Will Austerity Be The Catalyst For War?

As always SocGen's Dylan Grice comes out with some tremendous insights in his latest weekly piece "Double dips, siren calls and inflationary bias of policy." While the gist of the piece is presenting a comprehensive overview of the traditional and cognitive biases toward inflationary policies and away from hard, unpopular, deflationary/austere measures, Dylan provides a chilling anecdote involving the 1980s conflict between the UK and Argentina, in which it was precisely war that pulled an extremely unpopular government, that of Maggie Thatcher, out of the gutter of public opinion, and soaring in popularity. Thatcher, who came to power oddly enough on a "mandate to smash inflation, smash the unions and downsize government", saw her popularity immediately slide to 25% (see chart) as people realized the very real pain associated with austerity and a regime fighting run away government. A tangent in Grice's argument is that on very rare occasions, the people of a country do end up making the decision to take on hardship, instead of kicking the can down the road (are you listening Summers?). Yet they promptly grow to regret their decision. So what was it that saved the government, and allowed the Conservatives a second term in which to complete the painful austerity project? The declaration of war by Argentina's General Galtieri over the Falkland Islands. The result was soaring popularity for the Iron Lady, and the rest is history. Looking forward, now that all of Europe is gripped in austerity, and make no mistake - this very same austerity is coming to the US on very short notice (sorry Krugman), and popularity ratings for all political parties are crashing, has the political G-8/20 elite been focused a little too much on the Falkland war? Is war precisely the diversion that Europe and soon America hope to use in order to deflect anger from policies such as Schwarzenegger's imposition of minimum wage salaries yesterday (yes, this is pure austerity)? And is there a Gallup or some other polling "unpopularity" threshold that the G-20 is waiting for before letting all those aircraft carriers parked next to the Persian Guld loose? Read the below excerpt from Dylan and make up your own minds.

From SocGen's Dylan Grice

How about the UK in the 1980s though? Wasn't Thatcher elected in 1979 on the back of a promise to bring down inflation, smash the trade unions and downsize government? In other words, wasn't Thatcher elected with a mandate for deflation, which demonstrates that sometimes electorates do elect governments to take tough decisions?

Strictly speaking, the UK in the early 1980s doesn't belong in the same category as Canada, Sweden and Finland in the early 1990s. It had lurched between crises in the 1970s the way an all-day drunk lurches between lampposts: inflation peaked at 25% in 1975; the IMF were called in 1976; the bleak "winter of discontent" of 1978/79 saw widespread power cuts and widespread strike actions by, for example, rail engine drivers, lorry drivers and ambulance drivers.

More infamously, rubbish piled up in Leicester Square after Westminster Council allocated rubbish to be dumped there when refuse collectors went on strike, and coffins piled up in Liverpool after gravediggers went on strike. When asked what the council would do should the gravedigger strike continue Liverpool's Medical Officer said the decomposing bodies would probably have to be thrown in the sea! The gravediggers soon got what they asked for and the strike only lasted two weeks.

So when in 1979 the UK electorate voted in Thatcher on a ticket of painful deflation, the crises caused by a weak and out-of-control-government weren't simply abstract, as they are to most of us today. They were real, and it was in the midst of this chaos that Thatcher came to power.

However, despite winning a clear mandate to smash inflation, smash the unions and downsize government, her immediate reward for carrying out her election pledges was to be marked as the most unpopular prime minister in British political history and by early 1982 her approval rating had slumped to 25%. Despite having voted for Thatcher’s painful medicine and having even understood the need for it, UK voters in the “hot” state people inevitably feel when unemployment spikes had less tolerance for the bitter medicine than they thought they would have in the distantly “cold” state of May 1979.

Squealing with pain and begging for it to stop (364 economists - including former and future Nobel Prize winners - signed an open letter decrying Thatcher's plan to raise taxes in the depths of the 1981 recession to cut borrowing as having no basis in economic theory). Thatcher's chances of a second term to complete her project looked doomed...?

But Britain wasn't the only divided nation in need of social healing at that time. On the other side of the world the widely-hated Argentinian military dictatorship of General Leopoldo Galtieri was experiencing severe economic crisis and widespread social unrest of his own. And to deflect from his domestic problems he did what pressed tyrants have done since the beginning of time - he picked a fight with a foreigner he felt sure he could beat.

Located in the South Atlantic only 300 miles from Argentine shores but 8,000 miles from Britain, the tiny Falkland Islands has been a territory of the UK since it was appropriated from the Argentines in 1833 for its strategic value in navigating Cape Horn. Since this had rankled with generations of Argentinians (as it still does today), Galtieri calculated that an invasion would deflect from his disastrous domestic policies. He also calculated that the UK would balk at the military response required to defend the Islands. The Brits would be vastly outnumbered with implausibly long supply lines and, anyway, the islands were mainly inhabited be sheep.

And America was his new best friend too. Hadn't Reagan just warmly received him as a bulwark against communism in Latin America? Hadn't the administration's National Security Advisor just called him the "majestic general"? Convinced that even if Thatcher wanted to retaliate, she'd be talked out of it by the Reagan administration, he launched a surprise invasion on 2 April 1982. And that morning, Galtieri must have felt pretty pleased with himself. And that morning, Galtieri must have felt pretty pleased with himself. Upon hearing the news, enthralled crowds of patriotic Argentines momentarily forgot the death squads, the 9,000 to 30,000 disappeared "subversives", the daily grind of high unemployment and 130% inflation, and instead gathered outside Galtieri's balcony in a carnival-like atmosphere to celebrate and show their approval of the invasion. His plan was working like a dream.

But the tribal instinct is a part of the human condition, not only the Argentinean one, and the British public were equally thoroughly gripped by the same fervent collective delusion that we call 'national pride.' Galtieri had miscalculated. Thatcher did respond militarily. The British army - though outnumbered - were better trained and equipped than their foe, whom  they dispatched within two months. In the national delirium of that rare episode in the terminal decline of what had once the world's largest empire - a national victory - Thatcher's approval rating, like that of her previously despised party, soared (see chart below). An election was called, duly won by the Conservatives, and the painful austerity project was completed in a second term. The rest, as they say, is history.

Thatcher has gone down as the iron lady who turned Britain around and transformed its fortunes. But how different would the story have been had it not been for the "majestic general?" The Thatcher experience shows how fragile support for painful economic policies can be even when the democratic mandate for those polices has been won.

Like the Canadian and Scandinavian austerity experience in the 1990s, the painful programs adopted succeeded as much by luck as by political bravery. And this is what worries me. It's not that I'm ideologically wedded to one side or the other, it's that the precedents just aren't encouraging. The Weberists are right to worry exactly because the Krugmanites are right  that the required austerity will be so deeply painful and politically risky. Policymakers won't make it happen, so the bond market will make it happen instead.