Debunking austerity – how big were the costs to growth?

Jonathon Hazell

One of the best things about conference season is that it gives you a good insight into which of last year’s policies each party thought were popular, and which need to be quietly binned. The result? Both main parties seem to agree that austerity is a vote winner. Consider: Labour pivoted to the ‘cost of living crisis’, whereas the Conservatives think voters austerity so much that they have decided to propose semi-permanent austerity, spending and tax cuts be damned. George Osborne sees vindication in recent output growth. However as Simon Wren-Lewis notes, a single quarter’s good performance is weak success at best, pointing out that:

‘We could close down half the economy for a year. The next year economic growth would be fantastic. Only a fool would argue that this showed that closing down half the economy for a year was a great idea.’

This is a more general problem. In politics austerity seems like a debate between partial truths, with recent events seeming to have austerians carrying the day.  But empirical economics has spent the last five years testing the claims of austerity, and fairly emphatically found the reverse.

Looking back on the 2010 general election campaign and after, the argument rested on two points:

1) Multipliers on government spending were small, so fiscal contraction would barely harm  overall demand

2) Austerity could be expansionary for growth due to business confidence effects,

This was taken to mean that the overall costs to growth were small.

Government spending multipliers

These are the fall in total demand associated with a given pound of tax rises or spending cuts.  Put simply, small government spending multipliers mean austerity will be relatively painless. When the OBR and the IMF forecast the economic effects of coalition spending plans, they used a multiplier of 0.4-0.5. However the balance of evidence suggests under current circumstances, multipliers are about three times as high, around 1.5. We know this because of a very public mea culpa from the IMF – their chief economist, Olivier Blanchard, released a study earlier this year working out multiplier values based on how overoptimistic IMF forecasts had been. These estimates are also consistent with the best historical evidence we have. So when we see that UK growth performing very badly relative to its OBR forecast in 2009, this is completely consistent with much more severe than anticipated effects from austerity (on which more below):

AusterityGraph1

So why were forecasters so over-optimistic in 2009? Normally monetary policy can offset the effects of a fiscal shock by cutting interest rates. Given that they have been at their zero lower bound since 2008, monetary policy has essentially been exhausted as a tool. The jury is still out on quantitative easing, but most studies over the last few years give it a much smaller and less certain impact than conventional rate cuts.

Expansionary austerity

The complementary argument put out (mostly by George Osborne)  in 2010 was about austerity boosting growth, through so-called ‘confidence effects’. The basic idea was that households and businesses were cutting back spending because of uncertainty over high public debt, potentially higher tax rates, or a sovereign debt crisis. Regardless of whether or not this is a sound analytical argument (and it is difficult to more than assert a theory of the mass psychology of households and businesses) it had some empirical backing from a paper by Alberto Alesina and Silvia Ardagna, which the Treasury explicitly relied on to make their case. Alesina-Ardagna claimed that fiscal consolidation led to higher growth. However they did so on the basis of some quite flimsy statistical work. In a nutshell, if their result holds at all it is when output growth is strong (i.e. the opposite of the UK recently), and interest rates can be cut by central banks. The IMF debunked it in 2011 on that very basis, after controlling for whether fiscal contraction takes place at the peak or trough of the business cycle. This explains the massive underperformance of the Euro Area and the UK versus less contractionary countries:

AusterityGraph2

Costs to growth

Given the above, then, it’s no surprise that the best estimates of the costs of austerity have been huge.  Alan Taylor, one of the world’s pre-eminent macroeconomic historians, attempted to estimate the total cost to output of budget contraction since 2009 along with his co-author Oscar Jorda. The result? Austerity probably cost the UK 3% in terms of lost output. By the very nature of counterfactuals, we can never know if this figure is correct. But serious criticisms of the paper, including by the authors themselves, have tended to focus on the fact that they fail to control for interest rates being at the lower bound, when monetary policy is exhausted. In this light, 3% is probably a conservative estimate of the total cost of austerity. Given that there has been no comparably rigorous piece of contradictory analysis, this should be, at the very least, our base case.  Jorda and Taylor underline this in a graph:

AusterityGraph3

As important as the work above is the total absence of the reverse – serious and unrefuted empirical economic research coming out in favour of the pro-austerity arguments has been slim to none. Given the debates that sometimes mark out macroeconomics as a discipline, this speaks volumes.

So does writing against austerity equal staking out a political position? I would argue exactly the opposite. At least in terms of the cost to growth, the line that austerity is disastrous is apolitical. Rather, from a macroeconomic perspective it is a firmly refuted position, like the gold standard, or money supply targeting. And yet it doesn’t seem as if key political actors have updated their beliefs to fit this – it is for this reason that Simon Wren-Lewis  likens the debate to ‘climate change denial’.

Economics and politics seem to have reached opposite conclusions to the same debate. What does this say about the impact of economics on policymaking? And if the evidence isn’t enough to sway this particular political discussion, are we going to be permanently worse off?

Update: Turns out the OBR broadly agrees with Jorda and Taylor

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16 thoughts on “Debunking austerity – how big were the costs to growth?

  1. Great post Joe! Very glad that you’ve decided to share your thoughts with us!

    I especially liked the way you ended your blog with some questions. That’s seems like a really good way to get people thinking.

    Good job! Can’t wait to hear more about “Debunking austerity – how big were the costs to growth?”

    I’ve written a Haiku:

    Austere measurements:
    Do they limit growth? Or were
    You just born like that?

    My haiku also contains two questions. Think of it as a tribute.

  2. Brilliant stuff Joe, you’ve explained the story of the last three years with great clarity and in a language that even I can understand.

    Looking forward to spending many a long, tedious evening made glorious morn by your incisive, cutting analyses, putting the politicians in their place. Keep it up!

    • Nick, it’s obviously true that people write about austerity all the time, and that it gets quite boring. But – correct me if I’m wrong – very few actually talk about what *economists think* about austerity, no? And that’s why the debate is both (a) overdone and (b) not very well informed. Which hopefully means it’s worth blogging about as an economist

      • ***Yes, no one talks about what trolls think. That’s where I come in.***

        In regards to mentioning coalition policy, you missed out the context.

        1. Yes, the conservatives believe in Expansionary Fiscal Contraction. But regardless they would have no choice but to implement it anyway as it is a European wide strategy. If Labour are saying they’d do anything different, they need to tell us how they’d stand up to a body they are not willing to have a referendum on.

        2. I feel you are implying, EFC doesn’t not work because it just inherently doesn’t work. It doesn’t work, because there is a context to what everyone else is doing. Europe, considering it is an organisation based on trade to a large extent can’t have every bloody country trying to run current account surpluses, that just isn’t logically possible. It’s egregiously stupid in fact. Austerity might work better if it were not a wider European policy/strategy to be imposed on everyone at the same time.

        AND FINALLY….

        3. Using the OBR’s and IMF’s poor attempts at “ceteris paribus” to back up your arguments grates on me. Arguments that run along the lines of, “had they done this things would have gone like this…” highlight the key fallacy within ceteris paribus.

        Let’s imagine a world where the Cons had decided to go against the joint strategy of the EU… looking at Britain within a vacuum, one could surmise higher growth. The political reality, is that Britain does not have enough of a strong voice within Europe to dictate economic policy. So it’s only other option would be to break ranks, which I am not sure would be one, legally possible and even if it were, I suspect Europe would have to respond very aggressively (making an example and all that schtick). The models for possible growth, do not and cannot take in the political realities of Europe’s assured reaction.

        I in no way support austerity, I just have random meaningless opinions that are wrong. But till then, “I’m drinking from the bottle.”

      • Totally agree on (1) and (3) and mostly on (2).

        I would just note on (2) that I certainly wouldn’t argue that EFC can’t work, nor that trade isn’t important for why it should. The main thing, though, is whether or not interest rates are at zero. If they aren’t then the BoE can totally offset whatever fiscal contraction, and otherwise it cannot (dubious success of QE and/or forward guidance notwithstanding). But yes, there’s also a bit in the IMF paper controlling for global growth conditions which makes exactly that point. Just put another way, if interest rates aren’t at zero and the BoE is doing it’s job, then the multiplier on government spending should always effectively be zero.

      • Do you really think it would have been impossible for the UK to avoid austerity when the others in the EU were doing it? Just because others in the EU followed the path of Austerity does not mean that Britain had to. The main reason for austerity in the EU was because of the Euro, Britain wasn’t frogmarched into austerity by the EU, it just decided to join the others with unhelpful comparisons to Greece. The only other point is maybe you mean that Britain could not dictate the whole of the EUs economic policy, which I agree with, but I do think it has enough influence to dictate its own economic policy.

        Secondly the whole point of econometrics, a discipline which has been developing for 50 years now, is to try and answer these questions. It is not perfect but we shouldn’t just say “We don’t get these things completely right therefore we shouldn’t even try”. It is vitally important to make these estimates so that in future our policy making is more effective.

      • I will deal with your second point first.

        1. Let me guess you are an economist? 50 years is a short time span for a social science that has as much power as economics.
        2. The nature of the crisis has changed so dramatically since 2008. (From banking to sovereign, though I recognise that the significance of this shift is debated as it is a shift of debtor to a large extent) Considering the change in circumstances, to use that graph was fatuous.
        3. Regardless of the advances, the OBR aren’t dealing with an issue that is akin to, “if a car maintains speed at this point it will reach it’s destination which we can see up ahead on this clear road in an hour.” Even that isn’t a perfect science. They were dealing with the deepest economic contraction in a long time which no one of significance, bar Krugman (who has also predicted 10 of the last 5 recessions), spotted. To then use their graph as a marker as “what could have been” is disingenuous.
        4. I understand the value of ceteris paribus in economics. But I understand its value, “to an extent.” And no matter how far forward econometrics moves we had best not forget, that for as long as it is based on “ceteris paribus,” it is based on a 2000+ year old philosophical law that depends on an external environment remaining constant. Last time I checked, Cicero might have been a genius, but that is still an incredible flaw in any modelling… (I agree, it is better to model than to not)

        On your first point

        1. Yes, it was made easier because everyone is in the euro
        2. HOWEVER, the decision for the EU to adopt austerity was taken by the European council.
        3. Britain sits on the European council and are a member of the eu
        4. Eurozone leaders did not have a secret meeting without the brits to inject only themselves with austerity
        5. It could have gone it alone. Yes. And I can only imagine what the German, Greek and French electorates (and all the other elections across Europe in the past 3 years) would have said at their recent elections… “what about Britain.” Then the pressure would been built to place pressure on Britain for a) going against what was unilaterally voted for and b) for humiliating the leaders of several countries to their electorate
        6. Could have imagined the French election turning in to a battle about who is going to stand up to Britain pissing on the EU as opposed to how to victimise some random immigrant.
        7. Great strategy for keeping the EU onside.
        8. It would have ended in tears.

  3. You missed crowding out effects. And we don’t have the luxury of knowing what would have happened if we had stayed with Gordon Brown’s lunatic spending targets.

    • On crowding out effects: No I definitely didn’t. Bear in mind that crowding out effects are a *theoretical* explanation for why *empirically observed* multipliers on government spending are low. And so observed multipliers of 1.5 are completely consistent with crowding out effects existing in theory, but not being large enough to bring the multiplier back to 0.4-0.5 ish.

      In any case, it is a fact of macro, from basic models all the way to cutting edge research (e.g. this: https://static.squarespace.com/static/50c0f331e4b02ad9eb35bd11/t/50efc8e0e4b02cdfa2b2f332/1357891808698/christiano-etal-2011.pdf if you’re interested) that crowding out effects effectively don’t exist in theory when interest rates are at the zero lower bound.

      On Gordon Brown’s lunatic spending targets, what exactly is your point? We do know (or at least the evidence above is a very good argument for) that this would have been better than the coalition alternative. At the very least it would have made the recession less severe. Possibly it would have been an issue over the longer run, but that’s not really anything to do with business cycle management.

  4. What would you say to those who contend that the UK didn’t have a choice in austerity? It may have been nice to be in a position to maintain spending plans but the majority of British government debt isn’t denominated in sterling and as a result confidence in the currency is needed to keep bond yields low. Do you think it is conceivable that we could have had a currency crisis? That would have left us with serious problems and a potential default. Austerity is certainly better than that.
    Also what do you say someone like Fraser Nelson who contends that spending has been pretty much flat over the past four years?(https://twitter.com/frasernelson/status/382101694831546368/photo/1) How can that graph represent austerity?

    • Fair point – it’s completely that I didn’t explicitly bring up the debt crisis point, and certainly one to return to in another post. But that notwithstanding, the arguments on behalf of debt crises are extremely weak. Let’s think of things separately ex ante (i.e. in 2010 as the Coalition was putting together fiscal consolidation) and ex post (i.e. now).

      Ex ante:

      It is just not true that Britain has a large amount of non-sterling denominated public sector debt (http://www.bankofengland.co.uk/statistics/Pages/iadb/notesiadb/foreign_debt.aspx). It is the fourth largest sovereign debt market by currency (after US, JPY and EUR denominated debt) globally. It doesn’t issue currently more than a miniscule amount of foreign currency denominated debt. This is why it wasn’t ever likely that we could have had a currency/FX crisis in the style of emerging markets in the late 90s, or Eurozone now, where you have interaction of foreign denominated debt and FX depreciation. We also know this for a fact. Consider – the 25% depreciation in sterling in 2007-09 had minimal effects for debt dynamics (perhaps inflationary and/or good for trade balance, but obviously these are separate)

      Hence confidence in the currency is not required to keep interest rates low, because the BoE controls interest rates and doesn’t need to worry about exchange rate stability. Again we know this for a fact – UK government bond yields have been completely invariant to massive swings in the sterling, and the BoE has never felt the need to respond to them, nor should it have done. Once we know that the BoE will maintain zero interest rates on short term debt *irrespective of currency movements* where does the potential default come from?

      Ex post:

      Another way we can look at this is with the benefit of hindsight. We know now that large sovereigns with their own currencies (i.e. UK, US and Japan) face record low interest rates – this is clearly linked to the fact that they are in control of their own currencies, and has had no link to speed or size of fiscal consolidation (given that they all have vastly different debt dynamics and attempts at austerity). Hence we now know that the argument above circa 2010 is correct. Therefore as an economic prescription it is obvious in hindsight that fears over debt and/or currency crises were wrong. This implies we should now be shouting about a reversal of austerity as loudly as possible (whether or not this is politically feasible is slightly different)

    • On the Fraser Nelson flat spending point, this is a really, really long discussion, and perhaps one for another blog post. I would note a couple of things though:

      1) The fall in spending in 2012-13 was very large.

      2) The figures quoted are misleading because:
      a) They do not account for tax increases (i.e. VAT) and only spending cuts, hence they do not account for the total fall in the budget deficit
      b) They are measured in gross terms. The appropriate measurement is total budget deficit as percentage of potential GDP, accounting for how the fiscal balance is changing against the underlying trend growth of the economy. On these figures, you get:

      2010 2011 2012 2013
      OBR, cyclically-adjusted primary balance: −7.0 −4.5 −3.2 −1.5

      Which is indicates huge fiscal contraction.

  5. Hello,
    Take away control of money supply from private central banks (Federal Reserve, ECB, World Bank, IMF, BIS) and establish Public Banking (publicbankinginstitute.org) and national debts disappear. Voila! No more debt / no more austerity.
    Thank you,
    Jerry / Michigan / USA

  6. Hmm, yes, but I think the politicians of the left now feel intellectually winded and unsure where to go. They had learned to trust the market and did so because they developed a way of funding peace with ‘markets’, realising that they generally ‘work’ as a means of making economic decisions but can fail at times. And that failure can be a modern justification for a modern intervention by a modern political left who believe in markets and also in socially minded government. Trouble is, the market let them down.
    The right can cope with this and happily blame it on their labour predecessors. They use it to justify their policies of less government and more freedom and reliance on markets. Notice the irony? When Cameron says, “If debt was the problem, more debt cannot be the solution”. My riposte would be “if markets were the problem, more market freedom cannot be the answer”. I can’t understand why Austerians are winning. The only thing is that the the left or centre have no real answer.
    We are in dangerous political times that will create a huge divide in society if we are careless about these things. Just a thought.

    • Completely agreed and very insightful, except on one point. Even though Ed Miliband has failed to articulate a robust social democratic response on the specific question of austerity, hasn’t he spotted this exactly political opportunity more generally? This is perhaps the whole point of the energy price ceiling which is technically very similarly to a windfall tax, but rhetorically anti-market in line with your argument.

      I would argue, perhaps, that the communication problem with austerity is also about the inability of politicians to explain ideas like the Paradox of Thrift to voters. Hence why Cameron’s line above was so successful, and why Ed Balls (despite being very familiar with all of this) has been so ineffectual. Hence why Labour have chosen (or tried to choose) to argue along your lines, but in other areas.

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