SARAH GREEN: Welcome to the HBR IdeaCast from Harvard Business Review. I’m Sarah Green. I’m talking today with Mark Blyth, professor at Brown University and author of the new book, Austerity– The History of a Dangerous Idea. Mark, thanks for coming in.

MARK BLYTH: Oh, it’s very nice to be here.

SARAH GREEN: So in your preface, you write that austerity as a route to growth and as the correct response to the aftermath of a financial crisis does not pass the sniff test. And actually, you use some more colorful language, but I’m going to stick to that version for now. So I’d like to get into some of the reasons why, and why, if it’s such a bad idea we keep coming back to it.

But first, I’d like to start with where we are now and the problem we’re currently trying to use austerity to solve, which is debt. Specifically, you have written that the debt crisis in Europe is not really a sovereign debt crisis, even though we’re all calling it that. So let’s start there, and then tell us what it really is.

MARK BLYTH: OK. That’s jumping halfway in. But let’s see if I can do that and then backpedal to why it’s a bad idea and then go forward. So why is it not a sovereign debt crisis? A sovereign debt crisis is the consequence of a private sector crisis.

So what actually happened is you may remember four or five years ago, there was this thing called the financial crisis? Right. So basically, when private sector debt gets very, very high and the underlying cash flows can’t support it, it collapses. And at that point, when you’ve built too big to fail institutions, as you had in the United States and also in Europe, you essentially take on that debt to the public balance sheet. And then you do that transfer. So you can think of it as sort of the greatest bait and switch in human history.

So essentially, you build a business model around being too big to fail, which is essentially a free insurance and an extortion racket. And then when that goes bang you hand all that to the state. And the state puts it on its balance sheet. You get bailed out. And then you turn around to the state and say, my goodness, look at all that debt. That’s terrible. We’ve been spending like drunken sailors. Now we need to cut it back.

Well, apart from the obvious bait and switch , then there’s a question of distribution and proportionality. Who exactly is going to cut it back? And that’s sort of the second level of disingenuous on this. The people who created this debt have just been bailed. They tend to be the higher earners in society. They tend to be the people who do not rely on government produced services.

So the very people who will suffer the cost of the bust are the ones who are now being asked to pay for the bill. So they pay once through the bust itself, through consequent unemployment, lower growth, et cetera through the bailouts. And then they’ve been asked again by cuts in public services, the public sector services that they actually consume. So there’s a double inequity going on in front of the bait and switch.

SARAH GREEN: That raises sort of a second interesting moral and ethical question. But before we even get into that, it came as a surprise to me, actually– and I’ve been trying to follow this pretty closely– the countries in Europe that have cut their budgets have cut their budgets and put into place austerity measures– their debt loads, you write, have gotten actually bigger and not smaller. Why has that happened?

MARK BLYTH: An easy way to think about this is if you imagine the economy as a sum, like a fraction, 1 over two, two over three. So the denominator on the bottom is the size of the GDP. And the numerator is the size of your constant stock of debt. So if you cut and there’s no other compensating source of growth, then what’s going to happen is you’re shrinking your denominator. Reciprocally the numerator has to get bigger. So you end up with more debt rather than less.

Now what’s meant to obviate this is what Paul Krugman and others call the confidence fairy. And it’s worth spelling out why it really is a fairy story. Because in order to obviate this, particularly if you have lots of countries who are all each other’s trading partner simultaneously contracting, then you’re going to have some confidence response. So by cutting spending, some [INAUDIBLE] confidence.

Now that tends to be very sort of [? insulated ?] and assumed. You see it in the financial press a lot, you know, confidence effects. Well, what are people really talking about?

Well the formal argument really goes like this– when a government says in the middle of a recession, I’m not going to supply any compensatory stimulus. I’m actually going to take a huge hack at government debt, what this supposedly does is signal to consumers that their lifetime income has changed. And they will now pay less taxes in 10, 15 years out, or whenever this happens.

And realizing this, having very long cited expectations and wonderful calculating abilities, they will turn around and say, hey, I’ve got more money to spend now. So let’s spend money now in the middle of a policy induced recession while I’m worried about keeping my job. And then if we all do that, then we’ll cure the recession and we’ll have less debt.

Doesn’t sound a bit like a fairy story? Now that doesn’t work. Now given it doesn’t work and you have a symmetrical contraction on the zero bound interest rates of zero, what happens as you shrink and shrink and shrink and shrink and that numerator gets bigger and bigger and bigger.

My favorite example of this is poster child for austerity, Latvia. Everyone celebrates the fact that they’ve had this huge drop in consumption austerity and a huge bounce-back. Two things to remember– they got the bounce-back when they stopped doing austerity. But more significantly, their debt load has increased four-fold since the crisis.

Could you imagine if Italian debt had gone up 400%? There wouldn’t be any Europe left. And yet, that’s the poster child? Stop me if I’m wrong.

SARAH GREEN: Well, so that raises an interesting question, which is why have we made these poster children, as you say? I mean, if austerity’s not really working then why do we think it is?

MARK BLYTH: I think two reasons. The first one is the Germans are in charge of Europe. And their in charge of the monetary institutions of Europe. And they’ve always had a particular way of viewing the economy. Any public money getting spent that isn’t indirectly appropriate through family policy or something like this, is always and everywhere some kind of inflation, and we’re going to end up back in Wiemar five minutes later.

The second thing is, and more seriously, by designing the EU around a set of what you might call [? all the ?] liberal institutions, a [? competition ?] authority made a very strong monetary authority. They’ve replicated the domestic institutions of the German economy. Now Keynesian-type thinking has never made any sense in Germany for the following reasons. It’s all about exports. So if you’re all about exports, what you worry about is cost control and competitiveness.

So the Germans were having a very, very hard time initially in the crisis. It looked like they’re exports we’re going to fall off a cliff. But then robust demand in Asia made up for that. And they still seem to be doing well.

Well, part of the reason they’re doing well is because they haven’t given their workers a real wage increase in 10 years and they’re exporting to China. They then turn around and say to the rest of Europe, you should be more like us. But as Martin Wolf in the Financial Times put it beautifully, how can everybody be like us? How is Europe going to run a surplus as a whole at the same time the Asians are doing the same thing? Who are we going to export to? Mars?

So there’s a huge fallacy of composition– the whole is not the same as the sum of the parts– in the way that Germany and the European elites, particularly European Commission, thinks about this problem. So having locked themselves into that way of thinking and then blamed it on supposedly lazy Greeks and others, it’s very hard to get out of that.

SARAH GREEN: So in that case, let me ask you this. Have there ever been circumstances where austerity has worked?

MARK BLYTH: The Germans have a nice one for this, which is jein, yes and no simultaneously. Because the cases that you see that look like this are not what you think. Basically, during the 1980s, there’s four of five cases that pop up. Canada is the best example, plus United States.

So what happened in Canada? Well, they did these periods of successful fiscal consolidation. And they did. They paid back a lot of that from a position of strength. The United States economy is nine times the size of Canada. The Loonie went through a 40% devaluation. They sold us lots of stuff when we were in an upswing. That gave them enough growth and surplus to pay back their debt.

If you’re caught at the top, as Kings once said, of all people, the boom, not the slump, is the time for austerity. If you cut at the top, it’s easy. If you cut at the bottom, when everyone else is trying to do it and it’s each other’s trading partners you’re cutting against, it goes nowhere.

So in the cases of so-called expansionary austerity– Canada, Australia, Denmark, Ireland– they’re all small states who are in an upswing with larger trading partners who devalue the currency. That’s simply not available to Europe as a whole. So jein. There are cases, but even those cases are not what you think.

SARAH GREEN: So give me a sense of then, in that case, why does this– as you call it a dangerous idea– why does this dangerous idea keep coming back? And how does it play into that sort of morality question that you raised earlier?

MARK BLYTH: So basically, you kind of have to go back all the way to the beginnings of liberal economics. So go back to John Locke. Go back to the second treatise on government. Locke’s classic is the fifth chapter. He talks about property.

Now what does he say there? He says, basically, I realize– and Smith realizes this later and Hume realizes later. Everyone realizes, Ricardo– that when you let markets do they’re thing. When you markets and private property and wages and land and the whole thing, you get enormous income skew. We’re living through it right now.

So unless something gets in the way to alter the skew, then you end up with great inequality. That inequality needs to be policed, which means you need a state. And that state’s meant to protect you. But any stay strong enough to protect you is also strong enough to come and steal your stuff, hence, the Second Amendment under typical liberal neuralgia about the state.

So this neuralgia is a real problem It’s [INAUDIBLE] liberalism as [INAUDIBLE] says [? there. ?] So how did we solve it? Paradoxically, we solved it through government debt. Because here’s the idea– you can’t trust the state. You can’t live with it. But at the same time, you need it. You can’t live without it. You don’t want to pay for it.

So imagine if someone comes along with a debt instrument and says, I’ll tell you what. I’ll sell you this, right? And then you can give me the money that I need to run myself– me being the state– and then I’ll pay you interest for doing so. What? It’s brilliant. It’s a free option. It’s perfect, right? This is great.

So I am the guy who needs a state. And I get the state to pay me money for the state to protect my property rights. Brilliant. Slight flaw in the plan according to liberalism. You go through Smith and Hume, you’ll find this argument. Ricardo as well.

The problem is to do that, you’re going to have to offer a rate of return on those assets which is superior to that which can be found in the market. So what do you do? You crowd out the market for investment. It gets diverted into government securities. As Hume put it beautifully, “all of the gold and silver that makes commerce possible is chased from the land through the instrument of debt.”

And then eventually, the income stream support an the debt can’t be supported. You end up selling it to foreigners. Think about all the fear about China holding American debt, right? Same ideas over and over again. And eventually, we’ll all end up ruined and bankrupt. And that’s the way that it goes.

Now that’s one version of events. But there’s another version where you had John Stuart Mill leading to Hobbes and leading to Keynes and others that says well, it doesn’t have to be this way. I mean, essentially, if you have a state which is strong enough not just to police inequality, but to alter the income skew, it can raise enough taxes that it can fund itself and police and protect the private property and capitalism without it becoming egregiously imbalanced.

So you had these two versions of liberalism which have been dominant and subordinate in different moments in history. Sometimes– the 19th century through the 1930s– it was very much the Ricardian and Smithian version. For the past sort of 30 to 40 years prior we heard the Keynesian version. And then with the neoliberal turn, we’re kind of back in that neoliberal or Austrian version of events. And that’s where those arguments come from.

Now there’s a wonderful book by an economist who pass a little while ago called Al Hirschmann called The Rhetoric of Reaction. And the subtitle is Perversity, Futility, Jeopardy. And he says that basically, any and all arguments against reform can be put into any of these categories. And it’s true. It’s completely exhaustive typology.

And you can take any of the arguments for austerity about why we need to do this and it becomes perversity, futility, jeopardy, right? Or, if you don’t do this, you’ll end up with even worse problems– perversity. Or, if you don’t do this, well, it won’t work anyway. So you have to do something else. So you get variations of this. All of those ideas are drawn basically from the Locke’s classic list of liberalism 200, 300 years ago. So when you’re basically banging out the same answers over and over again for 300 years without any modification, you might want to be a bit suspicious.

SARAH GREEN: And here’s my question then in that case. If I am a manager or a CEO in a corporation just trying to figure out what’s likely coming next, how conscious do I have to be? Can I afford to hire a bunch of new full time employees? These sorts of questions. And you’re sort of keeping an eye on the Financial Times or something, trying to figure out what kind of environment we’re likely to have. How do you who to believe? I mean, if all of these models are flawed and economists disagree on what’s going on, then how do you know how to run your business?

MARK BLYTH: By ignoring them, quite frankly. There’s a bunch of charlatans in the main. And politically interested actors and people who’ve got skin in the game intellectually and can’t let go. So why would you listen?

The most important thing to any business, on my understanding, is the fact that they have a regular supply of customers coming through the door. So you basically look at is that going to continue? Now you might sit on the sides and say, well, you know, we’ve got all these uncertainties with ObamaCare. I love that one as an explanation for why the US business community isn’t invested in it. Because their are lots of other business communities across the world that are in similar states and they don’t have ObamaCare.

And let’s remember that since 2009 with the bailing of the financial sector, corporate profits have never been higher even though we’re in the middle of a recession. So what should we be looking for going forward? Here’s the risk factor. The US financial sector has delevered to [? choose ?] what do we need? We need the consumer sector to fully delever. Then when growth returns, you can basically pay back the public debt and the balance sheet. Because growth cures debt way more than chipping away at the nominal amount will ever do.

The problem here is that if the financial sector gets away, it will just generate another set of asset bubbles. And then people will stop delevering. And they’ll start to pile on more debt in the private sector again. So you’ll have taken all this private sector under the public balance sheet. And you’re generally in the conditions for doing it again.

That’s the real risk going forward. It is not the debt burden of the government. It’s the fact that they may have to do it again. And given that Dodd-Frank only did around the edges so far on too big to fail as a problem, that may be what you’re looking at as your larger risk factor for the United States.

SARAH GREEN: So tell me, why is austerity such a terrible idea?

MARK BLYTH: OK. Here’s the common sense version. You can’t cure debt with more debt. That’s absolutely true. Quite why we keep giving the Greeks and the Cypriots and everybody else more money then is a bit of a puzzle.

But that’s only a partial truth. And it’s a partial truth for three reasons. The first one is distributional. The people who are being asked to pay are the people who don’t have much income. So if you take away even more of their income in real terms, you’re not going to do much except create a great deal of political uncertainty and also political tension. Ask the Italians. That’s just round one.

The second one is what you might call a problem of composition, namely a fallacy of composition, the whole being different from the sum of the parts. So why would it makes sense for any one person, one firm, one state to try and clean up their balance sheet, that is delever and pay back debt, particularly when they have income coming in. If everyone tries to do it at the same time, the only thing that you’re going to do is end up shrinking the economy as a whole. And the stock of debt itself will get bigger. So when you do symmetrical contractions, it becomes self-defeating. And that’s what we’ve seen in history many, many times over.

And the third one is a kind of logical problem, which is essentially, that you have to explain why it is that when the economy’s falling around your ears and the government cuts, then people suddenly become more confident and want to spend their money. I mean, let’s think about it. Who actually decides to open up a factory in the middle of a recession?

SARAH GREEN: So we’ve been talking about some pretty high level things here, complicated debt instruments, national economic policies, very high level stuff. Take this down to a much more immediate and personal level for us if you can. Why do you want to see people turn away from austerity personally? What are you hoping to get out of it?

MARK BLYTH: Well, why even bother writing this book rather than all the other books one could write? It’s actually a very personal reason. As you can hear from my accent, I’m not from Milwaukee. I grew up on the East Coast of Scotland in the late ’60s and early ’70s. And my mother died when I was very young and I was given over to my paternal grandmother.

So what I was raised on was this thing that everyone thinks is a total waste of time, the welfare state. And if it wasn’t for the welfare state, well, I don’t how I would have got to school. I certainly would never have got to university. And I certainly wouldn’t have become a professor at an Ivy League university.

So when people talk about the idea that we all need to tighten our belts, I’m all in favor of that the minute we’re all wearing the same pants. And we’re not. Because the people who have been asked to tighten are the ones that have the least going one on their waist to start with. And that would have been me and people like me.

What upsets me about this is the inequity of the distributional cut. That is to say by cutting away at government debt, you’re basically making sure that the next me isn’t possible, whereas the son of someone far farther up the income distribution will be unaffected by those choices. When you do that in a democracy, it’s destabilizing. And it’s also, I think, profoundly anti-capitalistic. Because it’s meant to be a level playing field. It’s meant to be meritocracy. You’re not meant to have the skew enforced by government cuts.

SARAH GREEN: Well, Mark, thank you for joining us today.

MARK BLYTH: It was a pleasure.

SARAH GREEN: That was Mark Blyth, professor at Brown University and author of Austerity– The History of a Dangerous Idea.