Yanis Varoufakis: why austerity doesn’t work

Yanis Varoufakis explains in the short video below why austerity doesn’t work. He uses the example of the UK economy, and leaves out the foreign sector (trade and investment), which does simplify things. I would argue that including the latter in the model is in fact vitally important to our understanding in the case of economies open to foreign trade and investment.

One reason for this is because a deflation which results from government austerity reduces the demand for imports from abroad, which negatively affects trading partners. Devaluing the currency can also have this effect, and is potentially an example of a ‘beggar-thy-neighbour‘ policy. The devaluing country may only gain at the expense of others, which can invite retaliation. This can take the form of competitive devaluation: if one country devalues, its growth might increase for some time, but if all countries do the same, the global benefits may be zero, while their distribution will tend to be uneven.

A small country open to international trade can adopt a deflationary fiscal policy and devalue its currency, in order to rebalance its economy away from domestic demand and improve its export competitiveness. This has often been the policy imposed by the IMF on developing countries in crisis as a condition of lending.  But if all countries deflate and devalue, the result will be a global recession.

This illustrates the importance in macroeconomics of analysing the world economy as a whole system, whose interacting parts can produce effects not obvious when looking at a single economy. This is an insight found repeatedly in the work of Michael Pettis, whose book The Great Rebalancing offers an original explanation for the Great Recession of 2008 and the likely global economic outcomes in the years ahead.

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2 thoughts on “Yanis Varoufakis: why austerity doesn’t work

  1. Devaluing a currency isn’t the same as deflation. A currency may be devalued naturally during an economic slowdown, or consistently undervalued to promote the export sector, but that does not necessarily translate to deflationary pressure within the economy.
    I think “anti-inflationary” would be a better term than “deflationary.” For example, when the IMF works in countries with high inflation, the goal isn’t deflation but rather manageable levels of inflation, e.g. 2-4%.

    • Thanks for your comment. Yes, devaluation is clearly not the same as deflation. In the post, I referred to IMF policies which in certain cases promote a combination of fiscal austerity and devaluation. I meant that the austerity would lead to recession or at best stagnation if applied to many countries. The devaluation itself could have variable effects depending on other countries retaliating etc, but could offset the austerity. A small open economy could gain by combining devaluation and some degree of fiscal austerity, but many large economies doing this will have large negative effects on themselves if they are relatively closed, or on their trading partners if they are more open.

      If there is a general shortage of demand in the global economy, as we have at the moment, then in the absence of global cooperation (which rarely seems to happen), there will be pressure for countries to adopt policies which weaken their currencies, especially if their sources of domestic demand are weak eg Japan and the Eurozone. By itself, this could lead to larger current account surpluses or smaller deficits, and could weaken demand in their trading partners who are unable or unwilling to retaliate.

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