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Understanding the crisis: Why austerity is failing

published 23 October 2012 updated 17 October 2012
written by:

Five years have passed since the onset of the economic crisis in the United States and in Europe, and much of the world’s economy still remains deeply depressed. Even in regions where the economic situation has stabilized, any growth that has arisen has not been sufficient enough to supply for the increasing demand for decent jobs. Unemployment and underemployment rates still remain high, especially amongst youth. In fact, the IMF has recently downgraded its long term projections for the global economy, and is forecasting that growth will continue to be sluggish for at least the next two years.

Why has this crisis persisted so long?

The magnitude and duration of the current economic downturn has been unrivaled in the post-war era. One reason why a recovery has proven so elusive is that many governments have misunderstood the nature of the economic problems that we face. Consequently, they are making matters worse by pursuing public sector austerity measures that misdirect their focus on the symptoms rather than the cause of the crisis.

What caused the crisis?

While most analysts agree that the crisis began with the financial meltdown of August 2007, its roots arguably go back much further to a number of developments in the 1990s and 2000s. The deregulation of the world’s financial markets, rising inequality in wealth and stagnant wage growth, widening imbalances in global financial flows, and the emergence of highly complicated and increasingly risky financial instruments all led to growing economic instability.  Long before the current crisis began, there were early warning signs of brewing financial trouble: the Japanese asset bubble of the late 1980s and early 1990s; the Swedish banking crisis in the early 1990s; the East Asian financial crisis in 1997; and the Russian financial crisis of 1998, which precipitated the liquidation of Long Term Capital Management, one of the world’s largest hedge funds at the time.

The origins of the latest financial meltdown also arose during a period of low interest rates and easy credit fuelled a housing boom in both Europe and the United States. As the asset bubble grew, lenders began packaging and re-selling mortgages as obscure and unimaginably complex new financial instruments. Mortgage and consumer debt was “securitized” – basically, bundled into bonds that were sold to other investors around the globe with a stamp of approval from private rating agencies. This process of securitization was intended to eliminate risk, but it also reduced lenders’ incentives to be prudent. As a consequence, lending standards deteriorated and risky debt infected the whole global financial system. When housing prices eventually fell, the system tumbled over like a house of cards with global reverberations.

When the financial crisis first hit, most governments responded appropriately by enacting stimulus measures in the form of public investments in infrastructure and services, including education and training. Learning from the mistakes made during the 1930s, most policymakers used the power of public spending to boost aggregate demand in an effort stave off a repeat of the Great Depression.

Beginning in 2010, however, many governments abruptly changed their approach. Some even began arguing, without any evidence, that the crisis arose as a result of irresponsible public borrowing. In fact, the crisis was precipitated by excessive private sector borrowing and lending, including loans that were issued by over-leveraged banks. The bursting of the asset bubble on both sides of the Atlantic led to a credit freeze as well as a massive decline in production, trade, and employment. As a consequence, tax revenues fell while government spending rose as a result of rising demand for social benefits as well as the need to bail out struggling financial institutions.  In short, in almost every case the governmentdeficits and debt we see today are a consequence, not a cause, of the crisis.

What has been the impact of the crisis on education?

What emerged as a financial crisis in both Europe and the United States has now evolved into an economic and fiscal crisis that has unevenly played out across different regions and countries of the world. With the focus now on fiscal retrenchment and austerity, most governments in the North have slashed spending on public services, including education. This has led to freezes and reductions in the salaries of educators, cuts in benefits and pensions, increases in class sizes, inadequate working conditions, teacher and staff lay-offs and redundancies, deteriorating learning environments, and reduced services for students with special learning needs.  In the higher and vocational education sector, many jurisdictions have capped enrolment and raised or introduced tuition fees.

Several governments across the OECD countries have used the so-called fiscal crisis to justify ideologically-driven attacks on teacher trade union rights. Some jurisdictions have stripped teachers and other public sector workers of the right to collective bargaining. In other cases, labour laws have been reformed to allow for more poorly-paid, short-term and insecure employment contracts.

For the emerging economies, the effects have been more muted to date. These countries initially experienced only a mild downturn following the financial crisis and were able to initially protect education sector spending. Their growth forecasts are now being downgraded, however, and the potential impact on the education sector is now uncertain.

The global economic crisis has also indirectly affected education funding in lesser developed parts of the world. Increased pressure on national budgets has affected the ability of many of the world's poorest countries to finance education plans.  Seven out of eighteen of the lowest-income countries surveyed for the EFA Global Monitoring Report (2011) cut their education spending in 2009.  To make matters worse, less developed countries are also seeing development aid from donor countries being cut.

What are the alternatives to austerity policies?

Austerity measures have worsened the economic crisis.  The countries that have enacted some of the deepest public spending cuts have also been witness to the steepest drops in economic output. This is not only the case now, but it has also been shown to be the case historically.  In an examination of 173 examples of public spending cuts across a range of countries, the IMF found that in nearly every case the result has been a deep contraction in economic activity. Unfortunately, this is a lesson that too many policymakers have failed to take up.

Exiting this crisis will involve tackling the causes, not the symptoms. The specific policies that will be needed will vary from country to country, but there is one common lesson to be learned: governments must re-shift their focus from deficit consolidation to an emphasis on job creation. Strategic investments in public infrastructure and services, including education and training, are essential to the creation of decent jobs desperately needed to reduce unemployment. High rates of joblessness, particularly amongst youth, can all too quickly become endemic and make economic recovery and future deficit reduction even more difficult.

Increased public spending on education and training is a sound investment in long-term and sustainable growth. Borrowing rates for most countries remain low, and the high rates of return from education spending are well documented. True, this will increase deficits in the short-term, but it will also help reduce public debt over the long term because these investments produce long-run efficiency gains, higher incomes, and more sustainable economic growth.

In addition, many countries need to look at reforming their tax systems. Inequality has risen significantly across the globe, and there is a growing body of evidence showing that greater income inequality produces a greater risk of economic instability. A modest increase in taxes on the wealthy, as the French Government is now proposing, would not only generate sorely needed revenue to support public services, but it would also help to address rising inequality.

Further, action is needed to close the myriad tax loopholes and tax avoidance schemes that the super-rich and corporations regularly use. A more concerted effort on the part of the international community to shut down tax havens as well as to introduce a tax on financial transactions and speculation would help to raise revenues for public services and restore some sanity to financial markets by putting sand in the wheels of financial speculators.

Finally, some countries will need to look at restructuring both private and public debt. Many financial institutions still deny the fact that it was their bad loans, risky and aggressive lending, and complex repackaged debt instruments that drove up private debt levels and pushed the global economy to the brink. It is a small price to pay for these banks to be required to write down some of the debts of consumers, homeowners and governments.

The champions of austerity are espousing failed ideas that were rejected by nearly all economists after the economic calamity of the Great Depression. To continue down the path of austerity will only bring continued mass unemployment and irreparable damage to public services, education and training included. It is time to articulate an alternative agenda to austerity, one that puts decent work and strong public services at the heart of a sustainable path toward recovery.

The opinions expressed in this blog are those of the author and do not necessarily reflect any official policies or positions of Education International.