "banish gold and silver from the commerce of the state … and by that means render all provisions and labour dearer than otherwise they would be."

When this issuance of debt eventually hits a ceiling, governments will need to sell more of it to foreigners, and that will result in foreigners possessing "a great share of our national funds [which will] render the pubic … tributary to them." And if all this comes to pass, as it inevitably must according to Hume, liberty is undone. With taxes at their limits paying interest on the debt, there is no room to absorb any kind of financial shock. Consequently, even more debt will be issued, "a continual taxation of the annuitants," which results in a government that has "mortgaged all its revenues [and that will] sink into a state of languor, inactivity and impotence."

Hume predicted the end of Great Britain due to excessive debt issuance just at the moment that Great Britain was about to dominate the world for a century. It's hard to be that wrong; and yet the arguments against debt, in essentially the same form, continue to be used today, three hundred years later. Facts, it seems, seldom triumph over a good liberal ideology, and when it comes to a good liberal ideology, you can't beat Adam Smith.

From his notes on the division of labor in the eponymous pin factory to the "invisible hand" guiding selfish actions to common purposes, Smith's sound bites are well known. The details of what Smith said about the economy are far less well known and quite surprising. Smith brought together much of the scattered work of early economists on the nature of money, economic growth, the role of capital and labor, and a host of other issues, and then had the good sense to put it in one accessible place: The Wealth of Nations. As Albert Hirschman observed, this book was no academic project. It was an argument for capitalism before its triumph, and a very successful argument, too.

If customers have confidence in a banker's promissory notes (his paper money), he will then be able to lend out more in paper than he keeps in reserve in gold to cover his withdrawals. Today, we call this "fractional reserve banking." Yet Smith, like Hume, sees money as being unable to affect real variables in the long run, so simply adding paper money to the economy will not lead to growth.

It is, then, the inherent frugality of the Scots—their parsimony—that appears to be the key to growth (industry). Why be parsimonious and buy investment goods rather than foreign wines? We do this, according to Smith, because of a sentiment that comes "with us from the womb, and never leave[s] us until we go into the grave"—a sentiment leads to economic growth.

For Smith, the act of saving drives investment, not consumption. Why? Because the wealth of the nation is its total income. Take what is used for the reproduction of labor (wages) out of this income, and what is left is profit. Profits are then reinvested in the economy via merchants' savings, which are lent out to the productive members of society (other merchants) to invest. Today we call this supply-side economics. Investment both drives consumption and makes consumption possible—not the other way around. Because of this "the greater part of it [income] will naturally be destined for the employment of industry." Underlying this worldview is a particularly Scottish psychology that is worth unpacking because it suggests why the idea of austerity has such moral force, even today.

For Smith, because saving leads to investment, there are no lags and leakages of income; neither hoarding nor uncertainty is possible. Consequently, debt has no role in his system while saving is both good and natural to us. As Smith puts it, "Parsimony, not industry, is the immediate cause of the increase of capital … whatever industry might acquire, if parsimony did not save and store up, the capital would never be the greater." Frugality thus becomes virtue while prodigality becomes vice such that "if the prodigality of some was not compensated by the frugality of others, the conduct of every prodigal, by feeding the idle with the bread of the industrious … [would] impoverish the entire country."

Smith’s capitalism rests upon a psychological predisposition to save rather than spend. As Smith puts it rather hopefully, although “some men may increase their expense very considerably though their revenue does not increase at all, we may be assured that no class or order of men ever does so … because the principles of common prudence … always influence … the majority of every class.” Clearly, Smith did not envisage the twenty-first-century American mortgager or the European universal bank. But what did he see, and fear, was something that would upset this natural desire to save and invest: easy money, which is what credit markets (debt) offer. In short, by perverting the sensibility of saving into lending to the government, “great nations are … impoverished by … public prodigality and misconduct."

Smith fully acknowledges that the market cannot exist without the state. Indeed, an entire book of The Wealth of Nations details the necessity of the state supplying external defense, internal justice, and even the training and education of workers. Most interestingly, he is disarmingly honest concerning the political effects of capitalism, noting that “wherever there is property there is great inequality,” such that “the acquisition of valuable and extensive property … necessarily requires the establishment of civil government.” A civil government that, “in so far as it is instituted for the security of property, is in reality instituted for the defense of the rich against the poor, or of those who have some property against those who have none at all."

Having admitted that he needs the state, Smith must now find a way to pay for it, which necessitates taxes. Smith’s first principle of taxation is progressivity. That is, “the subjects of every state ought to contribute … in proportion to the revenue which they respectively enjoy under the protection of government.” This seems to imply that the rich should carry more of the tax burden since they enjoy more revenues protected by the state. However, Smith’s examination of different forms of taxation leads him to downplay progressivity, recommending consumption taxes on luxuries—anything above bare essentials—as the best way to fund the state. Yet consumption taxes are perhaps the most regressive form of tax. So, how does that sit with his idea of proportionality?

It sits well if you start with the observation that “the whole consumption of the inferior ranks of people … is in every country much greater … than that of the middling … and above … rank.” Therefore, taxing anything except luxuries “would fall altogether upon the superior ranks of people,” which would diminish their parsimony, and thus lower growth. But there is no way that a consumption tax on nonessentials will suffice to fund a state of the size envisaged by Smith. How, then, can goverment be funded? The answer is government debt, and Smith doesn’t like that answer.

Smith’s problem with debt is that states, unlike merchants, are not by nature savers. Indeed, to his regret, “the parsimony which leads to accumulation has become almost as rare in republican (merchant-run) as monarchical governments.” As a consequence, merchants are indirectly saddled with “enormous debts which at present oppress, and will in the long-run probably ruin, all the great states of Europe.”

Hume may have given us the economic rationales for limiting debt, so familiar that we find them repeated unmodified today. But it is Smith who turns debt into a morality play. He gives us the moral arguments against debt that still resonate today.

Smith lived though the trauma of the collapse of Ayr Bank, a debt-financed Scottish bank that threatened the solvency of Smith's main benefactor, the Earl of Buccleuch.

Long before Locke's time, states piled up debt and went bust with monotonous regularity, impoverishing their lenders in the process. In their own lifetimes both Hume and Smith saw examples of debt financing going awry. Smith lived though the trauma of the collapse of Ayr Bank, a debt-financed Scottish bank that threatened the solvency of Smith's main benefactor, the Earl of Buccleuch. In his writings Hume reflected on the earlier attempt by John Law, another Scot, to discharge the national debt of France by issuing shares in a giant trading company that used the bank of France as its fiscal agent. By 1721, when the resulting bubble popped, France went bankrupt—again.

There was no positive role for the state in Ricardo's vision. Indeed, the one thing that had to be avoided was any attempt by the state to cushion market adjustments, disruptive though such adjustments were. As Ricardo opined, even if "the condition of the laborers is most wretched," government should not try to compensate their lot. Attempts to "amend the condition of the poor … instead of making the poor rich … make the rich poor." As such, the proper role of the state is to teach the poor the "value of independence" rather than to alter the distributions of the market. The state should police the frontiers of property, but it should not alter the distributions of that property.

Yet the state was changing its role throughout the nineteenth century, despite Ricardo's admonishments. Those very nineteenth-century activities of nationalism and state building demanded a far more interventionist state than that envisaged even by Smith. Furthermore, the very success of capitalism brought forth a variety of social movements that demanded political representation, economic compensation, and social protection, all of which cost money and threatened private property.

Mill's most famous philosophical treatise, On Liberty, tried to find a path between the encroaching claims of the masses and the protection of individual liberal rights, while his Principles of Political Economy demarcated ever more precisely the areas of legitimate state action, even in the area of government debt. That is, rather than repeat Hume's and Smith's "inevitable enfeeblement of the state through debt" thesis, Mill argued that so long as government borrowing did not compete for capital and thus drive up the rate of interest, debt issuance was acceptable, even if taxes would be preferable.

Britain’s New Liberalism came into being when British Liberal Party elites essentially sided with Mill over Ricardo. They sought to develop the role of the state as both the defender of capitalism and as a tool for social reform in an era of class conflict and incipient mass democracy. In short, if the primacy of private initiative and of liberal market institutions were to be maintained, then the poverty and inequality Ricardo regarded as natural and inevitable could no longer be tolerated. Moreover, the British New Liberals did not see this embrace of the state as a necessary evil, as a papering over the cracks to avoid revolution. Rather, the New Liberalism acknowledged the state’s responsibility for the ongoing management and reform of capitalist institutions.

The long-term consequences of this transformation of British Liberalism were dramatic. Universal pensions, unemployment insurance, and the intensification of industrial regulation all followed in the early twentieth century. Twenty years later, the heirs to this movement were the great social and economic reformers of the 1930s and 1940s, such as T. H. Marshall, John Maynard Keynes, and William Beveridge. They in turn pushed the New Liberalism still further, laying the foundations for a comprehensive welfare state.

If the New Liberalism was what we might call “Mill’s modification”—a pragmatic adaptation to the complexities of the modern economy, then Austrian economics was “Ricardo’s rejection”—a fundamentalist reaction against the modern economy. The Austrian economists believed that liberalism was best defended, not through more redistribution and state management, but through the complete withdrawal of the state from its role in the economy. To borrow a term that is commonplace today, the Austrians were the original “neo” liberals.

Where British New Liberals began to see recessions as ameliorable through more spending, the Austrians saw in recessions the necessary pain of austerity after the interventionist “party.” In sum, while the New Liberals and their mid-twentieth-century heirs embraced the state and intervention, the Austrians, in particular, Friedrich Hayek, Ludwig von Mises, and Joseph Schumpeter, rejected these notions entirely.

First, they challenged the New Liberal claim that the operations of the unadulterated free market endangered capitalism using the counterargument that the market had a long-run evolutionary structure that government intervention could neither change nor predict. As such, intervention is always and everywhere harmful. Moreover, because government interventions produce market distortions and malinvestments, they were the source of credit booms and busts. Markets were stable unless they were interfered with. Capitalism wasn’t inherently unstable: government made it so.

Perhaps the most famous characterization of American austerity thinking comes from a line attributed to Herbert Hoover’s treasury secretary Andrew Mellon in response to the crisis of the late 1920s and early 1930s: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” The result would be that “rottenness [will be purged] out of the system. … People will … live a more moral life … and enterprising people will pick up the wrecks from less competent people.” Adam Smith, it seems, was alive and well on the Potomac. Yet, despite the moral invocations, the Hoover administration did not exactly cleave to Mellon’s “liquidationist” line.

American economists of this period did not see depressions as accidents amenable to treatment. They saw them as a part of the nature of capitalism itself: regular, cyclical, and expected occurrences. The basic model drew upon what was called “modern business cycle theory,” which was cut from broadly similar cloth as the Austrian ideas described above. A particularly clear expression of this theory can be found in publications of the 1923 President’s Conference on Unemployment, which Hoover had created as commerce secretary under President Coolidge. The lead author of the report, Columbia University economist Wesley Mitchell, argued that “a period of depression produces after some time certain conditions which favor an increase of business activity … [that paradoxically] also cause the accumulation of stresses within the balanced system of business, stresses which ultimately undermine the conditions upon which prosperity rests.”

These “certain conditions” were elaborated upon a decade later in another authoritative volume, this time by a collection of Harvard economists. In it Joseph Schumpeter, an Austrian émigré and follower of the work of other Austrian economists of the period, such as Hayek and Von Mises, argued that capitalism has at any given point a distinct “capital structure,” that long-run evolutionary form alluded to earlier, which manifests itself as the particular mix of productive assets that investment has generated over a given cycle. When there are investment booms, as there inevitably are in capitalism, both “too much” and “too much of the wrong type” of capital is invested in the economy.

For Schumpeter, entrepreneurs make investments, many of which go bad, but capitalism progresses because of these failures, not despite them. We need failures, or capitalism does not evolve. The process of liquidation, of failure, produces the raw material for the next round of innovation and investment. As such, intervention, whether inflationary or otherwise, would cause two problems. First, it would obstruct the necessary liquidation process, propping up firms with cheap money, only postponing the inevitable day of reckoning. Second, it would disrupt the price signals that entrepreneurs rely upon so that they would not know in which sectors to invest. Investment would fall, despite the government intervention that was intended to increase it.

Liquidationism therefore argues for an inevitability—the slump must happen—and also for intervention’s unintended consequences—if you get in the way of that inevitability you will end up making it worse. The consequence of this line of thinking is austerity—purging the system and cutting spending—which becomes the essence of recovery. Austerity may be painful, but it is unavoidable since undergoing such emetic periods is the essence of capitalism’s process of investment and discovery. There was, therefore, no alternative.

The Hoover administration therefore actively sought not alternatives to austerity, but compliments and palliatives that took the form of voluntary policies to smooth the adjustment of labor and capital to new uses. Those policies were always conceived of as helping adjustment pro-cyclically rather than compensating for it countercyclically. For to do the latter would, Schumpeter warned, “lead to a collapse worse than the one it was called into remedy.”

This Austrian strain in American thinking about the inevitability of cycles, the centrality of the entrepreneur, and the importance of failure, coexisted with and was boosted by another line of American economic thought that stressed the need for a policy of “sound finance.” Favored by the banking community, these ideas reinforced the Austrian flank by insisting that business confidence, the key to supply-side growth, would only be restored if the government credibly signaled that it would allow the emetic process to unfold as it had to via austerity. While temporary relief of the symptoms of unemployment could be countenanced, the state’s role in such moments devolved to balancing the budget, even raising taxes in a recession if this was deemed necessary, to restore the investor confidence. During 1931, the last year of his administration, Hoover did exactly this to signal resolve in the face of financial difficulties. The result was the worst depression in American history.

If these ideas sound familiar today, it’s because, like the ideas of Hume and Smith, the same arguments are being recycled again, eighty years later. The idea that the current crisis was generated by the malinvestment of the past, particularly in real estate, is hardly an unreasonable point of view. That Fannie and Freddie caused a global crisis, the extension of that viewpoint, is not. The notion that taxes should be raised to balance budgets in the middle of a recession is the policy orthodoxy of the IMF-EC-ECB troika in the Eurocrisis and US budget reformers such as the Simpson-Bowles Commission. The need for “the return of business confidence” to start the recovery forms the centerpiece of contemporary British austerity policy, despite its yielding zero results to date. But then, as now, the Americans were far from alone in expounding such ideas. Indeed, back in the 1920s such ideas had a pronounced British accent.

The so-called Treasury view expounded in this policy paper was really the latest iteration of the same classical liberal ideas we have encountered already. As the world’s largest economy in the nineteenth century and the anchor of the gold standard, which facilitated international adjustments between surplus and deficit countries through movements in domestic money supplies tied to gold, the United Kingdom was a firm believer in free trade, free capital movements (very important for the City of London as a financial center), free labor (that is, no regulation thereof), and a limited liberal state. Although that limited liberal state had been growing rapidly and acquiring new responsibilities during the prior two decades, it still accounted for only about 12 percent up until the eve of the First World War.

The Treasury's argument, echoing Hume and Smith, was that to borrow money to finance spending, the government would have to offer better terms than those available elsewhere. This would have the effect of reducing overall investment by "crowding out" private capital while increasing the debt for what would offer only a temporary respite rather than a full-blown cure. As Conservative chancellor of the exchequer Stanley Baldwin put it in 1922, "Money taken for government purposes is money taken away from trade, and borrowing will thus tend to depress trade and increase unemployment." Such views, however, were not limited to the Treasury. The mindset was so widely shared that no less a figure than John Maynard Keynes argued in 1924 that "public money which has been raised by borrowing, can do nothing of itself … and it may do actual harm if it diverts existing working capital from the production of goods."

The British elite's rather monolithic view began to splinter in 1925 when Keynes criticized Churchill's decision to go back on the gold standard after an eleven-year hiatus. Churchill put Britain back on at a high exchange rate, which, though it was good for the City of London and for foreigners holding sterling, was terrible for British exports. As a consequence, unemployment, already bad, shot up, and economic activity declined. Keynes had predicted that this would occur, and indeed it did, much to the chagrin of Churchill and the Treasury.

This conflict between Keynes and the Treasury, odd when one considers that Keynes was a Treasury advisor throughout this period, was exacerbated in 1929 when Keynes, with Hubert Henderson, produced the pamphlet "Can Lloyd George Do It?" in response to Liberal politician David Lloyd George's much-discussed proposals in a prior pamphlet called "We Can Conquer Unemployment." In his assessment of George's proposals, Keynes "first adumbrated the … relation of saving to investment." That is, he argued that saving doesn't drive investment if "investment is free to fluctuate under the influence of expectations" such that income and employment adjust to the ex post level of saving. As a consequence, government should "fill the gap/prime the pump" by spending money that business is sitting on because of uncertainty about the future.

By 1935, although the Treasury was still arguing that although “public works as a remedy for unemployment were quite futile,” government nonetheless still had a role to play in maintaining “the impetus of recovery” in specific areas of the country via spending. Indeed by 1937, the Treasury was willing to propose that a reserve fund of necessary public works be deliberately left not completed so that when a downturn worsened they could be released as a countercyclical measure. But even here, concerns with inflation arising from debt-financed expenditure and the need to pay back the accumulated debt limited the appeal of such logics, even in the midst of a deep depression.

But Keynes’s work was as much a consequence as a cause of the shift away from austerity. As Joan Robinson put it pithily, “Hitler had already found how to cure unemployment before Keynes had finished explaining why it occurred.” But these new ideas from Keynes and many others at about the same time were important precisely because, unlike the old instruction sheet, they explained not just the slump but normal times too, within one framework. Pro-austerity ideas could not credibly claim to do this after two decades of waiting for a recovery that was “just around the corner.” After all, the liquidation process had run its course for an awfully long time, but it seemed, against Secretary Mellon’s expectations, that there remained a shortage of more-competent people and cheap capital waiting—just around the corner—to pick things up again. Keynes’s General Theory could explain where such folks were hiding and why they were doing so.

Keynes showed that decisions to save and invest were temporally separate, and that savings did not necessarily lead to investment. Saving could just as easily lead to hoarding and reduced consumption. The job of the state was, then, to alter the investors' investment expectations by raising prices so that profits could be made, thereby making it rational to begin hiring workers again and, by doing so, to get out of the slump. Rather than savings leading to investment, consumption via workers' paychecks ultimately drove investment. Today we call this demand-side economics.

Schumpeter attributes the failure of austerity to two conjoined mechanisms: the substitution of the large conglomerate and the manager for the small firm and the entrepreneur and the collapse of the risk-taking culture that supported entrepreneurial activities. … By 1942 Schumpeter hadn't changed his tune, or his mind: he had simply lengthened the time frame and added in a few harmonies.

Indeed, rather than engaging Keynes and his ideas directly, Capitalism, Socialism and Democracy abrogates a robust defense of liberalism in favor of a lengthy discussion of Marx and a bureaucratic-cultural explanation as to why capitalism will inevitably be replaced by socialism. His argument is worth retelling since it shows the dead end that Anglo-American austerity thinking found itself in by the mid-1940s. Rather than engage, it retreated into moral commentary and "fin de siècle" certitudes.

Apart from normalizing turmoil, Schumpeter focused on changes in industrial structure of capitalist economies and the rise of very large firms to explain the failure of austerity to produce recovery. This is his long-run evolutionary story in which the locus of production and innovation has undergone a scale-shift, and as a result, the capitalism of small producers, entrepreneurs, and perfect competition “is not only impossible, but inferior” and on its way to being replaced. Bureaucratization and institutional change are the prime movers in this story, driving economic evolution, taking innovation out of the hands of entrepreneurs and putting it in the hands of specialists and managers in large firms. Firms become giant bureaucratic entities that are slower to adapt to environmental shifts and that operate on much larger scales. They become, in short, more like, and more dependent upon, states. Oligopoly and interventionism go hand in hand.

More importantly for Schumpeter, this scale-shift takes a cultural toll. Whereas in the past “the rugged individualism of Galileo was the individualism of the rising capitalist class,” today, technology and bureaucracy have together removed the possibilities for such individuals to thrive. As he laments, “the capitalist process rationalizes behavior and ideas and by doing so chases from our minds … metaphysical belief” such that “economic progress becomes depersonalized and automatized.” When large firms take over production it is not the entrepreneur's income that is replaced. After all, he gets shares in these new conglomerates. Rather, his social function is made redundant, “the stock exchange [being] a poor substitute for the holy grail.” This may lead to a material progress, to more consumption and all that Keynes thinks important, but it is for Schumpeter a morally empty future.

As for those in the once proud investor class, they, too, now only care about consumption, thanks in part to these newly fashionable theories, with the result that both the bourgeois family unit and the ethic of saving, Smith's sentiment, disappear from the world. As Schumpeter put it, “The bourgeoisie worked primarily … to invest, and it was not … a standard of consumption so much as a standard of accumulation that the bourgeoisie struggled for and tried to defend against the government.” Thanks to the twin forces of bureaucracy and technology, the bourgeoisie has given up this struggle. “When all is said and done, it [the bourgeoisie] does not really care.” And when no one cares for capitalism, the result is socialism.

Anti-austerity it seemed, had won the day. But the victory was not complete. Austerity survived in one part of the world immune to Lord Keynes: the German-speaking world. Austrian school economists continued to give austerity a globalized intellectual home, while German ordoliberals, as we shall shortly see, gave austerity a national base of operations.

With the Keynesian view ascendant, conservatives like Schumpeter had a choice: admit that they were wrong (or at least accommodate themselves to the new ideas that seemed to fit the facts better than the old ones) or find something else to talk about. Schumpeter chose the latter path, and so he spoke about the death of saving, the end of family virtue, and the triumph of bureaucracy. His own retreat was emblematic of the retreat of austerity as a serious intellectual argument among the economic mainstream of Anglo-American countries.

Unlike in Schumpeter's world of entrepreneurs and competitive small firms, these companies in many cases started as large-scale concerns made possible by the complex state and banking linkages typical of late-industrializing states. These firms innovate incrementally, improving their dedicated product lines one step at a time using specialist engineers and scientists. Most of them haven't seen an entrepreneur in a century. There has been plenty of creativity, but very little destruction—at least of firms—in Germany.

Taken on its own terms, ordoliberalism is a peculiar form of liberalism. It does not suffer from the “can't live with it, can't live without it, don't want to pay for it” problem that lies at the heart of Anglo-American liberalism. In the same way that Keynes solved the austerity problem for the New Liberals in Britain, ordoliberalism solved the problem of the state in Germany by transcending it, but in an entirely different manner. Ordoliberals see the role of the state as setting the framework conditions necessary for markets to operate effectively in the first instance. The state they are happy to live with is not, however, the macroeconomic manager focused on the demand side of the economy that emerged out of British New Liberalism. Rather, the ordoliberal state is a rule setter that enables competition and aids market adjustments through the development of specific economy-wide mechanisms and institutions.

We tend to forget that Britain and the United States are the exception rather than the rule when it comes to the relationship between states and markets. The former had the advantage of turning capitalist without competitors, allowing a small and limited state to develop, while the latter was geographically isolated with a huge internal frontier to exploit. The rest of the world, the late industrializers that came after these states, operated under vastly different and more competitive conditions. This matters because when you enter the world economy determines in no small part the type of state that you develop to engage with that economy, with the basic rule being the later the developer, the bigger, and the more interventionist, the state.

When we think about interventionist, late-industrializing states, we tend to think of the states of East Asia. Yet, French experiments from the Place des Vosges to the Crédit Mobilier Bank notwithstanding, the original developmental state was Germany. Playing catch-up to the British in the latter half of the nineteenth century forced Germany (it came into being in 1871) to act as the broker, and in many cases as the insurance agent, among industrial, commercial, and agricultural interests.

All late developers have a scale problem. To catch up with already industrialized states, the state in a late developer must underwrite the risk involved in investment because the scale of the capital required to industrialize after other states have done so outstrips the capacity of any individual entrepreneur to do so—hence the size, structure, and longevity of German firms.

Critical throughout Germany's development has been the role of the state in suppressing consumption and increasing savings to provide adequate pools of capital for large-scale industrial investments, while also providing transfers to smooth, rather than block, such policies. As such, the mantra of Erst Sparen, Dann Kaufen (first save, then go shopping) to save and invest before consuming—a parsimony that Smith would have applauded—formed the austere core of German economic thought long before the 1930s, when ordoliberalism appeared.

Ordoliberalism took form under the aegis of Walter Eucken, Franz Böhm, and Hans Grossmann-Doerth, the founders of the Freiburg school of economics during the 1930s. Their bête noir was the private economic cartels rather than the state. The Freiburg liberals argued that Germany's basic economic problem in the 1920s was "the inability of the legal system to prevent the creation and misuse of private economic power." Note that private, not public, power was the concern. The individual needed to be protected from the state, to be sure, but acknowledging that the state was not the only threat worth worrying about marked Frieburg's departure from the "can't live with it" version of Anglo-American liberalism.

For Walter Eucken in particular, capitalism was not the haphazard assemblage of individuals envisioned by Smith. Rather, it was composed of two fundamentally incompatible structural orders that he termed the "transaction economy" and the "centrally administered economy." Although these orders are incompatible in their essences, real economies necessarily combine elements of both, and that's where the problems start. Especially when parliaments get involved, elements of the administrative order can be captured by the most powerful members of the transactional order, hence the fear of cartels and private power.

As Eucken defined the role of the state in the economy: "First principle: the policy of the state should be focused on dissolving economic power groups or at limiting their functioning. [ … ] Second principle: The politico-economic activity of the state should focus on the regulation of the economy, not on the guidance of the economic process."

As legal theorist David Gerber notes, this notion "turned the core idea of classical liberalism … on its head by arguing that the effectiveness of the economy depended on its relationship to the political and legal systems." Although early ordoliberal work during the Nazi period gave primacy to a strong state as the promoter of such an order, this view changed over time—and circumstance—to the position that economic policy should not be dictated by a strong state, especially one that could be captured. Rather, the state needed to be strong enough only to provide an "order," an Ordo, and a consequent Ordnungspolitik, an "order-based policy," whereby the legal framework governing action both by firms and the state together forms the economic constitution critical, according to the Freiburgers, to any successful economy. Ordnungspolitik therefore restrains both the state that practices it, and the private sector that grows within it, through the indirect regulation of the economic constitution.

This economic constitution was not simply something that could be set down on paper, however. Ordoliberals argued that the correct economic constitution cannot simply be deduced from theory and imposed by the state. It must be actively supported by members of the community to which it applies, and crucially, its implementation must be based upon a reciprocal duty of those members to act in the terms laid out in the constitution. In short, everyone needs to follow the rules, and everyone doing so reconstitutes and legitimates those rules.

To make this happen, the appropriate state policy was not to set the conditions of investment or to manipulate the level of prices via monetary stimulus, as the Keynesians argued. Instead, given its concern with limiting private power, competition policy, supported by the monetary policy of a politically independent central bank, formed the institutional core of the economic constitution. A dedicated monopoly office would ensure that the economy as a whole conformed to the meta-rules of competition, while an independent monetary authority would play the supporting role of keeping prices stable. Both institutions would be separate from and would not directly answer to the parliamentary state.

By attacking concentration and cartels while keeping prices stable, ordoliberals hoped to generate growth by enhancing the competitiveness of German firms and the attractiveness of their products. The policy objective of these institutions was therefore the encouragement of "achievement competition" rather than "impediment competition," whereby the quality of products manufactured would create the demand for them, in a modern supply-side restatement of Say's law. Under such institutional conditions the benefits of rapid growth would flow to all members of society.

As we elaborate below, these new institutions and the underlying ideas that served as the blueprints for them were bolted, after a brief period of internal struggle among postwar Christian Democrats, to the existing Bismarkian patriarchal welfare state to form what Alfred Müller-Armack called "the social market economy," a "system of legal rules which can satisfy the general feeling of justice," which would tie citizens to the economic constitution as they realized its benefits. As Ralf Ptak observed, despite their deep misgivings about the welfare compensation, ordoliberals keenly appreciated that the "stability and security [of] the working class was prerequisite to securing the market economy." As a consequence, although the ordoliberals really did not want the economic constitution to be tied to a welfare state, circumstances and politics dictated otherwise: the market economy had to become social.

That ordoliberal arguments would become the local economic instruction sheet for economic policy in postwar Germany was almost overdetermined. First of all, the German population was exhausted and hungry while the country's capital stock was decimated. Fearing political instability, the postwar authorities needed growth, and like the population they governed, those authorities were suspicious of growth coming from "big-state" projects, whether from the left or the right. Second, the Freiburg school, which was not shy in hawking a growth project, emerged from the Nazi period unsullied and more or less intact. While some members were arrested and a few key players such as Wilhelm Röpke were driven into exile, the core of the school was in the right place at the right time, armed with what seemed to be, in the German context, new growth-friendly ideas. The ordoliberals also had powerful sponsors in the form of the leading newspaper of the day, Franfurter Allgemeine Zeitung, and the ear of the Allied occupation authorities, at least once the Allies moved out of the punitive phase of the occupation.

Germany's economic profile as a late developer has always been export-oriented manufacturing; so it was natural for Germany's postwar economic elites to focus on the reconstruction of export capacities and the recovery of export markets as a way to achieve the rapid growth they sought. Ordoliberals may have sought to preserve smalland middle-sized firms and feared cartels, but they had no problem with large firms per se, especially those that were able to produce export-led growth. But export-led growth requires a strict policy of cost competitiveness, which in turn requires wage control through the restriction of consumption and a strong anti-inflationary stance. This further strengthened the hand of the monetary authority over the fiscal authority, as controlling inflation became the monetary complement to ensuring competition.

Fourth, the postwar political party system was a mess, and the center parties, particularly the Christian Democratic Union (CDU) were looking for a new set of ideas that spoke to their (predominantly) Catholic members' conceptions of their interests. With its appeal to community, its distrust of private as well as public power, and its somewhat reluctant—but necessary given the conditions of the times—acceptance of welfare state redistribution through the family, ordoliberalism found both a willing audience and a launch vehicle in the CDU.

Consequently, when the German Social Democratic Party came to power in 1966 with a pro-Keynesian agenda in response to faltering growth rates, it found little receptivity to these ideas in either the bureaucracy or the academy. Locally, Keynes was “crowded out” in theory. Amplifying this exclusion, the monetary authority, “the fiercely independent Bundesbank … placed strict monetary limits on deficit financing,” thus locally crowding out Keynesianism in practice. This is hardly a surprise when one considers that the Freiburg ordoliberals had foreseen such a role for the monetary authority, arguing that “a strong central bank [would be] the guardian against any misuse of power by the political authorities.” In ordoliberal terms, spending equals misuse, and the central bank was specifically designed to prevent such misuse.

In sum, postwar Germany prospered with austerity-focused ideas of a particular type at its core. Germany both possesses and professes a liberalism that embraces the state and transforms it. In doing so, it does the same for austerity. The fact that ordoliberalism, ordnungspolitik, and the rest, are all about rules means precisely that good economic governance is not about spending. If the rules establish a framework within which prosperity is established through the enhancement of competition, then the supply side of saving and investment, rather than the demand side and consumption, still rules the day. Ordoliberalism may have modernized liberalism, but its economics in many ways remain as classical as Smith and Hume.

In the context of a late-developing, export-led economy that needs to force savings to catch up the British, this makes perfect sense: Erst Sparen—Dann Kaufen. But just as we saw in chapter 3, it rather spectacularly ignores the fact that for someone to be running an export surplus, someone else must be running a deficit. We cannot all run surpluses and save. Someone has to spend so that there is demand for these exports. Thus, a fallacy of composition of a different type rears its head again; and this is where the transfer of these austerity-based principles into the EU's constitutional framework and in Germany's policy response to the crisis, really shows up. If Germany's focus on rules, obligations, a strong monetary authority, a weak parliament, and no spending to compensate for busts sounds familiar, it should. It's the basic design of the EU. Germany's response to the crisis, and the crisis itself, both spring from the same ordoliberal instruction sheet.

When the rest of Europe stagnated in the late 1970s, Germany suffered the least and recovered the quickest of all the major European states. Its ability to withstand the inflationary pressures of the period became the model for other European states: first, through the abortive currency pegs to the deutsche mark of the 1980s and 1990s; second, through the incorporation of ordoliberal principles into the ECB constitution and the EU Commission's competition-focused policies; and third, through the rules-based approach to governing the Euro project. From the Maastricht convergence criteria to the Stability and Growth Pact to the proposed new fiscal treaty—it's all about the economic constitution—the rules, the ordo.

If states have broken the rules, the only possible policy is a diet of strict austerity to bring them back into conformity with the rules, plus automatic sanctions for those who cannot stay within the rules. There are no fallacies of composition, only good and bad policies. And since states, from an ordoliberal viewpoint, cannot be relied upon to provide the necessary austerity because they are prone to capture, we must have rules and an independent monetary authority to ensure that states conform to the ordo imperative; hence, the ECB. Then, and only then, will growth return. In the case of Greece and Italy in 2011, if that meant deposing a few democratically elected governments, then so be it.

The basic objection made by late-developing states, such as the countries of East Asia, to the Washington Consensus/Anglo-American idea "liberalize and then growth follows" was twofold. First, this understanding mistakes the outcomes of growth, stable public finances, low inflation, cost competitiveness, and so on, for the causes of growth. Second, the liberal path to growth only makes sense if you are an early developer, since you have no competitors—pace the United Kingdom in the eighteenth century and the United States in the nineteenth century. Yet in the contemporary world, development is almost always state led.

As Martin Wolf put it beautifully, "Is everybody supposed to run current account surpluses? If so, with whom—Martians? And if everybody does indeed try to run a savings surplus, what else can be the outcome but a permanent global depression?"

Germany was able to take the lead in Europe because German ideas have been at the heart of the EU and the euro since its inception. This is also why the Germans were able so successfully to turn the debate about the crisis their way—they were the only people who really believed what they were saying. Whereas the Americans were Keynesians by default, the Germans were ordoliberals by design. In monetary matters above all, credere (belief) matters.

The imprint of these ideas on EU institutions is not in doubt. There is no place for Keynes and compensation in an economic union in which competition produces growth through the production of competitive products and the running of surpluses, not the shallow demand of the money press. In such a world, the slump, not the boom, is the right time for austerity.

If the influence of ordoliberalism has been felt primarily in Europe, then the influence of Austrian ideas lies in the United States. Austrian ideas have long had an American pied-à-terre, as we saw in Schumpeter's diagnoses of the 1930s. They came back into vogue in the current crisis because they seemed to have been onto something that few Keynesians (except Hyman Minsky) had paid much attention to, and in doing so they gave us another set of reasons to be austere.

In the late nineteenth century, Austrian economics emerged in the Austro-Hungarian Empire from the debate over the role the state might play in fostering economic development following Germany's state-led growth spurt. The key figure here was Carl Menger, one of the first of the so-called marginalist economists, who saw economic value as a question of subjective utility and relative prices, rather than as a function of costs of production. More important for our purposes, he was also dead against the state being involved in helping capitalism along the way. Megner started a "methodological debate" (Methodenstreit) with members of Germany's Historical school of economics over these matters that led the Germans to label Menger and his followers "the Austrian school."

For these theorists—Ludwig Von Mises and Friedrich Hayek being the most prominent, along with Joseph Schumpeter as the Austrian émigré voice in the United States—the free market has a long-run evolutionary structure that government intervention can only harm. Siding firmly with the "can't live without it" school, the Austrian school rejected the state as having any positive or necessary role in the economy. They also rejected the increasing mathematization of economics that was underway at that time. Seeing the economy as evolutionary, disequilibrial, and driven by entrepreneurs acting in uncertainty, they preferred historical analysis to differential calculus.

By 1944, Hayek found himself similarly ignored, in semiretirement, writing on the dangers of socialism in his epic The Road to Serfdom. Hayek's earlier Prices and Production, his Meisterwerk on business cycle theory, like Schumpeter's 1939 Business Cycles, arrived dead at the presses.

First ignored and then defeated in Europe, Austrian ideas survived in America, where their popularity has ebbed and flowed for nearly a century. Although battered and beaten-down by the Keynesian revolution after World War II, Austrian ideas never quite disappeared from the American scene. They staged something of a comeback in the 1970s when Hayek was awarded the Nobel Prize in economics and served as a popular justification for Reagan's supply-side policies, but they disappeared again until the current crisis brought them back to the fore. Why this reappearance? The answer lies in what they said about banks.

Despite Keynes's General Theory being subtitled "of Employment, Interest and Money," postwar economics never put all that much thought into money. There was a view that gained prominence in the 1970s—monetarism—that thought about money a great deal, and we will examine that view shortly for different purposes. But for most economists from the 1930s on, money was seen in pretty much the same way that Hume saw it 200 years before, as short-run stimulative, long-run neutral, and/or potentially inflationary. Money, it is sometimes said, "changes neither preferences nor possibilities." Money in the form of credit, therefore, is simply one person's nonspending transferred to another person to use for an interest payment plus the return of the principal. Put more simply, one person's debt is another person's income. It's simply a redistribution of existing assets and nothing to get excited about.

This view made it perfectly possible for mainstream economists in the 2000s to talk about "the elimination of the business cycle" while living in a period of "Great Moderation," where the volatility of the past had been tamed by good central bank policies. And then, of course, the world blew up, right in the middle of this supposed Great Moderation, just as the Austrians would have predicted. And while everyone seemed to know that the explosion had something to do with asset bubbles and banks, at the start of the crisis few had a convincing story about how the banks had caused it. This is where the Austrians came back in. Their writings from the 1930s seemed to describe the 2008 financial crisis perfectly.

Writing in the 1920s, Hayek and Mises drew attention to the rather obvious fact that banks make money from the extension of credit. And while each bank may wish to be prudential, each has an incentive to expand credit beyond its base (at that time, gold) reserves to stay in business against more aggressive banks and/or capture market share. Moreover, banks are encouraged to do so by the presence of a central bank that backstops the financial system with liquidity. Both these forces produce an expansion of credit beyond what "real" savings would allow and lower the interest rate on loans.

Indeed, the very worst thing that can happen is for the government to get involved. By flooding the market with liquidity, keeping the rate of interest low when credit is scarce, or attempting to stimulate the economy to smooth out the cycle, government intervention simply prolongs the recession. Moreover, intervention produces a further pathology that is perhaps even more dangerous: it creates, according to Mises, a capital strike among investors.

According to the Austrians, then, we should not be surprised to find lots of companies sitting on very large piles of cash in the middle of a recession. Per contra what stimulators would tell you about this behavior being a response to uncertainty about the future or a lack of demand, what's really behind it is the perfectly rational belief that given half a chance the government will inflate or devalue its way out of trouble on the backs of the investor class. Companies may be sitting on piles of cash and not investing, but the recession is not, as Keynes would have you believe, the capitalists' fault. Rather, investors are quite reasonably covering the risk of backdoor expropriation by the state through inflation or devaluation. The fear of the state taking away your property—the original liberal nightmare—rears its head once more. Instead, "public opinion is perfectly right to see the crisis … as a consequence of the policy of the banks." Consequently, the sum of the Austrian view is that we should let the banks fail and then restart the system.

It is hardly surprising that these arguments resonated in America after the crisis. They have, after all, a submerged prior history in the United States stretching back to the 1920s via Schumpeter. Indeed, as a description of what went wrong in 2007–2008, these ideas seem to fit the facts rather well. Banks, the dangers of debt, excessive leverage, asset inflation, a collapse of savings: it's all there. The "don't bail them out" message taps into a strong current of populist American opinion. Meanwhile, the "don't intervene/let it run its course" message found strong support in the right wing of the Republican Party and among elements of the financial community that were not too big to fail, particularly hedge funds. Why, then, apart from few key high-profile figures such as Glenn Beck, Peter Schiff, Ron Paul, and (the younger) Alan Greenspan, is it difficult to find mainstream economists, even in America, who publicly accept the Austrian theory of the business cycle? To see why, we need to look at the assets and liabilities side of the Austrian explanatory balance sheet.

On the asset (theory) side, we find the action of central banks in producing asset bubbles with prolonged policies of too-cheap money and the epistemic hubris of managing the Great Moderation blowing up in the faces of the same central bankers who declared that they had tamed the cycle, which is not an unreasonable description of the 2000s. The broad sweep of an asset bubble’s inflation and deflation is well described by the basic Austrian model. The notion that debt is not simply redistributionary (my income is your debt) because leverage matters and that the payoff to debt financing is asymmetric, especially on the downside, is also a telling and important contribution. The problems start when we move to the liabilities (policy) side.

First, being the last redoubt of the “can’t live with it” liberals, Austrians bemoan austerity but see no alternative to it. “Do nothing” and let the economy “self-heal” are their main policy proposals. A version of this is currently being tried in the Eurozone, and as we saw there, the healing is not going so well. We should also remember that we have been here before. These same ideas were offered as explanations and implemented as policies in many countries in the 1920s and 1930s, and as we shall see in chapter 6, they didn’t work then either. As Keynes demonstrated, there is no reason for an economy to “naturally” return to a full-employment equilibrium after a shock. It can settle into a state far from full employment for a very long time. The Austrian explanation of sustained unemployment after a bust—the inability of the economy to self-heal as it should—is that trade unions are holding up the market-clearing wage. But in the United States, for example, where unions cover less than one in eight workers, such an explanation is simply not credible. Moreover, Germany and Sweden, countries with much higher unemployment rates through the business cycle, also have far higher unionization rates.

Second, if the only policy on offer is to get the government out of economic affairs completely, then its not clear how one does it short of engaging in a kind of “year zero” purge of the modern economy and polity. Similarly, the notion of relying on “real savings” rather than “artificial credit” would require the abolition of fractional reserve banking—where the bank lends out multiples of its reserves—and therefore an end to, for example, securitization, car loans, education loans, mortgages, and so on. It’s hard to see this as either welfare improving or politically sustainable in any meaningful sense.

Fourth, just as it does not follow that governments should always intervene to stave off market adjustments, as the “Greenspan put” and Ireland’s bank rescue showed only too well, to argue that there should never be intervention presumes knowledge of the system—it will return to full employment if left alone—that Austrians themselves say is impossible to attain. The Austrian counterfactual, that in the absence of interventions market allocation will be optimal, can never be satisfied.

Far from encouraging “self-healing,” nonintervention and noncompensation can produce the politics of permanent austerity, as Europe is finding out. Politically attractive to some, especially to antistatist conservatives, such ideas resonate in theory, but they detonate in practice.

Despite their finding German homes and American pied-à-terres, appreciating why these decidedly local ideas were able to spring to global prominence in the current crisis requires an engagement with what I term austerity's enablers: broader ideological and institutional shifts that bit-by-bit brought austerity back to the status of economic common sense after it had been relegated so decisively to the status of old-time religion. … They were part of a much broader intellectual shift in economics and economic policy worldwide that was part and parcel of the tearing up of the Keynesian instruction sheet in the 1970s. It is the rise of these neoliberal ideas that enabled the return of austerity as the commonsense thing to do in a slump. Remove these ideas from the intellectual fossil record and it is impossible to jump from the battered and isolated state pro-austerity ideas found themselves in by the 1960s to their modern instantiations.

Monetarism is a set of ideas developed in the 1960s and 1970s, most notably by Milton Friedman in the United States and by Patrick Minford in the United Kingdom. Monetarism's basic claims are twofold, with the first clearing the ground for the second's more substantive argument about the pathologies of the state. First, the Great Depression was caused by shortsighted Federal Reserve policy that led to a decline in the money supply. Contra Keynesianism, it was not caused by underconsumption or by a decline in the level of money income. This claim called into question the causal relationship between money and income seen by Keynesians. Second, and more important for enabling austerity arguments a generation later, is Freidman arguing that attempts by the government to stimulate the economy to full employment, which it would be tempted to do if it got that causal relationship backwards, can only show up as inflation.

Friedman’s argument was that if the government expanded the money supply to increase employment, employers would initially expand output in response to rising prices. Unemployment would decline, which would in turn boost wages. So far, so Keynesian. This cannot last, however, because Friedman, and this is crucial, assumed that unemployment was voluntary and was not due to a deficiency of demand. People choose labor or leisure at the prevailing wage. There is no demand-deficient unemployment in Milton’s world. In other words, the 25 percent of Spaniards who are presently without work simply don’t (by Milton’s presumption) want to work at the prevailing wage and are on vacation.

Once labor-market equilibrium is reestablished at this “natural rate” of unemployment, expectations will again adjust to the new, higher, underlying rate of inflation, and it can only continue to rise. With inflation rising and unemployment not improving, Keynesianism, according to monetarists, eventually eats itself.

Unemployment, then, only falls because of spending in the short term, as more workers are drawn back to work at the apparently higher wage, trading off leisure against labor. But because it is workers’ money wages that have increased, not their real wages (the money wage minus the effects of higher prices), nothing has really changed for them. Wages have gone up, and so have prices: it’s a wash. Realizing this, these newly employed workers, being voluntarily employed, either force up wages to compensate for the rise in prices, which their employers then pass off as price increases—inflation—or they withdraw their labor, bringing employment down to what Friedman called its “natural rate.”

Indeed, monetarism was in many ways simply a restatement of the quantity theory of money that goes all the way back to David Hume. Its power lay in how it provided liberals with an alternative way of thinking about the macroeconomy to that offered by Keynes, one that put money front and center. In doing so, monetarist ideas not only reduced the appeal of the Keynesian instruction sheet, especially in the context of the inflationary 1970s, they helped enable austerity arguments some forty years later.

By giving us a new set of reasons why state intervention to compensate economic downturns can only end up producing inflation, monetarism helped naturalize Austrian and ordoliberal ideas, pulling them off the fringe and into mainstream acceptance.

Their point of entry was to assume that agents inside the state behaved no differently from agents elsewhere: they maximized their incomes subject to their constraints. Rather than seeing politicians as neutrally steering the economy according to the vagaries of the business cycle with an eye to the public betterment, public choice theorists discerned a political business cycle, wherein state spending was matched to the electoral calendar to produce booms and slumps that were the cost of elected officials seeking to maximize votes.

Inflation is then the inevitable outcome of democratic governments trying to interfere in the economy. Just as market agents maximize income, so political actors maximize votes: inflation is the inevitable result. Unlike the invisible hand that promotes the public welfare by giving free reign to individuals’ income maximization, the visible hand that maximizes votes brings nothing but chaos to the social order and inflation to the economy.

During the Keynesian era, central banks almost everywhere were dependent creatures. That is, central banks were the financing agent for the national treasury: they cut the checks that the politicians said needed to be cut. As noted earlier, the one exception was Germany's Bundesbank with its singular goal of stabilizing the price level, which was only made possible by its unique late-developer profile and equally unique ordoliberal instruction sheet.

The telling contribution here came from two economists associated with the Real Business Cycle school, Edward Prescott and Finn Kydland. They pointed out that even if we don't assume that politicians are instrumentalist to the core, caring not a fig for the country as a whole, and assume instead the best of intentions, a "time inconsistency" problem sits at the heart of democratic decision making. Time inconsistency is familiar to any smoker who wants to quit: "really, just one more, and then I will stop." Politicians are time inconsistent insofar as they may sincerely promise to, for example, tackle the debt or lower inflation, but when a shock happens to the economy and/or an election looms, other priorities get in the way, and they renege on their promises; hence, inflation.

Kydland and Prescott argued that the key to solving this problem was for the central bank to be made independent from politicians and, in the manner of the Bundesbank, to be mandated to pay attention only to price stability. Critical here were a set of institutional reforms designed to shield the central bank from public scrutiny and central bankers from public recall or redress, while ensuring that these bankers are more conservative than the median voter to further protect the institution from populist demands.

Such reforms would ensure that government attempts to spend against the cycle would not happen in the first instance because the politicians in question would know that the central bank has credibly committed to holding the line on prices by being both institutionally protected and politically conservative. Thus the bank can “credibly commit” in a way that the politicians cannot. As a consequence, policy making should be delegated away from democratically elected politicians to independent conservative central bankers who will dish out the bad medicine when required because their jobs do not depend upon pleasing constituents—except, perhaps, their constituents in the financial sector who benefit from ultralow inflation—but that’s another story.

The acceptance of these ideas by a generation of policy makers, politicians, and economists as the common sense of the day considerably narrowed the space for any type of “spend against the cycle” compensation arguments—Keynesian or otherwise—long before the current crisis. Conversely, these arguments widened the policy space for austerity’s comeback considerably. After all, why compensate when we know that compensation only causes inflation? Why expect a stimulus to work when we know that it only ever promotes inflation and when politicians only enact a stimulus to get reelected?

What would have once been, without these ideas, simply the old-fashioned musings of cynical policy makers and their ancient economic advisors was now given a firm, and very liberal, theoretical foundation. Their evidentiary basis, however, was another matter entirely. The fact that these theories rest upon incredibly narrow operational premises and have scant evidence going for them is beside the point. That they are highly effective policy rhetorics that only narrow the menu of choice for governments is what matters.

Monetarism, as a specific policy of targeting the money supply to fight inflation, foundered on the rocks of defining what money in the modern world actually is back in the 1980s. But its legacy of assuming a natural rate of unemployment has been critical in sustaining arguments against spending and compensation. After all, why spend to get past the natural rate when that will only ever produce more inflation? If unemployment is “structural,” and not due to a lack of demand, then spending will not have any effect on it, so we should not try. The fact that the “natural rate” jumps around far too much across countries and time periods to be reduced to structural factors or unionization rates has done nothing to discredit it.

Similarly, the notion that unemployment is voluntary is, in the context of the current self-inflicted wound in Europe, downright offensive. Real workers must pay bills and feed families from jobs that have fixed hours and fixed wage rates. The idea that workers “trade off” labor against leisure by figuring out the real wage rate and then slacking off or going on an indefinite unpaid leave is the type of thinking that leads us to see the Great Depression as a giant, unexpected, and astonishingly long unpaid vacation for millions of people: original, yes; helpful, no.

The moral hazard logic embedded at the core of public choice arguments covers, and infects, all possible circumstances. Yet in doing so, it mistakes the mechanisms that generate trust—diffuse reciprocity, norms of mutual aid, and so on—for naïve weaknesses that can only be eliminated by more rules and stronger sanctions: exactly the things that eliminate the possibility of trust. While social capital does not trump moral hazard per se, when policy makers view all mutual interactions as agency problems, where one party will inevitably take advantage of another, the only solutions imaginable are the elimination of institutional ambiguity, the tightening of rules, and the writing of superficially complete contracts—which looks a lot like current Eurozone reforms. The problem is that what economists call moral hazard is what normal people call trust. You cannot eliminate the former without destroying the capacity for generating the latter. Without some degree of rule ambiguity and norms of reciprocity, trust cannot emerge. The EU’s political project was built on trust, not the elimination of moral hazard. That’s why it worked. Its monetary project is based on opposite principles. Yet at the end of the day, how can you run an economy, especially a pan-European monetary economy, without trust as its basis? While the German word for debt has the same root as the German word for guilt, schuld, the Italian word for belief forms the English root for the word credit, credere. At their base, money, trust, guilt, and faith are all norms, not rules. Smith’s self-interest and ordoliberal rules can only get us so far.

For the developing world, however, a version of neoliberalism that put austerity front and center became policy du jour courtesy of a policy consensus born in Washington years before it was tried in the developed world. It was the Global South where the policies unleashed upon the periphery of Europe, and which stand ready to strip the American welfare state, were first road tested. Once again, their failure did nothing to eclipse their popularity.

The Washington Consensus was a list of ten “must do” policies authored by development economist John Williamson in 1989. The full list was fiscal discipline, reordering public expenditure priorities, tax reform, liberalizing interest rates, (maintaining) a competitive exchange rate, liberalizing trade and foreign direct investment (FDI), privatization, and deregulation. They were intended to capture “the extent to which the old ideas of development economics … were being swept aside.”

Those old ideas, from the 1960s and 1970s, were the work of old-school Latin American developmental economists who championed industrial policy and other state-led industrialization projects. By the late 1980s, they were very much out of fashion, having foundered on the rocks of the Latin American debt crisis of the 1980s. Williamson’s new policy ideas were, in contrast, drawn from “ideas that had long been accepted as appropriate within the OECD.” As such, the failed old ideas that accepted a positive role for the state in economic development were juxtaposed with the new antistatist neoliberal ideas of the already successful, developed North.

Williamson has claimed, on repeated occasions, that he did not intend his list of policies to constitute “a general acceptance of neoliberalism.” But his list nonetheless captured the essential features of what we now call austerity policies rather well. Moreover, taking exchange rate and FDI policies off the list, it’s hard to see how this set of policies, drawn up in 1989 at the “end of history” moment, was reflective of the actual practices of OECD states in this period. For example, France, Italy, and all of Scandinavia, to name but a few OECD states, did not pursue such policies to any significant degree before 1999, let alone 1989. Outside the OECD the more successful developing states such as Korea, Taiwan, and latterly China, practiced these policies even less. Individual states may exhibit a few of these policies, with the United States and the United Kingdom once again at the forefront in generalizing their policies as universal, but the notion that they constituted an empirically settled consensus on “what the rich folks do” was taking it a bit far.

These Bretton Woods institutions (so named because they were set up in the aftermath of the 1944 Bretton Woods conference that reshaped the world economy after World War II) were, by the early 1980s, having a tough time of it. The IMF, in particular, had lost its original role and was struggling to find a new mission. The IMF was originally designed to provide offsetting finance to states facing exchange-rate shocks under the fixed-exchange-rate system that governed the world's money from the 1940s until the 1970s—the Bretton Woods system that pegged the dollar to gold and everyone else's currency to the dollar. Once the United States shut down gold convertibility in 1971, Bretton Woods fell apart, and the world's major currencies began to float against each other. The IMF, literally, had nothing to do.

As Dani Rodrik notes, IMF policy in this period, aided and abetted by the World Bank, devolved to a mantra of "stabilize, privative, and liberalize" as "codified in John Williamson's well-known Washington Consensus." The result was a series of one-size-fits-all policies that were applied from Azerbaijan to Zambia whose objective was to "minimize fiscal deficits, minimize inflation, minimize tariffs, maximize privatization, maximize liberalization of finance." It was, in other words, "expansionary fiscal austerity" in a developmental form, and the results were, by and large, terrible.

As Rodrik demonstrates, a decade into these adjustments the majority of “adjusted” countries had not yet returned to where they started from in terms of lost GDP—lost through the implementation of these policies. Successes were few, far between, and subject to frequent reversals. Latin America’s economic record was actually much better during the 2000s, a period when the pace of reforms slowed down considerably, and in some countries halted or was even reversed. As a recent survey of the results of IMF and World Bank reforms in Latin America shows, after the crises of the 1990s, the region’s reform index was basically flat in the 2000s. What seemed to be generated instead of growth were large financial crises, as capital accounts were opened up and controls on inflows were abolished—a uniquely IMF addition to the Washington Consensus checklist—and banking systems were liberalized. For Latin America in particular, the 1990s compounded the losses of the debt crisis decade of the 1980s. Far from creating growth, these policies shrank the economies that pursued them, just as we see happening in Europe today. … In fact, it’s hardly a stretch to see EU policy in the European periphery as little more than a localized set of structural adjustment policies implemented with just as much success as one would expect given past results.

Interestingly, what made the IMF so receptive to these ideas, apart from the changing intellectual climate of economic concepts and the tenor of 1990s graduate training in economics, was the then forty-year-old monetary model that the IMF used to examine the effects of its policies, the so-called Polak model. When the IMF was formed in the late 1940s to help countries with balance-of-payments problems through short-term financing of their deficits, the IMF needed to figure out how changes in a country’s exports and imports, bank credit, and foreign reserves interact over time such that the offsetting financing given to states (IMF loans) would provide the maximum bang for the proverbial buck. The result was the Polak model, the underlying assumptions of which tended to the austere rather than the reflationary.

In short, deep beneath the IMF's Keynesian surface in the 1940s a set of classical liberal assumptions was built into a model of the behavior of states that would not have been out of place in the British Treasury of the 1920s. The Polak model, a mainstay of IMF practice, primed the IMF to accept the conclusions of the Washington Consensus long before Washington Consensus ideas became the austere instruction sheet of the 1990s. That the liberal contradictions at the heart of postwar Keynesianism came into their first flowering at the IMF was not surprising. After all, the top management of this organization was from its inception dominated by people who hailed from central banks, treasuries, and ministries of finance—the institutions in which the "can't live with it, don't want to pay for it" form of liberalism was most likely to survive.

Given all this, you might think that the limited success of "austerity in the Global South" would encourage a rethink of these policies. In one quarter, it did. The IMF's sister institution the World Bank produced a report in 2005 that pretty much acknowledged the near total failure of the Washington Consensus checklist of reforms. But the IMF, echoing the classical liberal tradition, produced an evaluation the same year that argued the opposite. Indeed, according to the IMF report, the only thing that failed was, as ever, countries' implementation of the reforms, which left the content of the reforms both unquestioned and untouched.

What Karl Polanyi once said about the failed ideas of an earlier era also rings true in this instance: by the standards of the IMF, the Washington Consensus' "spectacular failure … did not destroy its authority at all. Indeed, its partial eclipse may have even strengthened its hold since it enabled its defenders to argue that the incomplete application of its principles was the reason for every and any difficulty laid to its charge." Once again, when it comes to austerity, mere facts seldom get in the way of a good ideology. And a good ideology, in the absence of supporting facts, can always supply a few good models to generate those facts when needed.

One of the most famous lines attributed (incorrectly) to Milton Friedman is "there is no such thing as a free lunch." In other words, growth is always costly in some respect, which is generally true. But an offshoot of the public choice literature developed in the late 1980s and early 1990s sought to indirectly challenge that truism by demonstrating that a free lunch of sorts is possible if the government forgoes dinner. That is, you can cut your way to growth while reducing your debt. At the same time, then, that the IMF was proving that such expansionary cuts do not actually work in practice by implementing Washington Consensus economics throughout the developing world, a whole new literature began to spring up proving that, despite such evidence, expansionary cuts do work, at least in theory, and at least in the developed (OECD) world.

The lineage of this new work goes further back and comes from another direction, however, beginning with the efforts of the midcentury Italian economist Luigi Einaudi. Einaudi was the founder of a school of public finance economics at the Bocconi University of Milan that produced an economics that was a hybrid of German ordoliberal ideas and what would later be called public choice economics. Einaudi was a contributor to The Economist magazine during the 1920s, a prominent academic economist in his own right, the first postwar governor of the Bank of Italy, and president of the Italian Republic from 1948 to 1955.

Einaudi’s intellectual legacy, and why he really matters to us today, lies not just in his ideas on Europe, even if they gave the drive toward European union an ordoliberal push from the Italian side of the border. Rather, Einaudi and his ideas matter because of the school of economics that he founded at the Bocconi University of Milan, which produced two generations of economists reared in these ordoliberal views. The modern argument for austerity was developed primarily by these second-generation Bocconi graduates, who went on to become some of the most influential members of the global economics profession, especially Alberto Alesina, Franceso Silvia Ardagna, Guido Tabellini, and Roberto Perotti. The importance of Alesina and his collaborators’ work in defining and defending the modern policy case for austerity cannot be overestimated. It is through their efforts that Einaudi’s legacy lives on in the form of an Italian ordoliberalism that, like Hume and Smith, has a deep distrust of the state and its management of debt as its core. It is this intergenerational legacy that has decisively shaped the final form of contemporary austerity arguments.

Given politicians' time-inconsistent preferences, "the (level of the) public debt is the state variable that gives the current government an instrument to control the future government." The short version of this complementary story is that conservatives should collect less in taxes and leave more debt so that any liberal government coming to power will be constrained.

This piece has an interesting ordoliberal slant to it insofar as it draws inspiration from an idea plucked from the German Council of Economic Advisors Report from the summer of 1981: cutting spending can increase growth by improving expectations. Giavazzi and Pagano picked up this idea and ran with it.

Specifically, if "the indirect effect ... [on] expectations of the measures taken are understood to be part of a credible ... program of consolidation, designed to permanently reduce the share of government in GDP ... [and thus] taxation in the future," then the shift in expectations will bring forth an expansion greater than the contraction caused by budget cuts. Inspired by this "German view," Giavazzi and Pagano went looking for similar cases and found two: Denmark and Ireland. While most Western European countries went through a punishing recession in the early 1980s, Denmark and Ireland, a bit later in the decade, cut spending and their economies expanded, Ireland being "the most prominent example of an expansionary cut in public spending."

However, politicians need not fear making these cuts because, according to these econometric results, states that cut “grow one percent faster than the G7 countries” while “business investment as a share of GDP rises by a full 1% point” and competitiveness improves. Tax increases, in comparison, cause the failing cases of adjustment. When done correctly, on the expenditure side “the good news is that major fiscal adjustments do not cause major recessions.” Moving beyond the cases of Denmark and Ireland, and dealing with the negative cases in a way that reinforced the message that cuts lead to growth, Alesina and his collaborators were laying the groundwork among neoliberal economists for expansionary austerity to be seen as “the new normal” rather than the policy exception.

“Tales of Fiscal Adjustment” brings together the claims made in this body of research and distills them into a few simple policy lessons. As Alesina and Ardanga put it, “Three ingredients seem to be important for a successful, long-lasting expansionary fiscal adjustment. It must combine spending cuts in transfers, welfare programs and the government wage bill, some form of … wage moderation, and a devaluation immediately before the fiscal tightening.” Raising taxes in a recession, as noted already, is said to simply make things worse. As such, a new form of TINA returns—there is no alternative to cuts.

The same expectation-based mechanisms as before are on display in this later paper but are more fully specified. Thus, in the absence of any significant liquidity-constraint, “when spending cuts are perceived as permanent, consumers anticipate a reduction in the tax burden and a permanent increase in their lifetime disposable income.” This leads them to spend and invest more today because they perceive that “previously expected large tax increases will not be necessary in the future,” which is especially true at higher rates of taxation. When such policies are followed in periods of “fiscal stress,” the results are better because the signal that the cuts will be permanent is more credible. So, not only should we cut, we should cut when it hurts, in the slump, not the boom, and we should cut decisively.

This time, however, to make the set of cases bigger, what constitutes a significant expansionary adjustment is now defined as a 2 percent improvement in the cyclically adjusted primary balance over two years. This yields a universe of fifty-one cases, nineteen of which are successful, and twenty-three of which are expansionary. The results of the econometrics confirm these claims. You get more bang for the buck when you cut in a slump, almost all contractionary expansions are the result of expenditure cuts, and now “successful adjustments experience a ‘spectacular’ investment boom during and after” the cuts.

To hone in on the particulars of these successful cases and fine-tune the policy lessons, Alesina and Ardanga select ten cases of fiscal adjustment: Ireland (twice), Australia, Belgium, Denmark, Canada, Netherlands, Sweden, Greece, and Italy (twice, but one is discounted). All occur during the mid-1980s through the mid-1990s. The results are remarkable, in part for their modesty. Of the ten cases (a limited number drawn from a distinct period to keep the sample manageable) only “two cases appear unambiguously expansionary: Ireland 1987–9 and Australia.” Denmark, per contra Giavazzi and Pagano, now appears to be “mixed.” Notably, “Canada, Netherlands, Sweden, Ireland and Greece show no sign of an expansionary fiscal advantage.” Belgium is “somewhat unclear,” while in Italy it was too soon to tell. In short, of the ten cases examined in detail, only two support the thesis advanced so powerfully on the basis of the earlier econometric tests: cuts lead to growth if and only if they are on the expenditure side.

To their credit, Alesina and Ardanga fully admit that the case for expectations having their purported powerful effect is “weak,” while acknowledging that devaluations, wage agreements, and several factors other than expectations matter. Yet despite these acknowledged limitations, when the crisis hit, “Tales of Fiscal Adjustment” was seen by anti-Keynesians as the appropriate instruction sheet on how to stop the twelve-month Keynesians discussed in chapter 3 from dominating policy during the bust, and it worked. But what clinched the case in policy circles, especially in Europe, was an update to “Tales” by the same authors written in 2009, especially a version of it Alesina delivered to the ECOFIN (Economic and Financial Affairs Council of the European Council of Ministers) meeting in Madrid in April 2010. … And despite acknowledging in the prior paper that the evidence for such expectations-driven expansions was “weak,” they deploy this explanation here again in full force and with no caveats about its actual explanatory power.

Alesina and Ardanga begin by noting that the ballooning of debts and deficits across the OECD is due in large part to the “bailout[s] of various types in the financial sector.” However, about this they “have nothing to say.” What they do have to say is that regardless of how we got into this mess, the only way out is through cutting the state. As before, they argue that “spending cuts are more effective than tax increases in stabilizing the debt and avoiding downturns.”

To make this new case for expectations-driven expansions, Alesina and Ardanga examine twenty-one OECD countries from 1970 to 2007 and select 107 episodes of positive and negative adjustment to make their case. Twenty-six of those episodes qualify as expansionary fiscal adjustments, occurring across nine countries. That is, debts are lower three years out and growth is higher than the seventy-fifth percentile of the average of the set of the observations. This time around, as we saw in the section on the effects of expectations, the results of the econometrics again lack the caveats of their prior piece.

Cuts lead to expansion and “have far superior effects on growth than those based on increases in tax revenues.” This time around Alesina and Ardanga even smuggle a quasi-Laffer curve into the piece, whereby cutting spending (rather than taxes) leads to more tax revenues, whereas “they [taxes] go down quite significantly in expansionary adjustments.” Most significantly, successful adjustments see welfare transfers fall, while unsuccessful adjustments see them rise. As such, the welfare state has to go because “it is very difficult if not impossible to fix public finances when in trouble without solving the question of automatic increases in entitlements.” And in complete contrast to what Keynesians believe, government spending lowers growth, since “a one percentage point higher increase in the current spending to GDP ratio is associated with a 0.75 percentage point lower growth.”

One year later, in April 2010, Alesina presented a simplified version of this paper at the ECOFIN meeting in Madrid. He began by noting that, unlike previous high-debt occasions, such as the aftermath of World War II, growth is not going to make the Eurozone's pile of debt disappear. Rather, there is no alternative (TINA) to fiscal adjustment.

Drawing on separate work on the composition of governments and policy making, Alesina assures the assembled finance ministers that if they go in this direction and start to cut budgets in the middle of a recession, not only will it make things better, it will not cost them their jobs. In fact, the public will reward them for their boldness since cutting the welfare state is neither unfair nor avoidable. Cutting is fair since "the rhetoric about the immense social cost of fiscal adjustment is blown out of proportion and is often used strategically by certain groups, not necessarily the most disadvantaged, to protect themselves." And it's unavoidable because the welfare state and its transfers are too big not to touch and are precisely what need to be cut to make growth return and reduce the debt.

As Anis Chowdhury has shown, Alesina's analysis was cited in the ECOFIN final communiqué and deployed in the rhetoric of Jean Claude Trichet, then president of the ECB; in the UK Treasury's 2010 emergency budget; and in the discussions of the US Council of Economic Advisors in 2010. And, as noted in chapter 3, it was written more or less word for word into the June 2010 ECB Monthly Bulletin, which cited both of Alesina's papers and drew directly on Giavazzi and Pagano and related works to make its case for cuts.

This, then, is the essence of modern austerity thinking. This is how it emerged. These are the personalities and the politics involved in its production. These are its core claims. It has been astonishingly influential and serves as the contemporary instruction sheet for economic reform in the European Union, and regardless of Obama's 2012 victory, we can most probably expect to see it deployed in the United States too. The only remaining question we need to ask is, does it work? The answer, as we shall see next, is certainly not in the big cases of the past in the 1920s and 1930s, not at all in Europe at the moment, and only very occasionally and under very specialized conditions elsewhere.

Crucially, those conditions have practically nothing to do with expectation mechanisms or cutting the welfare state. Deploying austerity in less than those ideal conditions has helped propel Spain and Greece to the brink of economic and political collapse and impoverished millions of people throughout the rest of Southern Europe. This is not “blown out of proportion rhetoric.” It is a fact. Austerity’s continuing application may well result in the eventual breakup of the Eurozone and have political repercussions that the weak institutions of the EU are unlikely to withstand. The cases cited as its successes, the justification for following this policy are, as we shall see, like positive cases of structural adjustment: few, far between, and quite possibly wrong.

Austerity works in the same way that Keynes maintained classical economics works, as a “limiting point of the possible positions of equilibrium.” That is, one special case out of billions of possible cases. He continued, “The characteristics of the special case assumed … happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.” Once again, what we learned in the 1930s has been forgotten. That forgetting is perhaps the strongest reason why austerity remains such a dangerous idea.

Now that we have examined austerity in theory, our purpose of this final chapter is to examine austerity in practice. But if austerity's intellectual history has been relatively short—you can't really argue all that much about state spending until states actually start spending in large amounts—its natural history has been even shorter. During the eighteenth and nineteenth centuries, economies went through boom and bust cycles and states, particularly those on the gold standard, did not try to compensate. Because those processes unfolded when classical liberal states were in charge, there was nothing to cut, and no democratic imperative to which policy makers had to respond. Laissez faire was the policy of the Belle Époque because La Belle, by and large, was not all that democratic. It's not until the early twentieth century, as detailed in chapters 4 and 5, that we encounter states that are both big enough to cut, and democratic enough to cause problems for austerity policy.

The second part of the chapter has two targets. The first section hones in on the positive cases highlighted by Alesina, Giavazzi, and others as examples of successful expansionary austerity because they form the countercase to the lessons learned from the 1930s: Denmark, Ireland, Australia and Sweden. I then juxtapose the experiences of these countries to the current state of the Eurozone to stress that even if these cases are granted positive status, which as we shall see is dubious at best, the conditions that made these cases possible are simply absent in Europe at the moment, especially the PIIGS. This makes the argument for expansionary austerity, at best, possible as a very special case, but wholly inappropriate as the general case.

Today, many seemingly sensible people on both sides of the Atlantic, but particularly in the United States, seem to think that the solution to any and all economic problems lies in returning to something called the gold standard. This is odd because apart from being a heavy, shiny rock, gold has no particular noteworthy features—besides being a major contributory cause of the two worst economic depressions in world history: the 1870s and the 1930s.

The gold standard solved this problem of trust by eliminating the need for it. The solution was to tie the notional value of different national currencies to gold at a fixed rate, gold being a conventional store of value that both is internationally exchangeable and cannot (easily) be altered by governments. X units of currency Y therefore could be exchanged everywhere for Z units of gold. And if all countries "pegged" their currencies to gold in this way, it facilitated trade by solving the fiat money/trust problem.

Since each country is pegged to gold at a fixed rate, when you earn foreign currency through trade, you can, in principle, take it back to the issuing country’s central bank and ask for the gold that backs it. Because the paper you now hold is convertible for gold at a fixed rate, the paper will be exactly equal in value to gold. So long as this promise of convertibility is maintained, you don’t have to worry about the value of the paper you are holding. If, however, a country on gold decides to run the printing presses to pay for imports in excess of their gold reserves, then that excess currency will show up in the countries exporting to these inflationistas. … Their reserves, sometimes called their “gold cover,” would be insufficient to cope with demand. This would call everyone’s attention to the fact that the issuing country is inflating its currency—issuing more than can be backed by gold at the fixed rate. This would cause people to lose confidence in that currency and dump it en masse, ending convertibility, and wrecking the offending economy in the process. Being on gold therefore gave holders of a foreign currency a “credible” signal that the money was “sound,” so long as convertibility was maintained.

But that wasn’t the half of it. The gold standard also worked as a mechanism of adjustment for international trade by bringing states’ exports and imports into balance through the inflation and deflation of domestic prices and wages. For example, if a country on gold exported more than it imported, it would, in effect, be importing gold from the recipient countries. This would add to its own domestic money supply, enabling the issuance of more domestic currency. It would also raise wages and prices as the economy boomed but It would also make its exports less competitive and its imports cheaper. Over time, this country’s trade surplus would turn into a trade deficit, with more imports than exports. Gold would move out of the country to pay for these increased imports. Domestic prices and wages would fall as the money supply (tied to gold) shrank, but the country’s competitiveness would improve (cheaper exports), and the trade balance would right itself as exports picked up and imports fell.

With everyone on the gold standard being open to trade and financial flows, the promise of convertibility combined with the flexibility of prices and wages to act as the mechanism of adjustment to ensure that the global economy produced a balance between imports and exports in one country and a balance across the system of countries as a whole. This is how the gold standard created the conditions for the growth of trade across the world, free from government interference and the danger of inflation. It was self-regulating, automatic, and impersonal—which was precisely the problem the moment ordinary people got involved.

You don't have to be a public choice theorist to see that you can only really run a system like this, where domestic wages and prices do most of the adjusting to external prices, if you are not a democracy. While widgets, potatoes, steel, and pneumatic pumps care not one jot about their supply price, labor most certainly does care, especially when that price (wages) goes down. By making the mechanism of adjustment the random inflation and deflation of prices and wages, a great deal of uncertainty, and unemployment, was created in these economies. It also created conditions where the domestic monetary authorities, to maintain that all important gold cover, would pursue austerity policies such as cutting spending and raising interest rates to shrink deficits, keep gold at home, and defend the currency. It was hardly surprising, then, that it was under the gold standard that labor across the world, both industrial and agricultural, started to join together in unions, political parties, and social movements to demand protection from the vagaries of the market and the policies of their own governments.

Making this worse apart from the effect of austerity policies, the global supply of gold puts a ceiling on growth. If trade demand increases faster than the money supply, and the money supply is limited by the gold supply, interest rates will rise and the economy will slump in response. The gold standard had, then, an inbuilt contractionary bias. It could solve the problem of inflation, but only at the price of creating deflation. Deflation is a particularly pernicious problem because in a deflation everyone's first best guess about what to do to protect themselves—for example, workers taking a pay cut to price themselves into a job—has the aggregate effect of cutting consumption, which shrinks the economy and makes everyone's unemployment all the more likely. States with large trade or budget deficits going into a recession fare especially badly in such situations because it becomes almost impossible to grow out of the problem as recession and deflation compound each other. Taking on more loans and more debt to gain temporary relief will not help in the long run because you cannot grow out of it.

By the time the euro arrived, democracy plus fifty years of the welfare state as a shock absorber had become even more of a constraint on such policies. Yet the euro demands deflation and austerity today, as it remains the Eurozone’s primary mechanism of adjustment. There may be no convertibility into gold under the euro, but the credibility of the claim to be able to pay back government debt performs the same function, providing an external constraint to policy as gold did eighty years ago. Indeed, the euro arguably provides even more of a constraint than the gold standard in one respect. Whereas states on gold can always “get off gold”—there is no need to print a new currency when doing so—the “once and for all bargain” that was the euro made states dump their old currency for good. There is nothing to go back to, which adds an extra layer of bondage to what is effectively a gold standard without gold.

The United States emerged from World War I stronger than ever. The main combatants—France, Germany, and Britain—returned much weaker. The European states sought a return to the gold standard as a way to restore the prosperity of the old era. There were just two issues about how to do this. First was whether to reestablish parity at pre-war levels, which would require significant austerity to get domestic prices down to where they needed to be, or to aim for new lower parities that would better reflect the actual conditions of these war-battered economies. The second issue was intimately related: how to cope with demands from these newly democratized populations for compensatory policies that would make this adjustment all the more difficult. These countries, and several more, opted for the hard road, and it would take years of grinding austerity to get them back on gold. Germany returned to gold in 1924, Britain in 1925, and France in 1926. Once they got there, as we shall see, things only got worse.

So long as US capital flowed to Europe, Germany could grow (or at least borrow) enough to pay its debts to France and the United Kingdom, which in turn used the same money to pay back its debts to the United States, so long as the United States sent it back to Germany to keep the whole system of payments going. As Fred Block put it with justified irony, “The American contribution to … the problem was to lend Germany huge sums of capital, which were then used to finance reparations payments.” If you think this sounds a little like continually giving the European periphery loans that those countries can never hope to pay back because of their already high debt burdens, again, you would not be completely wrong.

This had the effect of reversing the flow of capital to Europe as US capital came home to take advantage of these higher interest rates, which unexpectedly further stoked the stock market boom. After all, why put your money in Germany when you can make 15 percent buying shares in an investment trust and 7 percent in a bank deposit in the USA? The resulting capital flight placed enormous pressure on the German economy, which responded with ever-stricter austerity policies, especially, as we shall see, under Chancellor Brüning in 1930–1931. Deprived of external liquidity—all the money had gone back to the United States—bank runs in Austria and Germany were met with ever-tighter austerity policies in exchange for more loans (that failed to materialize) to stave off the inevitable default.

The critical point to note is that while there are a few positive instances of austerity leading to expansion among the legion of failures in this period, just as there were in the 1980s and 1990s, these episodes took place just after World War I, when the states in question, Germany and the United States foremost among them, were off the gold standard. As such, they could adjust their domestic costs by letting their exchange rate slide rather than through the forced internal deflation of domestic wages and prices. They were also implementing austerity at the height of the postwar boom.

Once gold was restored, the game changed and the application of any and all austerity policies simply made things worse—in some cases, as we shall see, with deadly results. The parallel to the Eurozone as a gold standard without gold (you can’t devalue, inflate, or default there either) is both obvious and vitally important. That is, if none of these countries managed to make austerity work when they were on the classical gold standard and were far more authoritarian, why would we expect anything different to occur today in the Eurozone—or even America—when they are far more democratic?

Unemployment slowly rose throughout the 1920s, making its reduction a political priority for both the Harding and Hoover administrations. As noted in chapter 4, Hoover, first as secretary of commerce under Harding and then as president, sought both limited public works and voluntary cooperative solutions to the unemployment problem. Neither policy had much impact on the recessions of 1924 and 1926. Indeed, given that the federal expenditures in 1929 were only “about 2.5 percent of gross national product” this was hardly surprising.

Even though the state had limited its ambitions to balancing the budget and ensuring convertibility, because of the unexpected bursting of the stock market bubble, Hoover spent $1.5 billion on public works when he became president in 1929. By 1931, overall federal spending was up by a third from its 1929 level. Given how small state expenditures remained relative to GDP, however, the now-accelerating decline in private spending meant that tax “receipts dwindled by 50 percent and expenditure rose by almost 60 percent.” At this juncture Hoover saw austerity as the only way, and the right way, to restore “business confidence” and balance the budget.

Hoover's contractionary policies were given a further negative boost by Britain's decision to abandon the gold standard in 1931. Confidence in the dollar fell as investors thought that the United States would follow Britain off gold. Capital began to flow out of the United States, interest rates rose, and bank failures soared. It was in these circumstances that Hoover authorized a tax increase, thereby producing a massive recession in the name of maintaining "sound finance." In December 1931, Hoover raised taxes by $900 million to eliminate the deficit. As Hoover put it in classic austerity-speak, "We cannot squander ourselves into prosperity." The price of this parsimony was to throw the US economy into depression. By 1932 unemployment had reached 23 percent of the labor force, up from 8 percent in 1930.

Since recovery seemed under way, the lip service that Roosevelt had been paying to the notion of balancing the budget became a policy issue, and after the 1936 election his treasury secretary Henry Morgenthau sought a return to orthodoxy. This led to a round of monetary tightening, which came on the heels of a fiscal contraction that was a result of new social security taxes kicking in. This increased unemployment, causing a short but sharp recession in 1937 and into 1938. This recession, a perfect natural experiment in austerity policy since the contraction was deliberate, expenditure focused, and happened in an upswing, failed miserably and shifted the balance of power from budget balancers to advocates of spending.

As the lynchpin of the gold standard and the largest foreign investor of the nineteenth century, Britain had major offshore liabilities in the form of foreign holdings of sterling-denominated assets. Returning to gold at a lower than pre-war parity would quite literally devalue those assets. This would have led to a serious run on the pound as investors tried to dump sterling en masse, just as the gold standard intended, which would have resulted in massive losses for the City. So when Churchill put Britain back on gold in 1925, the domestic economy was quite deliberately going to be squeezed so that the value of sterling and, not coincidentally, the profits of finance, would be maintained.

Britain stayed on the gold standard thereafter, pursuing, as we saw previously, austere policies under the watchful eyes of the Treasury, which refused virtually all efforts and initiatives to reflate the economy. Unemployment rose from 10.4 percent in 1929 to 22.1 percent in early 1932 as a result of the combined effect of the Treasury's austerity policies and the contractionary effect of being on gold, which demanded, of course, ever-more austerity.

What kept Britain afloat at this juncture, financially speaking, were precisely those "invisible" earnings on the capital account from sterling assets abroad that made up for the curtailment of exports and the reduction in domestic consumption wrought by austerity. The choice to save sterling was, then, not simply the City against everyone else. Banking was making a buck because sterling was not devalued, and that was (almost) balancing the books. Unfortunately, the sudden stop in capital flows from the United States in 1929 and the deleterious effects this had on Germany, Austria, and the other central European countries brought this happy state of affairs to an end. Britain now needed to import capital to cover its deficit, which was hard to do since it was all flowing to the United States instead.

Indeed, sustaining such high levels of unemployment had boosted unemployment transfers and worsened the deficit. This made any effort by the British state to borrow its way out of trouble ever more treacherous since doing so required further rounds of austerity policies to reduce the deficits that prior rounds of austerity had caused, so that Britain could be eligible for more loans to reduce the deficit. By 1931, Britain's austerity policies had become self-defeating.

The minority Labour government, in charge since 1929, was devoid of alternative economic ideas and went along with austerity policies sufficient to worsen the economy but insufficient to right the deficit. When the Labour government fell over how deep to cut, it was replaced by the National (coalition) Government. It enacted sufficient spending cuts and tax increases to convince J. P. Morgan and Company to lend Britain $200 million. But the loan was too little and too late to make a difference. With official reserves almost depleted (no gold cover) and unemployment at record levels after a decade of austerity policies, this final round of austerity forced Britain off the gold standard in September 1931.

The early postwar period was a difficult time for small export-dependent countries such as Sweden. As Erik Lundberg notes, "The strong deflation, the big decline in production (25 percent in the volume of industrial output), and the tremendous rise in unemployment were generally considered to be the natural and unavoidable consequences of the post-war boom of 1918–20." Nothing was done to cushion these blows and austerity was allowed to run its course. Real wages fell by 30 to 35 percent from fall 1920 to summer 1922, and contrary to liberal expectations, unemployment got worse rather than better. Like the British Labour party, the governing Swedish Social Democrats (SAP), lacking any other ideas about what to do, saw no alternative but to continue with austerity, accepting the recommendations of leading Swedish economists such as Gustav Cassel, who argued that "deflation, unemployment, falling prices and wages … were required" to cure the depression.

What changed at this juncture was the instruction sheet, which began to evolve from the mid-1920s onward, from austerity and gold toward a more expansionary fiscal policy and a more accommodating monetary policy.

Persisting with austerity, Sweden returned to the gold standard in 1924, a year ahead of the British, despite the further deflationary effect it had on the economy. GDP fell by approximately one-third and unemployment rose by one-third as a result. Being back on gold combined with an almost continuous contractionary fiscal stance in the latter half of the 1920s to produce unemployment of the order of 12 percent by the late 1920s, notwithstanding an export boom. Despite (or perhaps because of) this huge deflation, industrial unrest spiked, with five million working days lost in 1928 alone. When the combined forces of American capital flight, the central European liquidity crunch, and the British leaving the gold standard hit the Swedish economy in 1931, unemployment rose to nearly 25 percent in 1932. Austerity had helped Sweden produce an export surplus in the 1920s at the price of 12 percent unemployment. By the 1930s continuing austerity had produced the greatest slump in Swedish history and doubled that unemployment rate.

Reelected in 1932, the SAP eschewed austerity this time around in favor of policies that would give "the state … a totally different role than it had before in order to stabilize employment on a high level." The new SAP government proposed ninety-three million Swedish crowns in spending on public works. Crucially, however, rather than focus exclusively on policies that benefit labor alone, the government took the stability of the price level as the coequal policy goal alongside full employment, all the while resisting trade protectionism despite the collapse of the gold standard.

In 1933, the government resolved to ensure that business got on board by giving them a commitment to balance budgets over the whole cycle rather than over a given financial year. By 1936, this commitment spawned an economic commission that advocated the creation of a budget-balancing fund that would use accumulated surpluses to reduce government deficits. Countercyclical fiscal policy had arrived. Meanwhile taxation was structured in such a way that it stimulated investment. These reforms were in turn coupled to a policy of centralizing labor market institutions and promoting the increasing concentration of business to ensure trust and cooperation over wages among labor market partners.

Taken together, these initiatives facilitated an expansionary policy that worked through the supply side of the economy as well as the demand side, while taking the price-stability concerns of business seriously. As Swedish economist Rudolph Meidner said of economic policy in this period, the objective was to "maintain the market economy, to counter short-sighted fluctuations through anti-cyclical policies, and to neutralize its negative effects through fiscal policies. The rallying cry was full employment, economic growth, [a] fair division of national income, and social security."

The surprising thing was that it worked. Farmers, business, and labor all came together with the state in an encompassing coalition that allowed the costs and benefits of adjustments to be equally shared. Swedish austerity ended when it came off gold and actively changed its mind about how to run an economy. When Germany, Sweden's major trading partner, did the same and began to grow rapidly after adopting a very different kind of expansionary policy after 1933, external demand really picked up and austerity in Sweden disappeared for the next fifty years.

The hyperinflation that still scars the contemporary German psyche so deeply was not, as noted in chapter 3, promoted by some kind of misguided Keynesian stimulus. Rather, it was the German government's deliberate policy, designed to make the payment of reparations, especially after the French occupation of the Ruhr, all but impossible. In that regard, it was quite successful. Knowing that the reward for putting their fiscal house in order would be giving the French even more money meant that Germany decided to pull the fiscal house down. … Inflation proved to be a formidable weapon against reparations creditors, at least in the short run. It helped insulate Germany from the international slump of 1920/21, improving her export position and fueling internal demand. … It also exploited Germany's remaining foreign creditors, largely neutral countries, by depreciating the paper mark reserves they had accumulated during the stabilization period. … Above all, it paralyzed the financial system that would have been needed to organize an orderly transfer of reparations.

Moreover, while the hyperinflations are seen these days as an uncontrollable phenomenon, this one at least was not only deliberately provoked, it ended rather quickly with the introduction of the rentenmark, which was tied to, of all things, real estate assets. The new stable reichsmark succeeded it within a year. The next four years saw the German economy perform rather well, so long as US capital flows kept flowing. When those flows turned off in 1929, the German government abandoned the countercyclical policies it had pioneered in the 1920s, especially when its unemployment insurance scheme generated a large deficit, and reached for the austerity levers. The Reichsbank raised interest rates to encourage capital inflows, but the flows failed to arrive given the general shortage of liquidity in Europe following the Fed's interest rate hike. The only thing that happened was that the economy tanked further. Official reserves fell precipitously, and so did the gold cover.

As Sheri Berman brilliantly illuminates, the German Social Democrats of this period (the SPD) were intellectually Marxist but programmatically Ricardian: classical liberals in socialist clothing. Marx's economics were, apart from his view of the rate of profit and the possibility of a general failure of demand, as much Ricardo's as they were his own, especially as they were interpreted by the leading "theologians" of the German Social Democrats. Upon such a view, when the economy was in a slump, there was literally nothing to be done except let the system melt down until socialism magically appeared.

In fact, for the SPD, good economic policy meant being more orthodox than the liberals they argued against. As SPD member and one time vice president of the Reichstag Wilhelm Dittmann put it in a speech to the SPD faithful, "We want the current situation [the crisis] to develop further, and can only follow in the general direction that these tendencies show us." In response to this structuralist fatalism, the German trade unions began to agitate for an alternative "full-fledged Keynesian type assault on the depression" in direct opposition to SPD policies. This reflationary policy took form under the aegis of the so-called WTB plan (named after the formulators' initials), which the unions pressed hard upon the SPD and the government. Brüning ignored the plan and pressed on with austerity. But the SPD hierarchy set out to destroy it since it offended their faith.

The SPD's main economic theorist Rudolph Hilferding argued that not only was the WTB plan un-Marxist, it "threatened the very foundations of our program." As Berman put it, the SPD, as good Marxists, still saw letting the business cycle run its course as the only possible policy. Like the Austrians that they opposed in every other way, the SPD thought that intervention would simply delay the inevitable and make matters even worse. This was hard-core austerity thinking, except it came from the heart of the putatively democratic left. As Union leader Fritz Naphtali, who sided against the WTB plan, argued, "The crisis, with all of its changes and shifts of purchasing power, is a means of correction which must necessarily be accepted."

The centerpiece of their July 1932 election propaganda, the Wirstchaftliches Sofortprogramm (the immediate economic program) laid out an alternative to austerity that looked an awful lot like the WTB plan. The pamphlet's first three points could not have been more anti-austerity: first, "unemployment causes poverty, employment creates prosperity"; second, "capital does not create jobs, jobs create capital"; and third, "unemployment benefits burden the economy but job creation simulates the economy." Also, the program argued, Germany should get off the gold standard as quickly as possible.

In 1932, unemployment accounted for 30 percent of the workforce. By 1936, full employment was restored. However, because of the Nazis' repression of labor, real wages did not increase, and unlike Sweden, practically all the improvement was due to the fiscal stimulus of armaments. As Adam Tooze has shown, the much-touted work-creation programs of the Nazis were a propaganda sideshow. What really made the economy boom was the drive toward total war. As Keynes noted with regret in 1940, "It is, it seems, politically impossible for a capitalist democracy to organize expenditure on the scale necessary to make the grand experiment which would prove my case—except in war conditions."

Nonetheless, once the Nazis ended austerity and abandoned gold (even if they did this more through exchange controls than through devaluation), growth returned. That this turn against austerity took a particularly murderous direction in Germany does not invalidate the basic point that austerity didn't work. In fact, the point that really needs to be recognized is that repeated rounds of austerity policy, plus the ideological intransigence of the Social Democrats, helped to bring Hitler to power far more than any memory of inflation a decade earlier.

By 1933 the lesson should have been clear. You can't run a gold standard in a democracy. Eventually people will vote against it. They did so in Sweden and they did so in Germany. Austerity gave interwar Europe both social democracy and genocidal fascism.

In 1928, financial elites and those sections of the government pressing for an immediate return to gold enlisted the help of the major newspapers of the day to convince the public to return to gold. Typical was a series of editorials in Osaka Mainichi from the summer of 1928 through the spring of 1929. For example, when France went back on gold in June 1928, Osaka Mainichi argued that "France realized the repeal of the gold embargo: Japan should Shame Itself." The same editorial asked rhetorically, "Why shouldn't we repent ourselves of being left behind if we think our nation is a civilized and first-rate one?" In July 1928 the public was told that to rejoin gold "people must endure a pain of surgical operation … Shrink first in order to extend." Later that summer, an editorial noted that although a return to gold would be painful "it is a hopeful pain. Eventually it would restore us."

Having prepared the austere ground in this way, the final push to get Japan back on gold came from Junnosuke Inoue, the finance minister of the new Hamaguchi cabinet that was formed in 1929. Inoue was tasked with conducting a propaganda campaign that would clinch the case for gold. Thirteen million pamphlets, dozens of radio broadcasts, and many more newspaper editorials were unleashed on the public. And it worked. As Koichi Hamada and Ashai Noguchi report, "The motto 'repeal the gold embargo' became fashionable." Inoue himself authored several short books on the subject, each of which was a triumph of austerity thinking. As Inoue put it, "We cannot avoid fiscal tightening and liquidation at least once in the process," and so "the surest way is to go straight towards the repeal of the gold embargo … since we cannot avoid some pain … and sacrifice anyway." Inoue traveled the length and breadth of the country arguing his case, asking the people to be prepared for the tightening of the already austere economic environment.

The state had kept public spending in check throughout the 1920s, rising from only ¥1.2 to ¥1.4 billion over the course of the decade. The folks taking the brunt of this shrinkage in real terms were the military, who saw their spending cut from 47.8 percent to 28.4 percent of the budget over the same period. Amplifying Inoue's austerity crusade, his party's 1930 election slogan was "economy, disarmament, purification of politics, reform of China policy and removal of the gold embargo." The military were none too pleased. Inoue pressed on regardless.

Interest rates were raised "into the teeth of the depression" and government spending was cut by almost twenty percent from an already low level. By the time the London Naval Treaty, which condemned the Japanese navy to permanent inferiority status, was ratified in October 1930, the military had had enough. Prime Minister Hamaguchi was shot by a supporter of the military in November 1930 and died of his wounds the following year. Unperturbed, the finance ministry pressed on. In early 1931 they tried to cut another ¥28 million from the army and navy budgets. In October 1931 a plot by the army to overthrow the government was uncovered. The two facts were related. Civil-military tensions reached a head. The government blinked first and resigned in December 1931.

Inoue, however, was still campaigning for a return to the gold standard when he was assassinated in 1932. Later that year, a leading bank director and Takahashi's prime minister were also assassinated. Austerity was racking up quite a body count. A decade of austerity had convinced the Japanese military that they were "at war with the entire civilian political elite." Even Takahashi, the architect of recovery, was first excluded from cabinet by the military when he began to argue that since the economy had recovered (by late 1934), it was time cool the spending and worry about inflation. Two years later, Takahashi was murdered, along with several other political figures, in another abortive coup in February 1936.

Austerity not only didn't work in Japan. It created the worst depression in Japanese history, provoked an assassination campaign against bankers, and empowered "the wonderful folks that brought you Pearl Harbor."

The boom-slump-stabilization pattern that characterized the world economy in the early 1920s hit France in a peculiar way. By relying on German reparations to supply a large portion of their budget, when payments were not forthcoming, the resulting budget deficits had to be met with higher interest rates to attract capital. In such a situation a reasonable policy would have been to raise taxes, which is precisely where democracy and taxes came together to produce inflation.

France was a deeply divided society in which the political right sought to raise excise and consumption taxes on everyone else, while the political left wanted to tax only the right's income and wealth. Protecting the right, whenever it looked like the left might win an election, the Bank of France refused to roll over Treasury bills, that is, the short term debt instruments funding the government, thereby "forcing the authorities to print money." By 1924, after several rounds of stoking inflation this way, the right came to power and as expected raised taxes on the left's constituents. The left won the next election that same year but was unable to shift the burden back. As a result, deficits ballooned. Eventually, the left government resigned and in 1926 a rightist government under Raymond Poincaré raised enough taxes to close the shortfall.

What saved France to some extent was that the depression fell mainly on capital expenditures and investment rather than consumption. But even in France, there was only so much deflation a democracy could take. Reflation was needed, but reflating on the gold standard was simply going to produce capital flight, especially if the monetary authority decided not to play ball. For reflation to work, you needed supportive policies by the Bank of France, which was exactly what the Bank of France was not about to supply.

From 1932 to 1936 government spending was cut by 20 percent, industrial production fell nearly a quarter, the real exchange rate rose, and the money supply collapsed. Any attempt to compensate led to capital flight, which the Bank actively supported as a way of disciplining the government. The Bank planted stories in the press discrediting fiscal experiments elsewhere, insisted on budget cuts as the only way forward, and generally vetoed any policies that the democratically elected government promoted that did not meet with its approval.

The Popular Front increased wages, reduced working time, and reformed the structure of the Bank of France so that the Regents did not control the governing council. This was all very laudable, but it simply led to another round of capital flight, interest-rate increases, and more deflation. Reflationary policy, in the absence of effective capital controls, means that capital flight wins, especially when it is aided and abetted by the central bank. When the leader of the popular front Léon Blum suggested capital controls to make reflation and greater spending possible, he was forced out by the increasing capital flight that the Bank of France once again did nothing to forestall.

Even when France eventually abandoned gold in September 1936, little improved. To mix metaphors, while devaluation can create room to move, spending must pick up the slack. So when the monetary authority acts as a de facto veto on all policies except austerity, devaluation simply increases the import bill and deepens the slump. Most states in this period that left gold behind rebounded through devaluation plus spending, even if it was through rearmament. Yet the Bank of France continually vetoed budget increases that would have allowed the French military to modernize, and even mobilize, to meet the German threat. As a result, French defense spending between 1934 and 1938 was one-tenth that of Germany.

The interwar period taught us some valuable lessons about why austerity does not work and why its application is a dangerous idea. Building an entire international monetary order with an inherent deflationary bias that can’t work in a democracy is bad idea, number one. Number two, Einstein was right. If doing the same thing over and over again while expecting different results is the definition of madness, then repeated rounds of austerity in country after country was madness. No good came of it. Apart from a few short-term expansions in the early 1920s when countries were not on gold, not only did the application of austerity not work, it made the depression deeper, longer, and, arguably, laid the foundations for the war that would engulf the world in the 1940s.

The majority party in the Reichstag, the Social Democrats, was, perversely, even more orthodox than its liberal opponents. The result was a cross-party austerity that held the doors of power open, and the Nazis walked right through them.

Germany’s hyperinflation in 1923 had little to do with the austerity policies that followed or their ultimate outcome: the rise of genocidal fascism. Rather, as capital flight hit Germany in the late 1920s, austerity was applied to keep the country on gold, which had the effect of throwing the economy off the proverbial cliff.

The British heroically restored their pre-war parity and almost instantly generated a million unemployed and a slump that persisted until the end of the 1930s. … Japan underwent several rounds of deliberate deflation to get back on gold that proved utterly futile. In the process they annoyed their own military so much that it began to assassinate key members of the financial elite and forced a reflation of the economy far greater than the Swedes or the Germans ever managed. Finally, France remained on the gold standard longer than anyone else and ended up, arguably, suffering the most. They ceased to exist as an independent nation. French financial elites were so afraid of inflation, and were so determined to maintain the value of the franc, that they paralyzed the French military’s ability to mobilize against Hitler.

The original Giavazzi and Pagano paper from 1990 highlighted Denmark’s expansionary contraction in the period 1982–1986, claiming a political regime shift to the right, plus devaluation, plus a peg to the deutsche mark promoted growth. They were also “tempted” to say that the same applied to Ireland. Five years later Alesina and Perotti found fourteen successful adjustments in twenty countries over thirty-two years, with positive shifts in investors’ expectations, cuts on the expenditure side, and devaluations doing the work. These cases were more thoroughly examined in their article “Tales of Fiscal Adjustment,” in which the twenty-three positive episodes discerned in the data were narrowed down to ten case studies, of which, the authors concluded, “two cases appear unambiguously expansionary: Ireland 1987–9 and Australia.” Denmark, Giavazzi and Pagano’s best case now appeared to be a “mixed” result. Alesina and Ardagna’s main point was that “regardless of the initial level of debt, a large fiscal adjustment that is expenditure based and accompanied by wage moderation and devaluation is expansionary.” The 2009 update of this paper found nine examples of expansionary fiscal adjustments, and in every case “successful fiscal adjustments are completely based upon spending cuts accompanied by modest tax cuts.” The key channel for expansionary austerity to work, across all the cases, is the rational expectations of consumers.

We begin with Denmark, Giavazzi and Pagano's best case, but one that Alesina and Ardanga chose to label as "mixed." Alesina and Ardanga note that the size of the adjustment in Denmark was large, around 10 percent of GDP, and was "divided about equally between spending cuts and tax increases." They argue that centralized wage-bargaining institutions held the line on wage growth while the currency was pegged rather than devalued. This led to a disinflation rather than a devaluation, which nonetheless led to falling unit labor costs. Alesina and Ardanga do note, however, that after the initial successful consolidation, growth fell dramatically in 1988–1989 while unemployment rose, the main cause of which was the end of centralized wage bargaining—thus for them the case is "mixed."

In fact, later work by the IMF does not see Denmark as an example of "fiscal consolidation motivated by a desire to reduce the budget deficit" because the economy was overheating when the consolidation was undertaken. That is, the cuts were taken in a boom, not a slump.

The one country that routinely appears in the list of positive cases of expansionary austerity is Ireland in the late 1980s. Going back to the discussion in "Tales," Alesina and Ardanga narrate Ireland's experience from 1987–1989 as follows. When Irish debt to GDP reached 116 percent in 1986, a right-wing government came to power that cut transfers, the government wage bill, and taxes. Devaluation and negotiated wage moderation reduced unit labor costs by 12 to 15 percent. Growth rates and foreign investment both soared. Key to all this, as before, was the large expenditure-based cut plus wage moderation and devaluation.

If Denmark and Ireland don't really make the case for expansionary austerity and the all-important expectations effect, what about the Australian case? Actually, Australia problematizes the case for expectations-augmented austerity still further. John Quiggin has examined Alesina and Ardagna's “Tale” of Australian adjustment and declared it to be little more than “shoddy scholarship” that gets basic facts about the case entirely wrong. On Quiggin's account, and contrary to Alesina and Ardagna's telling of the tale, neither cuts in unemployment benefits nor capital taxes actually occurred in the Australian case, so their effect in altering expectations must be declared null and void. After all, if they didn't happen they can't have an effect. Similarly, the role accorded to wage bargaining by Alesina and Ardagna was, by Quiggin's estimation “absolutely opposite to the story told here,” which actually featured “a major expansion in the role of government” rather than any contraction. Most interestingly in this case, Alesina and Ardagna do to Australia what Bergman and Hutchinson do to Denmark—they omit the fact that “almost immediately after their story ends, Australia entered the worst recession in its postwar history.” Given Quiggin's demolition of the Australian case, we are forced to conclude that yet another often-cited positive case of expansionary austerity seems to collapse the moment any weight of historical evidence is placed upon it. Most significantly, the expectations mechanism, the key claim in all the literature, is again nowhere to be seen in the final analysis.

To recap Giavazzi and Pagano's main claims, the Swedish government ran up public debt to 67.8 percent of GDP during a massive recession, but most of it was its own choice. This was enough to create a bond spread of 1 percent (100 basis points = 1 percent = nothing to get worried about) over an equivalent World Bank note issue. This supposedly upset Swedish consumers (who apparently spend their time watching bond spreads) so much that despite being in the middle of a recession, rational expectations and Ricardian equivalence kicked in through the expectations channel to make sure that when free money from the state arrived in the form of a tax cut, it had no effect on consumption. Consumers rationally discounted the stimulus as a sign of terrible times ahead and offset the expansion via their longsighted expectations.

Anyone who knows the political economy of Sweden, especially in this period, would note a rather large omission from this paper's version of events—the triple meltdown of real estate markets, stock markets, and the exchange rate that happened to Sweden between 1989 and 1993. Sweden had just popped a bubble in its real estate and stock markets that developed after deregulatory moves by the government in 1987 massively expanded the supply of private credit, but you would never know that from this paper. As Peter Englund tells it, in 1989 alone "the construction and real estate stock price index fell by 25 percent … [and] by the end of 1990 the real estate index had fallen 52 percent." On top of this massive deflation, which had huge knock-on effects in the labor market, Sweden was hit by the deflationary effects of a currency crisis in the ERM mechanism that combined with the real estate bust to reduce GDP growth by −5.1 percent between 1991 and 1993. Then, and only then, did interest rates really skyrocket. No one cared one jot about the national debt at this point.

To explain this, there is no need to invoke the specter of Swedish consumers watching unlikely bond spreads while fretting about the national debt of one of the most solvent countries in the world. This is hyperbolic neoliberal fantasy looking for a set of supporting econometrics. Simply paying back debt when the economy is tanking, a classic “Balance Sheet Recession” a la Richard Koo, would suffice to explain what’s going on. That consumption didn’t rise is not a surprise unless you frame the problem in this absurdly counterintuitive way. That it stayed constant is the evidence for a common or garden stimulus effect—it didn’t fall despite the bust. It should have fallen further, but didn’t, because the tax cuts worked.

Arjun Jayadev and Mike Konczal undertook the first major critical examination of the 2009 paper’s data and key claims. They note several oddities in the paper. First, that of the twenty-six expansionary episodes identified in the data “in virtually none did the country … reduce the deficit when the economy was in a slump and … increase growth rates while reducing the debt-to-GDP ratio.” This is especially odd when compared to another finding, namely, that across these episodes “examples of successful consolidation were, on average, growing steadily the year before the year of adjustment.” In other words, and per contra one of the main claims made in the literature, it turns out that no state that tried this actually tried it during a slump.

Furthermore, and especially relevant to the situation of the Eurozone and the United States today, they find that while it is true that cuts in spending contract the economy less than tax increases, this occurs not because of expectations but because of the ability of the central bank to offset the contraction with an interest-rate cut. Given that interest rates are at or are near zero, no such effect will be forthcoming at the moment—there is only hurt to look forward to from such policies. Finally, even a devaluation, which is always an important component of expansionary adjustments, will not suffice to promote growth. “Because not all countries can increase net exports at the same time, this finding implies that fiscal contraction is likely to be more painful when many countries adjust at the same time.”

By the middle of 2011, empirical and theoretical support for expansionary austerity was slipping away. Even current members of the Bocconi School began to defect. Especially significant here was a piece by Roberto Perotti. Although he is critical of the new methodology employed by the IMF to question the case for expansionary austerity, Perotti nonetheless argues that almost all the time cutting your way to growth doesn’t work, at least in the short run.

Two IMF papers that appeared in July 2011 and July 2012 effectively brought Alesina's hour to a close. … Nicoletta Battini et al.'s "Successful Austerity in the United States, Europe and Japan"—an examination of the big cases that matter—pretty much pulls any remaining theoretical and empirical supports out from under the expansionary austerity case. … They argue, inter alia, that consolidating in a downturn is twice as risky as doing it in an upturn; that smooth and gradual consolidations always work better than strong and abrupt ones; that frontloaded contractions are more contractionary and worsen the debt-to-GDP load, and that cutting taxes is less contractionary than cutting transfers, especially when it's done gradually.

Indeed, the IMF's October 2012 World Economic Outlook concluded that the negative fiscal multipliers in the Eurozone had been massively underestimated such that the effect of cuts was amplified through the economy by as much as one-and-a-half times. This might go some way toward explaining quite why Southern Europe's expansionary consolidations have been anything but expansionary. Alesina's hour ended the moment the IMF remembered that austerity, when applied to real economies and the lives of real people, is still a very dangerous idea.

Undertaking the necessary austerity measures at an early stage … allowed the Baltics to benefit from positive confidence effects … allowed Latvia to return to the financial markets well ahead of schedule … allowed growth to bounce back after exceptionally severe output contractions. … The concept of “expansionary contraction” has been used and criticized in the ongoing debate about growth and austerity. The Baltic experience provides an indication that this need not be an oxymoron: even if fiscal consolidation weighs on the growth prospects in the short term, it has sizeable positive effects in the medium to long term.

For IMF director general Christine Lagarde, Latvia was an “inspiration” for Southern Europe. Olivier Blanchard, IMF chief economist and austerity skeptic, noted that the Latvians “can take pain.” Even Hillary Clinton praised Latvia, saying that austerity will ensure a “stable, prosperous future.”

Despite these states constituting an astonishing example of massive fiscal retrenchment and demonstrating a robust bounce back in growth, the REBLLs do not in fact provide much evidence for the expansionary austerity thesis. To see why, we need to understand that the economies the REBLLs built for themselves after communism were accidents waiting to happen. This is why they had to be so austere in the first place—the accident happened and it cost them a fortune. It’s an accident we have already seen in this book: yet another banking crisis that ended up on states’ balance sheets.

By the eve of the 2008 crisis, the REBLLs had developed a unique growth model based on massive foreign investment, even more massive foreign borrowing, and economic institutions that could only be described as open to money coming in and people going out. The problem with this growth model was that it was extremely vulnerable to external shocks due to its high degree of dependence on transnational capital flows, its tendency to develop large current account deficits, and its chronically weak export performance.

Encouraged by the prospect of EU membership for the REBLLs, which made these countries appear to be undervalued assets that would appreciate simply by adopting the euro, Austrian, French, German, Swedish, and even Greek banks went on a shopping spree to buy Eastern European banks in the early 2000s. REBLL banking sectors became between 80 percent and nearly 100 percent foreign owned in short order. These banks made little contribution to industrial investment, in part because there wasn’t much industry in some of those states in which one could invest, so they provided instead plenty of consumer credit to cash-strapped REBLL citizens and real estate speculators. Given the spread between the home banks’ funding costs and the rates they could loan at locally, this was a good deal for all concerned. This also encouraged local actors to load up on foreign currency loans, thereby building time bombs into their balance sheets set to explode the minute exchange rates moved against them.

This transnational credit pump created a phenomenal construction bubble that made the Spanish and Irish property experiences look tame by comparison. Spain and Ireland managed a paltry 6 and 8 percent annual growth in construction expenditures, respectively, in the 2000s. Romania was the laggard with 11 percent yearly increases. Bulgaria busted the curve with a near 20-percent-a-year increase. Therefore, while REBLL states busily cut their debt even before the crisis, their citizens and firms increased it exponentially in the form of nonproductive assets, on the back of weak exports and current account deficits, using foreign sourced cheap credit. All that was needed to make this whole system explode was a detonator—and the foreign banks provided that too.

At this point, the EU and the IMF intervened and orchestrated a massive bailout of the Central and Eastern European financial systems—in other words, of the Western banks' wholly owned foreign subsidiaries—just at the point when current accounts in these states were exploding. In Vienna in 2009, and long before any Greek or Irish bailout, an agreement was signed between the Western banks, the troika (EU-IMF-EC), and Romania, Hungary, and Latvia that committed Western European banks to keeping their funds in their Eastern European banks if these governments committed to austerity to stabilize local banks' balance sheets. … It's an earlier form of what is going on in the Eurozone with the periphery states' sovereign debt and the core banks' exposures.

Given this bust and deflationary bailout, the size of consolidation following the collapse was massive: 17 percent of GDP in Latvia, 13 percent in Lithuania, and 9 percent in Estonia, with half of it enforced in the first year, and most of it, per Alesina's recommendations, on the expenditure side. Double-digit public-sector wage cuts became the norm across the REBLLs despite the IMF's then managing director Dominique Strauss Kahn protesting that, at least in the case of Romania, the government should have taxed the wealthy instead. Expenditure cuts of such magnitude wreaked havoc in health, education, and social protection. Taxes were increased, but only on regressive value added taxes (VAT) and labor taxes. Massive tax evasion predictably followed, which simply worsened the overall fiscal situation.

A set of patently unsustainable and unstable economies financed by foreign credit bubbles blew up, quite predictably, the minute there was a shock to these economies. These countries are now supposed to be the role models for the rest of the world to follow? Spain is in bad shape, certainly, but is it really supposed to hollow out its economy entirely and live off more foreign borrowed money? Is Italy supposed to abandon its competitive export sector and sell off its banks? That would be what "following the example of the REBLLs" actually means. In fact, these so-called "models" are little more than the worst features of Ireland, Spain, and Greece combined, with no compensatory airbags, a sideline in divide-and-rule ethnic politics, and a libertarian instruction sheet. The REBLLs may have bounced back, but why would anyone want to copy policies that led to such an unstable and inequitable growth model in the first place?

If we add those who work part time or gave up searching for work, we get peak unemployment/underemployment of 30 percent in 2010 and 21 percent in the third quarter of 2011. If we add emigration to the figure, we end up with an unemployment/underemployment rate of 29 percent at the peak of the Latvian recovery.

Private-sector wage cuts did not happen on the scale needed to allow the increase in cost competitiveness that the deflation engineered to be effective. Unit labor costs were downwardly sticky during austerity programs despite massive public-sector cuts. This means only wage increases in Western Europe would make REBLL relative wages fall to more competitive levels, and that is hardly likely to happen in Western Europe in the middle of an austerity-induced double-dip recession. Similarly, REBLL austerity packages did not cut budget deficits as abruptly as the theory said they should. Latvia, Lithuania, and Romania ran much higher budget deficits at the peak of their austerity programs in 2009−2010 than did either Greece or Spain.

Austerity is also supposed to reduce debt. In fact, that's the whole point of it. Yet it didn't do it in the REBLLs and it didn't do it in the PIIGS. While all of the REBLLs had extremely low levels of debt—below 20 percent of GDP—going into the crisis, and had the advantage post-Vienna agreement of a sovereign bond market structure populated by patient (local or troika-tied foreign) investors who relieved bond market pressures, today they all have, with the exception of Estonia, more debt now than when they started, in some cases dramatically so. By comparison, imagine what would have happened if already high Greek or Italian debt levels were multiplied by four, as was Latvia's debt when it rocketed from 10.7 percent of GDP in 2007 to 42 percent in 2012. Indeed, the REBLLs will be saddled with much higher debt levels for a long time because of their austerity. Far from blowing up the Debt Star, they have built themselves a bigger one.

Fourth, and most critical in terms of exporting this “success” elsewhere, the external demand that caused the REBLLs to bounce back cannot be used to bring back the PIIGS or anyone else. While Bulgaria and Romania have relied on domestic demand and linkages to the German auto sector as the main driver of the economy, exports make about half of the Baltic States’ GDP. Since it is precisely domestic demand that suffers the most when austerity is implemented, this leaves exports as the main engine of growth. While all the REBLLs, but especially the Baltic States, have seen significant increases in exports, this provides little hope for anyone else since the REBLLs’ main trading partners are countries that have by and large avoided recession since 2008, such as Germany, or recovered very quickly, such as Sweden, Finland, and Russia. Finnish growth isn’t going to do much for Italy and Spain.

The Baltic States are a quick commute away from the economies of Scandinavia, to whom they offer wage arbitrage and a deregulated, culturally proximate, low-tax business environment. Spain can’t do that. It’s too far away and, crucially, it’s too big to replicate the same trick. While Romania and Bulgaria are medium-sized, middle-income states, the Baltic states are tiny. The average Baltic state is about the same size as a New York City outer borough. They can survive in the cracks of the world economy in a way that large economies cannot. Can you imagine what would happen to political stability if 4 percent of Southern Europe’s labor market left their respective countries in a three-year period? Where would they all go to find work? Lithuania?

Finally, the politics of austerity that made cuts of this magnitude possible in the REBLLs cannot be replicated in the Southern periphery, nor should we wish that it could be. A rather divisive ethnic politics was the card played by the REBLL governments in some of the Baltic States to isolate and marginalize opposition to austerity. Where that card was not played, in Romania and Bulgaria, citizen protest was strong enough to slow down the austerity drive, and most recently, defeat it at the ballot box in Romania in December 2012. Again, to take the example of Latvia, the biggest political party opposed to austerity was the party associated with ethnic Russians, which made the divide-and-conquer politics needed to isolate them, given Latvia’s history with Russia, much easier. Playing nationalism to force budget cuts is not a policy that ends well, as we know from the experience of the 1930s. Perhaps then, once again, those old lessons from the 1930s stand up to scrutiny much better than the new lessons we are encouraged to learn from the REBLLs.

In sum, the REBLL alliance does not prove the case for expansionary austerity any more than interwar Japan proves the case for sensible Keynesianism. The political and economic structures of these states are neither transportable nor stable. Their policies prove nothing about expectations or the sustainability of consolidations. Their recoveries and economies are inherently fragile and are based upon sources of demand that cannot be replicated elsewhere. They are in more debt than when they started.

When world leaders keen to legitimize the damage that they have already done to the lives of millions of their fellow citizens reach for examples such as these to vindicate their actions, applauding these countries for creating misery, it shows us one thing above all. Austerity remains an ideology immune to facts and basic empirical refutation. This is why it remains, despite any and all evidence we can muster against it, a very dangerous idea.

This book has examined the case for austerity as both a sensible economic policy and as a coherent set of economic ideas, and it has found austerity to be lacking in both respects. Austerity doesn’t work. Period. Insofar as the fossil record contains a few cases of what look like “expansionary fiscal consolidations,” as we saw in chapter 6, these cases are either driven by factors other than what the austerity proponents maintain, or those proponents simply get the case wrong. Expectations leading to confidence fairies really are a fairy story. The few positive cases we can find are easily explained by currency devaluations and accommodative pacts with trade unions. In general, the deployment of austerity as economic policy has been as effective in us bringing peace, prosperity, and crucially, a sustained reduction of debt, as the Mongol Golden Horde was in furthering the development of Olympic dressage. It has instead brought us class politics, riots, political instability, more rather than less debt, assassinations, and war. It has never once “done what it says on the tin.”

But the desire to apply austerity is not just ideological, although it is that. There are also good material reasons for the continuing application of austerity, especially in Europe—that is, clearing space on the balance sheet of sovereigns in case one of the region’s too big to bail banks goes bust. What began as a banking crisis in the United States continues as one in Europe. The euro has turbocharged this problem by effectively turning the twenty-first-century European economy into a classical gold standard.

In one sense—and leaving behind the Mother of All Moral Hazard Trades that was the generator of the European side of the crisis—the trigger for all of this was a classic case of good intentions gone bad. While the US financial system was, as we saw in chapter 2, an accident waiting to happen, what brought us down the particular path we find ourselves stuck on now was the decision to bail out the banks, starting with the US TARP program, in 2008.

Bailing led to debt. Debt led to crisis. Crisis led to austerity. Perhaps we could have avoided this sequence—as this book has shown, there were moments of choice. There was nothing inevitable about austerity—even if its root cause is a too big to bail banking system stuck inside a modern gold standard/monetary doomsday device that seems to have limited the options to “add central bank liquidity, squeeze the budget, and pray.”

Part of what follows is a conjecture—the business model of investment banking may be dying. If so, all the money we spent and have lost in recession was wasted on a system that may be in terminal decline anyway. Another part is a new tale of fiscal adjustment in two small countries: Iceland and Ireland. One let its banks fail and is now doing really quite well, especially when compared to Eurozone Europe. The other bailed them out and has condemned itself to a generation of misery because of it.

The final part of this concluding chapter turns to the question of how this all ends. The discussion of the cases of austerity from the 1920s, especially the French case, shows us that austerity is generated in part by the inability of societies, as Barry Eichengreen first proposed, to agree on an equitable distribution of the tax burden. There is a strong parallel to be drawn between France in the 1920s and the condition of the crisis-shocked countries today. The alternative to cut is to tax. Given this, there are two other ways out of the crisis in addition to the usual choices of inflation, devaluation, endless austerity (deflation), and default. The financial community will welcome neither of these two options, but it is not as if the other options on the table are great for them either. Those alternative choices are, first, what is known as financial repression, and second, a renewed effort to seriously collect taxes on a global scale. These efforts to get us out of this mess may not be popular, but one, or both, is coming.

At the end of the Bretton Woods era, when the United States finally went off gold in 1971, states around the world had to adjust to what Eric Helleiner has called "the reemergence of global finance." Floating exchange rates, deregulation, disintermediation, and the rest, which made finance the most profitable sector of the American and British economies by the 2000s, was the new order of things. But what was it all really based upon? After all, finance is most properly thought of as a part of the information system of the economy: linking borrowers and lenders while sitting in the middle collecting a fee. It's not an industry in the traditional sense, and it certainly should not have been producing 40 percent of corporate profits in the United States on the eve of the crisis—so why was it able to do just that?

Global finance made so much hay, not through efficient markets but by riding up and down three interlinked giant global asset bubbles using huge amounts of leverage. The first bubble began in US equities in 1987 and ran, with a dip in the dot-com era, until 2007. It was the longest equity bull market in history, and it spread out from the United States to boost stock markets all over the world. The smart cash that was being made in those equity markets looked around for a hedge and found real estate, which began its own global bubble phase in 1997 and ran until the crisis hit in 2006. The final bubble occurred in commodities, which rose sharply in 2005 and 2006, long before anyone had heard the words "quantitative easing," and which burst quickly since these were comparatively tiny markets, too small to sustain such volumes of liquidity all hunting either safety or yield.

Now, take away liquidity support and the hunt for yield and there's a problem going forward. You can only generate bubbles of this magnitude if there are assets that are either undervalued, or are at least perceived to be undervalued, and that can serve as fuel for the bubble. US equities had been flat for a generation back in the early 1980s. US housing was cheap and patterns of demand were changing. Commodities used to be a niche market. Finance changed all that, pumping and dumping these asset classes and taking profits along the way for twenty-five years. It was a great run while it lasted, but now, after the bust, could it be over?

Having pumped and dumped every asset class on the planet, finance may have exhausted its own growth model. The banks' business model for the past twenty-five years may be dying. If so, saving it in the bust is merely, and most expensively, prolonging the agony. Anticipating John Quiggin's Zombie Economics, we may have endured austerity to bring back the nearly dead.

Is there any evidence for this bold conjecture? A bit. Banks everywhere are delevering, which will reduce lending, hitting growth and thus the volume of business that they conduct. Bank equity prices and market capitalization have fallen drastically over the past two years. Revenues by asset class are falling. Underwriting has shrunk and trading is not what it used to be. Fixed costs are increasing while bonuses are shrinking and the sector as a whole is getting smaller. Meanwhile, what growth there is seems to be on the retail rather than the investment banking side. But retail depends more directly on the real economy, which is shrinking because of austerity. In sum, we may have impoverished a few million people to save an industry of dubious social utility that is now on its last legs. This is a discomfiting thought that strongly suggests that we really should not have bailed them after all.

The joke doing the rounds at the beginning of the crisis, before Ireland blew up, was, what's the difference between Iceland and Ireland? The answer was, one letter and six months. The joke, it turned out, was a prophecy. Ireland was discussed in chapter 3, and it was noted then that between 1994 and 2007 Irish GDP grew much more rapidly than in the 1980s and 1990s. During this boom period, when cheap money was abundant in global markets, Ireland's banking sector also grew rapidly, and on the back of the credit bubble grew a housing bubble. When the bubble popped in 2008, the Irish government issued a blanket guarantee to its banks and soon after gave five and a half billion euros to three banks: Anglo Irish bank, Allied Irish Bank, and Bank of Ireland. Unfortunately, since the assets of these banks were little more than dead real-estate loans, this was just throwing good money after bad.

Under the troika Ireland has endured round after round of austerity. Because of this Ireland is often held up as a role model for austerity, implying that things are getting better and that austerity is working. As ex-ECB head Jean Claude Trichet put it in 2010, “Greece has a role model and that role model is Ireland.” But if one looks at the economic consequences of the bust and the bailout, it’s hard to see the recovery.

The end result of all this activity was a full guarantee of the assets of the entire banking system: a total bailout. NAMA bought the assets at above book value with taxpayer money, sold shares of NAMA back to the banks, and they, in turn, used these shares as collateral to get liquidity from the ECB. In short, creative accounting and a helpful government enabled the banks to walk away scot-free from the carnage they had caused. Ireland was now shut out of international markets and placed at the mercy of the IMF-ECB-EC troika. Since then, over 70 billion euros have been injected into its banking system—divided by a population of some 4.5 million. Some 47 billion euros disappeared into Anglo-Irish alone, never to be seen again. The “assets” the taxpayer purchased via NAMA are not coming back anytime soon. The cost of bailing out the banks amounts to 45 percent of GDP, and that figure does not include the cost of the NAMA program, which is over 70 billion euros.

Low corporate tax rates made Ireland a popular site for multinational corporations to establish headquarters and declare their profits, which played an important role in the country’s boom. Google, Apple, Microsoft, and Facebook have set up headquarters in Ireland, but most of them have very few employees in the country. These firms pay a corporate tax rate of 12.5 percent in Ireland, which is just over a third of the 35 percent they would pay in the United States. Because of this dynamic, Irish GDP is inflated by global firms booking huge revenues through Ireland for tax purposes. When one looks at Irish GNP, which takes out such revenues, growth declined by 2.5 percent in 2011.

This anomaly also explains the high rate of exports from Ireland, which went from 80 percent of GDP in 2007 to 101 percent of GDP in 2010, which is also held up as evidence of the boom after the bust. The revenue of multinationals operating out of Ireland is booked as an export of Irish services—even if there is no real economic activity going on. Given this, exports of services have grown five times faster than the export of goods.

However, as Martin Malone of Mint Partners put it bluntly, “The entire increase from 2007–2012 in Ireland’s service exports is almost complete fluff … they are overstated by Euro 30 billion, which as a measure versus GNP comes to almost 25 percent of the total.” This overstatement of export-led recovery explains why unemployment has risen steadily, from 4.5 percent in 2007 to 14.8 percent by in mid-2012, even as emigration has risen notably, from 46,300 in 2007 to 80,600 in 2011 despite this supposed boom. Irish debt to GDP was 32 percent in 2007. Today it stands at 108.2 percent after three years of austerity. Indeed, if the cost of NAMA is added to the national accounts, its Ireland’s debt-to-GDP-ratio would rival that of Greece. Ireland bailed its banks, and then banked on an export-led recovery without a devaluation that was based upon phantom exports that create very few jobs and that are only made possible by tax dodging. Apparently this is Greece’s role model.

Iceland, in many ways, was Ireland on crack. Its bank assets to GDP ratio in 2007 was nearly 1000 percent. So when Iceland got into trouble, it was going to be the mother of all banking crises. But there was one important difference. Where Ireland followed the mantra of austerity, slashed spending, and bailed its banks, Iceland let its banks go bankrupt, devalued its currency, put up capital controls, and bolstered welfare measures. A comparison of the two is as close to a natural experiment of the effects of austerity and bailouts as you are likely to find.

Iceland’s transformation from a protectionist social democracy to a laissez faire center of international finance was fast and furious. By 2007, average yearly incomes had soared to the equivalent of almost USD 70,000. The value of the stocks of the fifteen firms listed on the Icelandic Stock Exchange increased sevenfold between 2002 and 2007, and the local real estate market more than doubled in value. The three Icelandic banks—Glitnir, Landsbanki, and Kaupthing—were behind this bubble. Their financial structure made Anglo-Irish look like a paragon of good management. Between 2004 and 2008, lending increased on average by nearly 50 percent a year. The banks self-funded on the basis of these loans and then invested heavily in their own stocks. When cross-financing between these three banks is added to the picture, self-investment was 70 percent of these banks’ capital base. If you are thinking of the great investment trusts from the era of the Wall Street Crash of 1929, you are not far off. On the back of this credit pump, private consumption increased and the Icelandic currency rapidly appreciated. By 2005, Iceland had become the most privately indebted country in the world.

By 2008, the Icelandic central bank found itself running out of liquidity when Glitnir, which had been struggling to refinance itself since the beginning of the year, found it couldn't access funding markets. The central bank offered it a loan equivalent to 25 percent of its reserves in exchange for 75 percent ownership, a de facto nationalization, which rather shocked the markets into action. The fallout from Glitnir immediately hit the other banks' funding sources such that private interbank credit was shut off as depositors withdrew their money. Meanwhile, the central bank was in no position to continue to act as a lender of last resort having already given away huge chunks of its reserves.

Iceland had crossed the Rubicon without realizing it. It was now in no position to bail out its banks even if it wanted to, and it wasn't in the euro so the ECB had no obligation to help. On October 6, 2009, the government passed emergency legislation that gave them the power to overtake troubled financial institutions, bypassing the central bank. Any plans the central bank harbored to bail the banks were now dead. The banks were to be allowed to go bankrupt and be taken into receivership. Their debts were not socialized; instead bondholders and foreign creditors bore the brunt of adjustment.

Allowing the banks to fail meant that they were less of a financial drain on the state. Their recapitalization cost close to 20 percent of Iceland's GDP26—a massive sum for such a small country, but an awful lot less than the still-growing Irish bailout via NAMA. Iceland's debt-to-GDP ratio in 2012 stood at 99 percent, a figure that would have been much higher had the banks been bailed out. Instead of austerity, the government pursued an expansionary policy behind these capital controls for the first year, followed by an evenly distributed fiscal consolidation. Everyone tightened their belts as the cuts were accompanied by a shift to a more progressive tax code that included substantial tax hikes for top earners and measures to help lowand middle-income families.

In terms of growth Iceland has fared better than anyone would have dared hope. The IMF projected a contraction of 10 percent in 2009 that turned out to be 6.5 percent. Apparently—note to John Cochrane—fiscal multipliers do exist after all. In 2010, the economy contracted by 3.5 percent, and in 2011 growth returned at 3 percent, based in part upon real exports of goods and services. Growth at a similar rate has continued into 2012, placing Iceland near the top of OECD growth performance. With higher marginal rates of taxation, returning growth, capital control, and equal fiscal tightening, Iceland is on target to eliminate its budget deficit in 2014 and have a budget surplus of 5 percent in 2016.

Finally, consider this bonus to the Icelandic experience of not bailing their banks. After initially falling quite rapidly, real wages have been rising at a brisk pace. This has helped reverse the trend of growing inequality witnessed between 1995 and 2007, when the after-tax Gini coefficient rose from 0.21 to 0.43, mostly because of the high incomes of top earners—a phenomenon seen in all highly financialized societies. By 2010, when capital income had collapsed and the tax code was reformed, the Gini coefficient was pushed back down to 0.245.

Can we generalize from Iceland to elsewhere? After all, we previously argued that we should not generalize from the experience of the REBLLs to the much larger states of Southern Europe. So what’s different here? Although Iceland is the definition of tiny, what matters in this case is not the size of the country, or its population, but the size of the banks relative to the size of the economy, its bank-assets-to-GDP ratio. In Iceland, that ratio was nearly ten to one at the time of the bust. In the United States that ratio was just over one to one. Iceland had ten times the bust of the United States’ worst-case-ever scenario, and it not only survived, it prospered.

Iceland not only survived letting its banks go bust, it became a healthier and more equal society in doing so. Although Ireland is a small country, and Iceland is literally the size of a city, and a small one at that, perhaps there are still, in the comparison of these states, two key lessons for the natural history of austerity. First, when you do the exact opposite of the austerity playbook, you not only survive, you prosper. Second, above all, don’t bail your banks.

The first path is usually known by the pejorative sobriquet of financial repression. Carmen Reinhart and M. Belen Sbrancia recently discussed this possible path. They concluded, by examining episodes of past high indebtedness, that states restructure their financial systems in periods of crisis in such a way as to allow them to create "captive audiences." Banks, pension funds, and other long-term debt holders are "encouraged" through capital controls, interest-rate ceilings, and other devices to hold a large amount of government bonds. The government then pays a low nominal interest rate on the bond while running a near-balanced budget with a positive but small rate of inflation. This creates an effective negative real interest rate on the bond such that the value of the debt shrinks over time.

Speaking of taxes, it's not just going to be sophisticated quasi-hidden liquidation and/or so-called Tobin taxes on financial transactions that are levied, either. Personal taxes have room to grow, too—especially in the United States. A recent analysis from the Congressional Research Service, which gives us an idea of what Congress might be thinking, noted that top marginal rate of income tax in the United States in the 1940s an 1950s, the heyday of US power, "was typically above 90%" while "the top capital gains tax was 25%." Meanwhile "the share of income accruing to the top 0.1% of US families increased from 4.2% in 1945 to 12.3% in 2007." This is an interesting juxtaposition of observations, to say the least. The justification for such reductions and gains is, of course, the supply side argument that more cash at the top leads to more investment and growth. Interestingly, the report concludes that "the result of the analysis suggests that changes over the past 65 years in the top marginal tax rate and the top capital gains tax do not appear correlated with economic growth." But they do appear to be "associated with the increasing concentration of income."

If big, powerful states want to go after it, they know exactly where to look, which is what they have been doing of late. Indeed, a new study by James Henry of the Tax Justice Network estimates that there is as much as 32 trillion dollars, which is over twice the entire US national debt, hidden away offshore not paying taxes, which makes for a very tempting target indeed.

So the debt is there and it needs to be paid off, or forgiven. Given that forgiveness outside the confessional is unlikely, and the other options, inflation and default, are even worse, it is pretty much inevitable that over the next few years financial repression and higher taxes on top earners will become a part of the landscape. The ongoing (at time of writing) negotiations over increasing taxes as part of the resolution of the 2013 US fiscal cliff debacle is simply the beginning. This is how we are going to deal with our debts—through taxes and not through austerity. Not because austerity is unfair, which it is, not because there are more debtors than creditors, which there are, and not because democracy has an inflationary bias, which it doesn't, but because austerity simply doesn't work.

25. For a typical example, see the two-page spread from the Peter G. Peterson Foundation, “For a Stronger Economy, Deal with the Debt,” in Bloomberg Businessweek, August 27, 2012. It contains a linear projection out to 2040. By that time global oil supplies may have run out, and the last thing we may care about is sovereign debt.

34. We note in particular how the crisis was at base a crisis of the “instruction sheet” of neoclassical economic theory. Indeed, the crisis itself can be considered a $13 trillion experiment on the robustness of these ideas, which begs a very important question. If these ideas were indeed falsified in the crisis, why are they still being used by financial and governmental elites to diagnose the crisis?

The same morality play is the British Government's explanation for the riots of August 2011 and the EU-IMF-Troika's lauding of the Baltic States as austerity champions in July 2012. Morality plays cover all contingencies.

If anything, it's the absence of the state in the repo markets that's worth commenting upon, since the absence of the state's guarantee of insurance explains the system's vulnerability to a bank run.

11. Assets are tied to the economy and can be a win-win thing for both buyer and seller. Derivatives are a zero-sum game in which only the bank makes money on both sides of the trade since one person’s payout is another’s loss.

13. A CDS is called a swap but is actually quite different from most swaps. It was called a swap mostly to avoid regulations that would kick in if it were named what it really is, an insurance contract. Insurance requires reserves to be set aside, but swaps don’t, which was a huge part of their problem.

22. Diversification is more than “not putting all your eggs in one basket.” Good diversification seeks to add assets that are uncorrelated or negatively correlated with other assets in a portfolio. Uncorrelated assets still must be expected to earn more than one would expect to get by depositing cash in a checking account, to be worth risking money and inclusion in a portfolio. Moreover, uncorrelated assets do not deliver those returns in a synchronized fashion: they do not have to rise and fall at the same moment in time.

Hence the still-manic finger-pointing at Fannie and Freddie, despite their ability to generate a global crisis being zero. There's only one Fannie and Freddie, and yet we have multiple states in crisis.

As we shall detail in the conclusion, it’s best to use GNP rather than GDP in the Irish case, since Ireland is a base for foreign multinationals that declare profits in Ireland for tax reasons. As such, Ireland’s net income from foreign sources and its foreign obligations are outsized relative to other countries and its services exports are overstated.

54. As of December 13, 2012, the EU has taken the first steps toward the creation of a banking union that recognizes the severity of these problems. The proposal allows the ECB to act as the common bank supervisor with authority over the Euro Area’s largest banks—those with assets of over 20 percent of GDP or 30 billion euros. Although significant, as indicated in the previous note (53), supervision and monitoring when you don’t have the cash to credibly bail are at best a step toward a banking union. They are not an institutional fix in and of themselves.

As Standard & Poor's put it, "We estimate that about 20 large systemically important European banks have cross border exposures to creditors in peripheral countries that far exceed their own tier one core capital."

Eurozone countries still have their own central banks, but they are central banks in name only. They are really the payments processors for exchanges between Eurozone countries through a network called the Target Two system. Some economists are very worried that imbalances in this system threaten to bankrupt the German central bank. Others discount the possibility entirely. It is indicative of EU institutions that knowledgeable insiders cannot even agree on how these institutions actually operate.

Carl J. Freidrich, “The Political Thought of Neo-Liberalism” American Political Science Review 49, 2 (1955): 511. A contemporary example of achievement versus impediment competition is to compare the competition on products that occurs between BMW and Mercedes. This competition betters both products such that both firms sell more cars. Now, compare this to the patent battles between Apple and Samsung, which is impediment competition. It is designed to keep the other firm out of the marketplace regardless of the quality of the product.

27. One of the less noticed consequences of partition in 1945 was that two-thirds of Germany's Protestants vanished into the German Democratic Republic. German Catholics suddenly became a much more sizable minority.

The fact that all of this was made possible by an astonishingly favorable macroeconomic context—the Bretton Woods international monetary system and American acceptance of an undervalued Deutschmark given Germany’s strategic position in the Cold War—should also be acknowledged. It seldom is, however, especially among German policy makers.

Studies have shown that economic growth is more likely to drop during an IMF program and after its completion, while social inequality increases. Faced with this reality leftist governments in countries such as Brazil abandoned IMF conditionality and adopted much more heterodox policy mixes.

Note that for the purposes at hand I am not trying to show that the Keynesians or anyone else was “correct” and that reflationary policies saved the day. All I need to do here is to show that austerity did not, as the British say, do what it says it does on the tin. Proving Keynes right is not necessary to prove austerity wrong.

14. Also at play here was the “seniority swap” that occurred when the 1929 Young Plan for reparations payments reversed the credit-default seniority of commercial claims over reparations claims that were present in the previous Dawes plan arrangements. Once this credit-protection clause was removed in 1929, commercial (i.e., American) capital evacuated Germany.

Bill Janeway objects to this parable of Ireland and Iceland for two reasons (personal communication, November 4, 2012). First, it underplays the systemic risk generated by failing banks in larger economies. Second, as well as bail or fail, there is a third option, which can be thought of as “bail, reform, and then send to jail.” Both objections are valid. But, as to the first, while the costs of austerity are massive, real, and lasting, the costs of systemic risk are, if there is always a bailout, hypothetical. To assume that the disease is always worse than the cure gives banks a license to extort taxpayers.