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Does UK Double-Dip Prove that Austerity Doesn’t Work?

by Matt Mitchell on April 26, 2012

in Austerity

The U.K. has slipped back into recession and Paul Krugman thinks this is evidence that austerity doesn’t work. Is it?

There are three questions with austerity:

  1. Will it work? Will it actually cut the debt?
  2. Will it hurt? Will it harm the economy or might it actually be stimulative?
  3. What mix of spending cuts and tax increases yield the best answers to questions 1 and 2.

Here is what the data says (and there is a lot of it):

  1. Sadly, most austerity efforts fail. According to research by Alberto Alesina, about 84 percent of fiscal reforms fail to substantially reduce a nation’s debt-to-GDP level.
  2. We’ve known for a while that austerity can be stimulative. Even left-of-center economists such as David Romer have acknowledged this possibility. But the evidence on this is decidedly mixed. As Alesina put it in his Mercatus working paper, austerity is about as likely to be stimulative as…well…stimulus. And we know the economics profession is quite divided on stimulus. So you shouldn’t hold your breath hoping austerity will boost economic growth. But remember, that’s not why we should be pursing austerity. We should pursue austerity because we know that we are on an unsustainable fiscal path and that in the long run, too much debt is very bad for growth. Furthermore, we know that the longer we put off reforms, the more painful they will have to be.
  3. Lots and lots of papers* have now studied this question and the evidence is rather clear: the types of austerity that are most-likely to a) cut the debt and b) not kill the economy are those that are heavily weighted toward spending reductions and not tax increases. I am aware of not one study that found the opposite. In fact, we know more. The most successful reforms are those that go after the most politically sensitive items: government employment and entitlement programs. Lastly, there is evidence that markets react positively when politicians signal their seriousness by going against their partisan inclinations. In other words, the most credible spending reductions are those that are undertaken by left-of-center governments. So slash away, Mr. Obama!

photo by: 401K/Flickr

I summarized these issues in this summary and in this presentation.

Given what we know about austerity, my advice to the UK would be: tweak your austerity measures so that they are more spending-cut-focused and less revenue-increase-focused. And go after the most politically-sensitive items. I wish I knew more about what they actually did, but my knowledge of this is limited and I’ve frankly heard conflicting reports (apparently in the UK, there are just as many arguments over the proper baseline as there are here in the U.S.!).

—————————————

*Most of the following papers directly test the question of whether spending-cut-focused reforms or tax-cut-focused reforms are more successful and more expansionary. A few test related questions but provide corroborating evidence for this question. All of them suggest that spending-cut-focused reforms work better and are more likely to aid the economy. The papers are in chronological order, but I’d recommend starting with the latest:

Francesco Giavazzi and Marco Pagano, “Can Sever Fiscal Contractions Be Expansionary? Tales of Two Small European Countries,” NBER Macroeconomics Annual, (Cambridge, MA: MIT Press, 1990), 95-122.

Alberto Alesina and Roberto Perotti, “Reducing Budget Deficits,” 1994-95 Discussion Paper Series No. 759 (1995);

Alberto Alesina and Silvia Ardagna, “Fiscal Expansions and Adjustments in OECD Countries,” Economic Policy, No. 21, (1995): 207-47;

Francesco Giavazzi and Marco Pagano, “Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience,” Swedish Economic Policy Review, Vol. 3, No. 1 (1996): 67-112;

John McDermott and Robert Wescott, “An Empirical Analysis of Fiscal Adjustments,” International Monetary Fund Staff Papers, Vol. 43 (1996): 725-753;

Alberto Alesina and Roberto Perotti, “Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects,” NBER Working Paper 5730 (1997);

Alberto Alesina, Roberto Perotti, and Jose Tavares, “The Political Economy of Fiscal Adjustments,” Brookings Papers on Economic Activity (1998);

Alberto Alesina and Silvia Ardagna, “Tales of Fiscal Adjustment,” Economic Policy, Vol. 13, No. 27 (1998): 489-545;

Roberto Perotti, “Fiscal Policy in Good Times and Bad,” The Quarterly Journal of Economics, Vol. 114 (1999): 1399-1436;

Juergen von Hagen and Rolf Strauch, “Fiscal Consolidations: Quality, Economic Conditions, and Success,” Public Choice, Vol. 109, No. 3-4 (2001): 327-46;

Alberto Alesina, Silvia Ardagna, Roberto Perotti, and Fabio Schiantarelli, “Fiscal Policy, Profits, and Investment,” American Economic Review, Vol. 92, No. 3 (2002): 571-589;

Juergen von Hagen, Hughes Halite, and Rolf Starch, “Budgetary Consolidation in Europe: Quality, Economic Conditions, and Persistence,” Journal of the Japanese and International Economics, Vol. 16 (2002): 512-35;

Silvia Adrian, “Fiscal Stabilizations: When Do They Work and Why?” European Economic Review, Vol. 48, No. 5 (2004): 1047-74;

Jose Tavares, “Does Right or Left Matter? Cabinets, Credibility and Fiscal Adjustments,” Journal of Public Economics, Vol. 88 (2004): 2447-2468;

Luisa Lambertini and Jose Tavares, “Exchange Rates and Fiscal Adjustments: Evidence from the OECD and Implicates for the EMU,” Contributions to Macroeconomics, Vol. 5, No. 11 (2005);

Boris Cournede and Frederic Gonand, “Restoring Fiscal Sustainability in the Euro Area: Raise Taxes or Curb Spending?OECD Economics Department Working Papers, No. 520 (2006);

Stephanie Guichard, Mike Kennedy, Eckhard Wurzel, and Christophe Andre, “What Promotes Fiscal Consolidation: OECD Country Experiences,” OECD Economics Department Working Papers, No. 553 (2007);

OECD, “IV. Fiscal Consolidation: Lessons from Past Experience,” in OECD Economic Outlook, 2007;

Andrew Biggs, Kevin Hassett, and Matthew Jensen, “A Guide for Deficit Reduction in the United States Based on Historical Consolidations That Worked,” AEI Economic Policy Working Paper No. 2010-04, (2010);

Ben Broadbent and Kevin Daly, “Limiting the Fallout from Fiscal Adjustment,” Goldman Sachs Global Economics Paper, No. 195 (2010);

David Leigh, Pete Devries, Charles Freedman, Jaime Guajardo, Douglas Laxton, and Andrea Pescatori, “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation,” in World Economic Outlook: Recovery, Risk and Rebalancing (Washington, DC: International Monetary Fund, 2010);

 

 

photo by: 401K
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  • Brendan Clarke

    Good article. Spending cut used in conjunction with higher taxation, causes an economic nosedive. It causes black markets because people start to try and try to avoid the taxes. Prices rise as businesses try to offset the new expenses and wages fall for the same reason. The public perceives less money in their pocket, higher prices in the shops and less services available from the state. The state doesnt get that much more revenue anyway as people spend less and do what they can to wriggle out of the taxes. So… Austerity yes… And lower taxes. Then we might have a chance at building wealth.

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  • TruthfulJames

    The problem is twofold, neither one of which is addressed in the summary.

    a. spending cuts which leave the current account still in deficit cause interest rate pressures as the Central government must increase its borrowing level. to refinance debt and finance new deficits.

    I would suggest that Nations might issue Consols to alleviate the refinancing pressure..  This would be especially useful in the present low interest rate environment.  These would seem to be the ideal paper for the ECB to buy. as well.

    b.  The distribution of proceeds in a public sector offering offers too much opportunity for what I call Public Lard — the continuing increase in Public Sector costs, otherwise referred to as the bureaucratic tax.

    Governments should consider lowering the capital gains tax to the lowest rate politically possible (zero would be best) as long as the money was reinvested in new projects or to bring existing capital assets up to economic speed.  This would apply to profits distributed as dividends as well.  Such returns used for other purposed or exported from the country would be fully taxes at the ‘consumption income’ tax rate.  Our (American) Central Government has reached such a size that the percentage allotted to its continuing well being is greater than that in private sector corporations.

    I would additionally suggest that ‘shovel ready’ projected be subjected to economic analyis of the net return at market rates on the investment.

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  • Simon Reynolds

    Interesting article.  But I don’t think you’re asking the right questions: I think that much more relevant are the questions:

    1) Why do governments which are sovereign in their own currency borrow to fund spending?

    2) Why does anyone take any notice of the credit ratings’ agencies?

    3) How do you explain the following sequence of events?

    a) On 27th July 2011 you say in your paper, “The Real Debt Crisis: What Can Be Done?”:

    “The specter of a credit downgrade looms, and it is frightful. A downgrade threatens to push interest rates higher, making it more difficult for consumers to borrow, for businesses to hire, and for the economy to grow. But even more frightening is the cause of the potential downgrade: unsustainable deficits fueled by government spending.”

    http://mercatus.org/sites/default/files/publication/The_Real_Debt_Crisis_Mitchell_07_27_2011.pdf

    b) On 5th August 2011, Standard and Poor’s announce: “We have lowered our long-term sovereign credit rating on the United States of America to ‘AA+’ from ‘AAA’ and affirmed  the ‘A-1+’ short-term rating.”

    http://www.standardandpoors.com/ratings/articles/en/us/?assetID=1245316529563

    c) According to the tradingeconomics website the United States’ Government Bond Yield for 10 Year Notes reached “a record low of 1.72 percent in September of 2011″

    http://www.tradingeconomics.com/united-states/government-bond-yield

    The rate was falling before the S&P announcement, continued to fall after it, and has been near the historically very low 2% rate ever since.

    Cheers

    Simon

    • Matt Mitchell

      Great
      questions.

      Maybe you
      can clarify question 1? My view is that governments borrow because a) they can
      and b) the median voter would like to receive government benefits without having
      to pay for them today (or perhaps ever if the costs can be pushed off to the
      next generation).

      Re. 2
      & 3: I’m not sure people do take ratings agencies seriously. Ratings are
      just ratings. If they tell markets something that they already know, then they
      won’t move markets. It looks like markets already knew the fiscal shape of the
      U.S. relative to other countries and didn’t think the downgrade conveyed any
      new information. As economists put it, “that information was already baked
      into the price.”

      As for why
      rates have gone down: remember, in bond markets, you don’t have to outrun the
      bear, just the other campers. And right now there are a lot of other slow
      campers out there. Compared with investing in Illinois, Greece, Italy, or
      Spain, the U.S. Treasury still looks like a pretty good bet. So as investors
      have fled those other assets, the U.S. government has benefited. But this
      shouldn’t make us complacent. The problems in these other assets don’t make our
      problems go away. And everyone agrees we have major problems with our long run
      spending trajectory. We cannot continue on our course and expect interest rates
      to remain low forever. If some government (Canada? Germany?) starts to
      look like a better investment, things can move quite quickly. But if I knew how
      to predict bond market movements I’d be fabulously wealthy!

      • Simon Reynolds

         
        Hi
        Matt,

        Thanks
        for your reply. Your blog is very informative.

        To
        clarify my question 1, it should read: “Why do governments
        which are sovereign in their own currency borrow to fund deficit
        spending when they could create the money instead?”

        Dan
        Kervick outlines a persuasive (to me) story here:

        http://neweconomicperspectives.org/2012/04/why-does-uncle-sam-borrow.html

        Here’s
        where I’m coming from. I’m a not an economist — but I’m trying to
        make sense of the macroeconomic turmoil since the global financial
        crash. I live in the UK, and I’m subject to the policies of the
        centre-right Conservative / Liberal Democrat coalition. The leading
        members of this government repeatedly argue that:

        a)
        austerity is necessary because of the “economic mess that was
        left by the last Labour government.”

        (To
        be honest, I’m not sure how our previous Prime Minister, Gordon
        Brown, and his government caused the US sub-prime crisis, the
        collapse of Lehman Brothers, the failure of Bear Sterns, AIG and the
        rest.)

        b)
        austerity is necessary because “the markets” will punish
        high deficits by demanding higher interest rates on government
        borrowing.

        c)
        high levels of public debt are unsustainable.

        d)
        there is “no more money”.

        I
        think all of these arguments are wrong — possibly mendaciously
        wrong — especially when applied to an economy where the government
        has control over its currency (ie a non-Eurozone econmy). I’m
        interested in the heterodox economic ideas of Bill Mitchell, Randall
        Wray, Scott Fullwiler and the other MMT proponents; and also also in
        the work of Steve Keen. These ideas seem to propose much more
        sensible responses to the current crisis than the mainstream
        austerity policies.

        You
        say in this post, “Sadly, most austerity efforts fail”.
        You also say, “We should pursue austerity because we know that
        we are on an unsustainable fiscal path and that in the long run, too
        much debt is very bad for growth”, and you reference the “Growth
        in a Time of Debt” paper by Carmen M. Reinhart and Kenneth S.
        Rogoff (R&R).

        Among
        the conclusions of R&R are: “Our main finding is that across
        both advanced countries and emerging markets, high debt/GDP levels
        (90 percent and above) are associated with notably lower growth
        outcomes.” They see a, “nonlinear response of growth to
        debt as debt grows towards historical boundaries.”

        But
        R&R admit: “Of course, there is considerable variation
        across the countries, with some countries such as Australia and New
        Zealand experiencing no growth deterioration at very high debt
        levels.” This is a bit disingenuous — their study shows that
        Australia, Belgium, Canada, New Zealand and Spain all showed greater
        GDP
        growth during periods when central government debt was greater than
        90% of GDP compared to periods when central government debt was less
        than 30% of GDP. Similarly, Norway saw marked improvement in growth
        during the periods when its debt was highest, while Sweden’s growth
        showed negligible variation during period with different debt levels.

        If,
        as you say, it’s not clear that austerity works, and if, as R&R
        have shown, that some countries see higher growth when their
        government debt is higher how is it possible to credibly argue in
        favour of austerity? Politically, I am on the left (real left, not
        the New Labour left). I believe that David Cameron and our
        Chancellor of the Exchequer, George Osborne, have imposed disastrous
        policies on the UK. But it’s not just crazy lefties like me who
        think this. Simon Wren-Lewis, who seems to be fairly mainstream, who
        is a professor of economics at Oxford University says: “Of course
        very little is ever certain, but we can be pretty sure that growth
        would have been significantly better if the current government had
        not imposed severe additional austerity measures beginning in 2010.”

        http://mainlymacro.blogspot.it/2012/01/uk-growth-reveals-major-macroeconomic.html

        Cheers

        Simon

        • Matt Mitchell

          Thanks Simon. I have to confess, I don’t take MMT very
          seriously. I can do no better than to quote Paul Krugman and Scott Sumner (two
          economists not known for agreeing with one another).

          Here is Krugman:

          The point is that there are limits to the amount of
          real resources that you can extract through seigniorage. When people expect
          inflation, they become reluctant to hold cash, which drive prices up and means
          that the government has to print more money to extract a given amount of real
          resources, which means higher inflation, etc.. Do the math, and it becomes
          clear that any attempt to extract too much from seigniorage — more than a few
          percent of GDP, probably — leads to an infinite upward spiral in inflation. In effect,
          the currency is destroyed. This would not happen, even with the same deficit,
          if the government can still sell bonds.

          The point is that under normal, non-liquidity-trap
          conditions, the direct effects of the deficit on aggregate demand are by no
          means the whole story; it matters whether the government can issue bonds or has
          to rely on the printing press. And while it may literally be true that a
          government with its own currency can’t go bankrupt, it can destroy that
          currency if it loses fiscal credibility.

          And here is Scott:

          That’s the flaw with MMT; it’s not net financial
          assets that matters, it’s currency. And the Fed doesn’t set interest rates,
          markets set interest rates. The Fed can briefly push them out of equilibrium
          (due to sticky prices) but this triggers big changes in AD and the price level.

          Re. R&R: I don’t cite them because they were the first
          or the only credible source to suggest that large deficits or excessive debts
          are bad. Basically the whole of the profession believes that at some point, deficits
          and debt become a problem. I cite them because theirs is the most sophisticated
          attempt (so far) to quantify a tipping point. You are right; there is considerable
          variation across countries. This means that there is still a lot of uncertainty
          as to when debts become unmanageable. But it doesn’t mean that there is doubt about
          whether they do, eventually, become unmanageable. It just means that we can’t
          be positive about when we will hit the tipping point.

           

          Given that, I think the better part of prudence is to
          make adjustments sooner rather than later. The longer we wait to address the
          fundamental imbalances in our policy, the more painful the adjustments will have
          to be.

           
           

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