Background information

1- Introduction

What is a crisis? A crisis is a concept that in general terms refers to a situation of disturbance, and in economics it is no different. Economic crises are those moments in which, for a wide variety of reasons, the economic variables destabilize. 

The most common indicators of a crisis are the imbalances that manifest in increasing levels of unemployment, inflation, business inactivity, poverty, etc. In this sense, crises may occur as a natural moment in the economic cycle, or they may be the consequence of specific shocks, most commonly in recent decades as a product of globalised economic dynamics. 

What is the difference between a crisis and a recession? 

The capitalist dynamic has been qualified as the cyclical process of fluctuations of diverse signals of different magnitudes. It is normal to find phases of expansion and accelerated growth following phases of depression and stagnation, as shown in Figure 1.

An economic cycle is that period of time in which expansion of the economy (GDP growth) is followed by a crisis in the rate of accumulation which then becomes a recession, which bottoms out at a given moment reaching the trough or depression, from which economic expansion begins again.

A recession is the phase of slowdown in economic activity in which consumption is reduced, leading to a decline in production, real income and employment. This recessionary phase can be more or less extended in time, but is generally considered to be of shorter duration than the depression. 

While the graph shows that the crisis is a disruption that changes the trend of the expansionary phase as commonly explained in textbooks, in our daily understanding, the crisis is often associated with the depression phase. 

The depression is the moment when the recession bottoms out or in other words when the recession is sustained over time and becomes more severe. What follows a trough is necessarily an upturn phase where the economic variables start to recover. In these situations, when the imbalances come to produce a crisis in an economy, it is necessary to try to reverse the situation to regain the equilibrium. Precisely, the chosen strategy and beneficiaries of that recovery depend on political economical decisions, and these aspects are the ones we will try to illustrate in this dossier.

How to do it in the best way is the question that economists and policymakers ask themselves, and, as it is easy to imagine, the formulas for action do not always agree. Each school of economic theory formulates different behavioural hypotheses, and different conclusions and practical recommendations. To understand the different positions, the two models of general reference in economics are posed, mainly the Neoclassical school on the one hand and the Keynesian analysis on the other, and the different propositions that each one of them follows.

2- The theory: two opposed models

All the macroeconomic relations have a quantitative dimension that must be closely followed and recorded in order to manage or intervene in them. The potential policy responses available represented by the myriad economic theories present discrepancies, as will be shown.  

The neoclassical model

The neoclassical model assumes that, at a given moment, there is a productive capacity (which we will call total or aggregate supply) determined by the number of factories, machines, equipment, etc. (physical capital) and workers (human capital). Further, it assumes that prices are always flexible. This flexibility is what would allow supply and demand to always return the economy to equilibrium at full employment. When there is an oversupply of a resource that results in its surplus,  its price would drop (the wages would drop) and then its demand would increase, thus automatically correcting the existing unemployment.

The main idea of this so-called liberal model is that to achieve equilibrium with full employment it will be enough to make prices completely flexible and allow markets to function freely. Exogenous interventions of any kind would be useless to correct imbalances, since imbalances are supposed to resolve on their own as a function of the freedom of markets and flexibility of price. According to this model, iInterventions will only lead to economic inefficiencies by causing either price increases (inflation) or displacement of individual spending. The latter might happen as rational private agents, who realize the State’s increasing deficit, foresee that taxes will be higher in the future and therefore would rather save than consume.

The Keynesian model

The starting hypotheses of the Keynesian model present a different vision of the operation of the economy and reach very different conclusions. The main difference is that for Keynes, prices are rather rigid, that is, that they would not respond to changes in demand. And he thought that this rigidity especially affected wages because workers are usually not willing to accept lower wages than they receive at any given time.

If we are standing on a level of production that does not have the capacity for full employment, it means that the demand of employment is lower than the supply. The capacity to achieve full employment could be propelled by increasing the aggregate demand which would result in the creation of more employment opportunities. Therefore, according to this model, the State’s interventions aimed at increasing aggregate demand would be very useful and necessary in order to increase production when the economy is below full employment. Only when the economy has reached its full employment level could any further intervention increasing the demand cause an increase in prices.

Instruments to respond to economic imbalances: fiscal and monetary policies 

The final aim of economic policymaking is to intervene in the general imbalance.  To try to achieve this objective, the State’s two main instruments are its fiscal and monetary policies.

Fiscal policy: this is the most relevant State intervention when trying to influence the aggregate demand. It can be defined as the policies employed to balance public income and spending. Public spending is defined by the sum of:

• The current expenses:  those destined to the remuneration of the personnel working to  service the public sector, the acquisition of goods and services, and current transfers.
• Public investment: those with which the public sector contributes to gross capital formation in the economy or capital transfer resources to other sectors. 
• Financial expenses: those destined to meet the interests and the burden of public debt.

Naturally, public expenditures must be financed. Public income can be gathered in three ways: 

• With the income from the sale of goods and services produced by public companies,
• Through coercive measures (mainly through taxes), 
• Raising public debt.

By managing the variations in the two components of the fiscal policy (income and spending), Governments generate changes in economic activity in different ways:

• Aggregate demand can be expanded by increasing public spending.
• Personal disposable income can be increased  —and with it, consumption and aggregate demand— by lowering taxes.
• Investment can be incentivized through tax credits or by reducing the tax pressure on profits.

Monetary policy: this is the set of interventions carried out by the Central Bank of a country to influence the existing amount of money creation and thus contribute to the achievement of the general objectives that have been set. Governments control the monetary policy by determining the key interest rates to stimulate or slow down the deposit money creation of banks and thus the investment and consumption enabled by loans.

The starting point of monetary policy is to influence the amount of money in circulation by making changes in interest rates in the money market: when the money supply increases, the interest rate decreases and vice versa. The interest rate fluctuations influence, on the one hand,  the money creation of the banks (with low interest rates banks have more incentives to give loans) stimulating the real economy by increasing investment or consumption; and on the other hand, rates influence individual behaviour (as low interest rates discourage saving already existing deposit money) also with the purpose of impacting the real economy once more by stimulating consumption. 

In both ways (directly influencing consumption, saving and investment, or facilitating credit), changes in interest rates can affect aggregate demand and, consequently, the level of production and income and employment. However, the fiscal policy is considered to be the most direct option as it intervenes directly in the real economy while monetary policy intervenes initially in the money market and only afterwards in the real economy, resulting in a less direct and therefore less effective impact on the economy. Furthermore, monetary policy is considered as a less direct instrument since the intention to stimulate  the economy by lowering the interest rate in order to stimulate the private sector to ask their banks for loans (that would – for sure – be used for investment and consumption), leaves the decision on the somewhat recalcitrant private sector. For companies and households the interest rate is only one factor among others which determines spending choices – and not even the most important one. 

The fiscal policy in contrast is directly creating new money to be spent into the economy. It’s transferred directly from the government to the bank accounts of the private sector, ready to create demand. No other decisions are needed from the private sector. And above all, it works when the key interest rate is no longer able to help the situation (for example when they can’t be lower than zero) and the whole private sector acts pro-cyclical.

How do the two models suggest responding to economic imbalances with the policy instruments?

To face economic imbalances the recommendations of the policy avenues aforementioned would be different essentially because they are departing from different assumptions regarding how the economy works. Therefore, the economic policy of the Neoclassical school rejects the use of incentives to increase the aggregate demand because doing so would produce price increases as they believe the economy is always at its full employment level. As a consequence, this line of analysis would avoid using fiscal policy, as the main objective of this policy is to affect the aggregate demand. For neoclassical theory, the imbalance situations are rectified by the flexibility of prices and the automatic mechanisms of the market. These are the adjustment mechanisms in this neoclassical model that results in the rejection of any other public intervention.

Regarding  monetary policy, although in the long term the variations in the money supply do not have much effect on income (since once the level of full employment is reached, it then cannot be exceeded), in the short term they are an adequate means to expand or contract the aggregate demand as the variation of the interest rate control consumption, investment and credit. In sum, the neoclassical model predicts that expansionary fiscal policy will only procure price increases, so the defenders of this model suggest monetary policy as the main instrument to intervene on the imbalances of the macroeconomic variables.

On the contrary, for Keynesians, the main instrument to intervene in the economy is fiscal policy due to its direct impact on aggregate demand. The variations in public spending lead to an increase in aggregate demand and income. Surely, this increase leads to a new increase in consumption opening up better expectations that, once again, lead to a further increase in investment. Thus, a series of chain reactions take place that, in the end, increases in income and gross domestic product (GDP) are greater than those initially generated by original expectations, due to what Keynesians call the multiplier effect. Therefore, managing the fiscal policy and with it, the aggregate demand is how this model suggests generating the necessary changes that an  imbalanced economic situation might require.

For Keynesians, the mechanisms of monetary policy do not differ from the neoclassical  model. In other words, if the interest rate is high the agents have more incentives to save, and if the interest rate is low, they have more incentives to invest and consume. The difference lies, however, in the effectiveness of the monetary policy. First, Keynesians question the actual effect of for instance lowering the interest rate as an instrument for stimulating the economy, considering that investment is such a volatile variable that depends rather on other circumstances: on the expected benefits, on the general conditions of the economy and of the expectations of the entrepreneurs. Secondly, Keynesians question the impact of monetary policy in times of recession. If the economy is on an expansive trajectory, many loans are requested and granted, stimulating the creation of bank money. In contrast, in a recessionary economy, the supply of bank money will even be reduced as more loans are repaid than taken out. Here, the private sector acts pro-cyclically and therefore makes the crisis bigger. In this situation, only the creation of money by deficit spending can help. The chain by which variations in the quantity of money transmit monetary impulses to the economy would be broken. For this reason, Keynesians argue that monetary policy is not effective in achieving increases in production, income, and employment.

Based on the main ideas in which each model bases their theories and their assumptions, we could simplify the suggestion of each theory as follows:

Consequences of each economic policy choice 

The models we have just analysed involve different points of view when making decisions about economic problems. Those issues are complicated and constitute for the economic authorities a decision regarding what measures to take when imbalances occur. Nonetheless, macroeconomic problems can be approached with sufficiently good knowledge thanks to theoretical proposals and empirical research. However the final decisions inevitably respond not only to scientific data but also to the preferences and ideologies of those who adopt them.

And this shows that the question of the effectiveness of the different economic policies depends not only on the framework of theoretical models as on the objectives that they want to achieve as a priority. If the fiscal policy and monetary policy were equally effective, models can predict that the same effect will be achieved by increasing the money supply or public spending. However, there is an obvious distributional effect that is not taken into account: although an increase in production and global income can finally be achieved, it is not the same if it is enjoyed by, for example, the holders of profitable assets or by the unemployed or pensioners. 

The different institutional framework within which these two policies are implemented must be considered. While the fiscal policy is subject – or at least should be – to the direct control of Parliaments, which are the seat of popular sovereignty, monetary policies are designed by central banks, institutions that are much less influenced by democratic control, especially since they have become independent. In short, it turns out that all economic policy measures are conditioned by value judgments and ideological assumptions and, above all, by the pre-eminence of one or the other interests in the social system.

3- Crisis: The World Economic Disorder and  opposing responses 

After having studied the theoretical problems of economic imbalance and the analytical instruments that allow economists to understand and respond to them, in this section concrete crisis examples are explored which place in the foreground the reality in which they occur, and the political measures adopted to face them.

Throughout the 20th century, the world economy was subject to great instabilities in the growth process. Three major global crises shocked the world economy while the models that planned their recovery varied throughout time.

The Big Depression and the Keynesian model 

At the break of the century, after a phase of expansion favoured by the appearance of new technology and global markets, the First World War gave origin to a new phase of economic depression. The war mobilized millions of people, who were subtracted from production; but when the war ended and all the economies recovered, a major crisis of overproduction originated, aggravated by insufficient demand. Temporarily, the economy flourished during the roaring Twenties, but the short-term affluence could not hide the deeper structural problems in the most important developed countries. The disorder created by the disappearance of the gold standard and the lack of monetary regulation of subsequent international exchanges caused a new crisis in 1929, known as the Big Depression.  

Until then, the ideas of the liberal model reigned in the economic policy of the industrialized countries. Following this theory, liberal ideas recommended that governments should not intervene to try to correct economic imbalances. However, markets showed an inability to resolve mass unemployment and crisis on their own. It was precisely in this moment that seeing that the market did not guarantee equilibrium by itself, Keynes proposed that the State would take a new active role with an economic policy model that corrects the imbalances and compensates for the insufficiencies of private spending. During the 1930s, several governments started spending on public works or any type of activity to create jobs. This increase on public spending and the consequent expansion of the aggregate demand (expansive fiscal policy) was what allowed families to increase their consumption, which, in turn, made it possible for companies to sell their goods. Therefore, thanks to State intervention and the multiplier effect, it was possible to create employment and make productive activity recover. In fact, during World War II governments’ intervention in the economy increased tremendously all over the world.  

After the war  the Keynesian economic model became more and more popular as it fitted well in the new reality. The combination of post-war long term and unpreceded economic growth and the consolidation of what was called the Welfare State (characterized by the wide range of social needs covered by public spending), sealed the Keynesian school victory. Challenging the neoclassical model by pointing to its imperfections and the necessary new intervention mechanisms, Keynes became the guide for the execution of economic policy for more than thirty years in most developed economies.

The oil crisis and the end of the Welfare State

The end of World War II opened a new period of growth, practically uninterrupted from the late 1940s until the mid-1970s. World exports went from 60,000 million dollars in 1948 to two trillion in 1980, which is a good indicator of the magnitude of the accumulation process and the internationalization of the economy of those years. The consolidation of the Welfare State and with it the rise in the standard of living in Western economies and the expansion of international investments was seen as such a permanent phenomenon that the world economy was considered to be on a stable and definitive path of economic growth.

However, throughout these years new economic disturbances appeared and the general growth, as well as the Welfare State model, were severely weakened. The stable upward trend in consumption (expansion of the aggregate demand) put pressure on prices and companies continued to rely on the cheap credit (low interest rates) to ensure that the increase in their productive capacity compensated for the wage increases that workers consistently claimed. The growth in public spending (fiscal policy) and money supply (monetary policy) added to the overheated economy in the West. All these factors led to a crisis in 1973 when the oil prices skyrocketed and the world economy entered a phase of disorder and acute crisis that lasted well into the 1990s.

As a consequence of a decision by the oil-exporting countries (OPEC) to, in an unprecedented manner, increase the price per barrel, the Western economies who were net oil importers, saw their trade balances deteriorate almost instantaneously. At the same time, governments continued to face enormous expenses. The first responses were to continue to carry out Keynesian policies to increase public investment: increasing social benefits as unemployment grew and helping companies in crisis. However as the crisis provided less and less public revenue, it turned out that the public deficits were getting higher, increasing public debt incessantly. All this brought with it the economic recession in Western countries, combined with a large drop in production and employment, a rise in prices, and the expansion of the money supply that attracted financial speculation and the financialization of the economy as a whole.  

The neoliberal model and the 2008 financial crisis

All the above gave rise, in short, to a world economic panorama dominated by unemployment, inflation, public and foreign deficits and the increase of social unrest that came with it. A general crisis of these dimensions required very forceful responses that began to occur, as early as the 1970s, in the military dictatorships of Latin America, which were the first regimes to apply liberal measures that would later spread throughout the world. The fall of the Berlin Wall in 1989 and that of the entire former socialist bloc together with the generalization of unemployment that greatly weakened the working classes, created the political conditions for a recovery aimed primarily at benefiting the regain of business profit. The theoretical support would come from the hand of neoclassical principles that were now reformulated in what has been renamed as neoliberalism.

The incorporation of new information technologies and the establishment of regimes of full mobility for movements of goods and capital made it possible to globalize a large part of productive activity. This was the new economic stage of planetary interconnection and predominance of neoliberal ideas that gave a response to the great crisis of the 1970s and opened the door to a new era of practically unencumbered financial disturbances. There were117 systemic banking crises in 93 countries and 113 episodes of financial stress in 17 countries from 1970 to 2003, shortly before the last major crisis in 2007.

In this context, a deregulatory process that had been established since the end of World War II allowed banks to spread low-quality, high-risk financial products that ended up contaminating the entire international financial system. With very low interest rates, banks in the United States granted hundreds of thousands of mortgage loans to people in very precarious financial situations. They were the so-called subprime mortgages, also called junk mortgages or NINJA loans, because they were granted to people “No Income, No Job and No Asset”. Such subprime mortgages were transformed and combined into new assets that the banks called Residential Mortgage Backed Securities (RMBS), that is, obligations guaranteed by residential mortgages, or Commercial Mortgage Backed Securities (CMBS) if they were commercial mortgages. They were acquired by investment funds (often owned by the banks themselves), which in turn derived them into new products, thus generating a perverse chain, because if the initial mortgage stopped paying, all subsequent products would immediately lose value. 

When these mortgages stopped being paid, as it was easily foreseeable that sooner or later, some banks would begin to record losses or even declare bankruptcy, already at the beginning of 2007. Little by little the contamination was spreading all over the world, the credit tap was closing and with that investment stopped, unemployment multiplied and governments were all facing another global crisis in 2008. What started as a financial crisis became a crisis in the real economy. Without clear recipes to deal with it, everything indicated that massive state intervention would be necessary, but that clashed with the dominant neoliberal thinking.

The conservative response: austerity

The response to the crisis since the 1970s, including the latest one of 2008, have been inspired by the economic policy launched by the conservative revolution that started almost at the same time that Margaret Thatcher in the United Kingdom and Ronald Reagan in the United States won the elections in 1979 and 1980, respectively: a conservative, neoliberal, market-driven response to economic, social and political problems. Both leaders started their terms by formulating two new economic policy objectives: the reduction of inflation and the reduction of the public deficit while placing confidence in the market as a mechanism for providing maximum efficiency in automatic balances and individualism instead of cooperation.

The implementation of this conservative response involved the application of a series of structural adjustment policies that removed the blockages that affected private initiative, enabling companies to recover profits and change the balance of social power. These adjustment policies focused on reducing aggregate demand, and specifically aimed to reduce the external deficit by using the traditional instruments of demand now in a restrictive sense: control of the money supply and credit, cuts in public spending, control of wages and devaluation of the national currency. Simultaneously, this model was accompanied by measures that relaxed the labour market rules, liberalized the financial markets and limited state intervention.

These structural adjustment measures have been applied with more or less intensity in almost all the countries of the world as the macroeconomic correction mechanisms. Especially after the great crisis of 2008, the European Union responded with an intensification of the so-called austerity policy with the implementation of the Troika. The Troika was a programme imposed together by the European Commission, the International Monetary Fund and the European Central Bank to certain countries (Greece, Ireland, Portugal, Cyprus, Spain, Hungary, Latvia and Romania) establishing austerity instruments in exchange for financial assistance. To deal with the debt that the crisis had left as the states took over the huge invoice that resulted from the rescue of the banking sector, very large cuts were imposed in public and especially social spending, thus trying to ensure that governments did not have to face such a large bill. However, these cuts in public spending entailed a negative multiplier effect much greater than expected, which instead of improving it produced a re-emergence of the recession in almost all of Europe, with the inevitable aftermath of more unemployment and more debt. At the same time and paradoxically, Germany, the country that made the strongest enforcements of these austerity measures in the above-mentioned countries, countered the crisis by setting up stimulus packages to incentive its domestic demand. 

Austerity measures were applied in less developed countries as well. As analysed before, economic crisis problems were followed by external debt problems. Following the conservative response, the main target of which has been the reduction of public deficits, international organisations ‘came to the rescue’ by granting loans establishing strict conditionality clauses. In this way, the agencies that granted them ‘aid’, the World Bank and the International Monetary Fund (IMF), ensured that emerging countries’ governments responded to the principles and interests of the great creditor powers. To respond to the payments, governments were forced to reduce consumption and imports, as well as public spending, which, according to the prevailing liberal beliefs, was always understood to be harmful.

The consequences were dire everywhere but even more severe in the poorer countries where the reduction of the welfare state meant a huge increase in poverty, unemployment and social unrest with record levels never before reached. In short, so far, austerity policies have enabled companies to recover profits and change the balance of social power, but they have not been able to guarantee lasting stages of stability and well-being, nor have they avoided major economic problems, such as mass unemployment, the waste of resources, poverty and inequality.

Counter-cyclical response: what government investment could look like

The primary economic policy applied in several countries to manage the crisis has followed the austerity policies described above. However, there are some examples of countries who decided to make a daring stand in casting aside the harshest austerity measures its European creditors had imposed. In this context, the recent experience of Portugal seems to be one of the first examples of this kind of counter-cyclical economic policies.

The aftermath of the 2008 crisis found Portugal at its worst recession in 40 years. Between 2011 and 2014 tens of thousands of businesses went bankrupt, unemployment soared above 17 per cent and hundreds of thousands of young skilled people emigrated, generating a loss of over 4% of the working population. In 2011 the government of Passos Coelho negotiated with the IMF a bailout following the typical austerity plan of cutbacks to welfare state services, cutting labour costs and pensions and privatising public assets, all measures leading to an aggregate demand collapse. Antonio Costa, by then the Lisbon mayor, signalled these measures as a submission to the neoliberal agenda which was exploiting the nation and expelling capital, rather than attracting it.  

After being elected Portugal’s prime minister in 2015, Anotonio Costa went against the norm by reverting the austerity measures that had affected working hours, holidays and taxes, as at the same time increasing the minimum wage by 20 per cent in two years. Interestingly, this policy was managed while keeping at balance the public spending and even reducing the fiscal deficit.  Costa’s policy raised people’s income by lowering taxes, especially for those with lower wages, helping to revive the domestic economy and with it lifting public investment and reducing unemployment , while still not overstretching the fiscal capacities. In short, he combined fiscal discipline and income distribution.  

Nevertheless, whereas for many this counter-cyclical response showed that crisis can be overcome without destroying jobs and living standards; for others, Costa merely introduced a few changes in the economy and has had the good fortune of being lifted by the European general recovery, falling oil prices, an increase in exports and the tourism boom. Therefore, critics argue that the expansion of the domestic demand was small and overcompensated by the amelioration of the balance of payments which allowed for catering to the economy without increasing the external financing need. Further, the lack of a long term investment plan for the country aiming at increasing productivity and the fragility of the banking sector have raised some concerns about the future path of the country.

It is still too soon to understand if these sorts of comebacks of counter-cyclical instruments are successful measures in the face of a crisis. In the case of Portugal, the country might, in the end, have simply benefited from the improvement of its macroeconomic situation thanks to the recovery of Europe. However, the underlying belief of Costas’ government, namely that by reducing unemployment and increasing people’s income confidence is strengthened, may be the beginning of a new change in the global political economy, as according to his ideas, confidence is a great driver of economic recovery.

4- The role of Political Economy: further advice

In recent years, globalization inspired by neoliberal adjustment policies has resulted in a consistenttransfer of wealth from labour to capital, from the peripheries to the centre and from the poorest population groups to the most favoured, according to reliable reports on the distribution of income and wealth.

Given all the considerations, it is surprising that the economic policies applied in recent years, sometimes imposed without excuse by international organizations, have been based on measures (mainly the radical control of inflation and budget deficits) that do not have sufficient theoretical or empirical support in the literature when presented outside of simple rhetoric. 

All this makes it possible to suspect that economic policy is not carried out based on objective criteria or neutral interests, but rather  from a very significant social conflict and in a context of great inequality, so that only the most powerful subjects and institutions can influence governments to adopt the policies that interest them most. These actors do so to ensure that the applied economic policies are those that best safeguard their economic, financial and political interests.

Therefore, we must understand the functioning of this most conservative economic science, the one which has the approval of the status quo, powerful means of dissemination and which reduces societies to the field of individuality and rational behaviour is in fact exclusively in the interests of profit. It is urgent for everyone to understand that behind every economic policy decision there is an interest in making the choice.