Smash hit

Many financiers have been calling, instead, for a “market solution” based on the so-called Austrian school of economic analysis: the seemingly common-sense view that a crisis created by excess debt cannot be treated with further borrowing but must instead be cured by cutting back inefficient spending and investment and liquidating insolvent businesses, households and banks.

The upshot, in the words of Murray Rothbard, the leader of the Austrian school after the death of its founder Ludwig von Mises, is that “recession is a painful but necessary process by which the market liquidates unsound investments and re-establishes the investment and production structure that best satisfies consumer preferences and demands”.

One does not have to go into the economic details of this argument to see why it makes no sense. Even if Keynes had not refuted the economic logic of the Austrian position back in 1936 in his General Theory, their prescription could never in practice be applied. Since the 1930s, when Andrew Mellon, the US Treasury Secretary, famously urged President Hoover to “liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate”, no other government anywhere in the world has dreamt of doing anything of the kind.

Some politicians, such as Mr Cameron, have toyed with Austrian ideas while in Opposition; others, such as Ms Merkel, have used them as political slogans. But none has come close to putting them into effect. In fact, the strictest proponents of liquidation and austerity in response to financial crises have often presided over the biggest growth of public borrowing.

There are two reasons why austerity never works in response to financial crises — and is never seriously attempted, even by politicians who pay lip service to “liquidationist” Austrian economics or the libertarian market fundamentalism of Ayn Rand.

The first is fiscal accounting. A collapse in economic activity devastates public finances, as we are seeing in Britain today. And once a nation gets into deep deficit, the only way to reduce deficits is to restore economic growth.

Even the most dogmatic theoretical proponents of Austrian economics, once they are put in the practical position of managing public finances, realise that cutting public spending or raising taxes during a recession will dig the public finances into an even deeper hole.

The second and much more important reason why austerity economics has never been tried in practice — at least since the 1930s — is politics.

In democracies, preserving living standards and jobs, protecting savings and keeping people in their houses, take a much higher priority than abstract Austrian arguments against preserving the Austrians’ “unsound production structures” or the burdens of debt on future generations.

And this is also true in dictatorships such as China or prewar Germany, which have generally attached an even higher priority to rapid economic growth and social stability — and have therefore been even more zealous in applying Keynesian remedies for economic downturns.

Politically, therefore, Ayn Rand’s idea of a capitalist economy run on strict free-market principles, with painful recessions allowed to run their course in order to liquidate the excesses of the borrowing booms, is pure self-delusion. Capitalism and private property would be swept away politically long before “liquidationist” economic theories could ever be put into practice.

Times Recommends

• We have kit and leadership. Let’s go
• Behind the scenes at the biggest deal
• Conferences — what a waste of money