The stupidity of the current macroeconomic stance in the UK is surprising in itself; but when combined with similar voices in Europe and the US, it is downright astonishing. Three years after the collapse of Lehman Brothers, the global economy is not going through a recovery from financial crisis, but simply entering act two after a brief intermission. On current form this play is a farce that will end in tragedy.

Policy discussion on both sides of the Atlantic is dominated by extreme fiscal hawks, who wrongly see public spending as the problem rather than at least part of the solution. The emphasis on fiscal rectitude is accompanied by the inability to rein in finance. All this condemns economies to financial instability, depressed and even contracting GDP and worsening conditions for ordinary citizens.

Consider: the UK government's focus is still on cutting the budget deficit, though the economy is not just tottering but into the downswing already. The Vickers report on controlling the financial sector is well-intentioned but so modest as to tend to irrelevance. It misses essential points about the financial system, and the lengthy grace period it awards to banks (more than seven years before they have to ringfence their operations) risks being completely overtaken by the likely future volatility in banking.

Part of the problem is that the bulk of the mainstream economics profession has forgotten basic Keynesian macroeconomics, and so is unable to offer even the most obvious advice. But the other aspect of the problem is deeper, reflecting the class configurations that create and intensify the mess. The choice between increasingly futile and counterproductive monetary easing and dithering about policies oriented to more austerity to satisfy bond markets is ultimately a political one, reflecting the continued power of finance.

There are some voices of sanity. The 2011 Unctad trade and development report makes the point that fiscal tightening, especially in the advanced economies, is likely to be self-defeating. It will reduce GDP growth and revenues – not just bad news for a sustained recovery but counterproductive for fiscal consolidation.

What is happening in Greece confirms this analysis. After aggressive cutbacks in public spending forced by the EU-IMF bailout, the economy shrank at an annual rate of 7.3% in the second quarter of 2011. This far exceeds the most pessimistic projections of the IMF or the EU. Since tax revenues can hardly improve now, even with the most sweeping attempts at better collection, fiscal balances will improve only with further public spending cuts. Even so, public-debt-to-GDP ratios will deteriorate.

The point is that fiscal space is not a static variable. Expansionary policies increase demand and revenues and therefore generate more tax revenues. It makes much more sense to grow out of debt than to plunge into a downward spiral worsened by public austerity.

Of course, how this is done matters. Tax cuts (especially on the rich) are less effective than spending on infrastructure, social transfers and subsidies. Multiplier effects are higher when public spending is directed to lower-income groups that have higher propensity to spend their incomes. How could any government, including in the UK, ignore this obvious point?

Arguments that cuts are necessary to appease financial markets are specious. Fiscal imbalances were a result of the financial crisis, not a cause of it: public bailouts accounted for a large part of Ireland and Spain's deficit.

Meanwhile, attempts to rein in banks have been limited – and strong re-regulation is required, not the namby-pamby approach of the Vickers report. The Unctad report points the way. Controls have to be tighter on the "too-big-to-fail" institutions. But re-regulation alone will not orient credit to real investment or make it accessible to small and medium-sized firms.

So there must be restructuring of the financial system: giant institutions must be downsized; the activities of commercial and investment banking should be clearly separated; and the aim should be more diverse financial systems, with a bigger role for public and co-operative institutions. Commodity markets, which have been subject to wild price swings related to speculative and herd behaviour, need to be made more transparent, with more controls on financial activity and direct intervention when required to curb price bubbles and prevent sharp declines.

Why are such obvious and sensible actions completely off the radar for most policymakers? Governments have been spooked and even paralysed by the very financial markets that they have just saved. They seem impervious to public protests from left and right – not only are workers, students and other citizens out on the streets, but even some of the very rich have asked for higher taxation on their wealth and income. This will have massive repercussions, not just in social and political tensions, but also in possibly prolonged economic depression.

This is an unusual moment in the history of global capitalism: the system's famed capacity for surviving and re-inventing itself seems, for the moment, to have disappeared.

* This article was originally published in the Guardian
http://www.guardian.co.uk/commentisfree/2011/sep/13/spooked-austerity-economic-grave

September 15, 2011.