The Myth of Expansionary Austerity

As the US and Europe turn from stimulus to fiscal austerity, claims are heard that spending cuts actually stimulate economic growth. That is the argument heard, not just from the Republicans in the US Congress, but also from the Obama Administration who have pretty much stopped listening to even mainstream macro-economists. And it is the argument of European finance ministers and the European Central Bank who think that a sharp dose of fiscal austerity across the Eurozone need not imperil economic recovery.

However there is very rarely any such thing as expansionary austerity, according to IMF staff economists.

In a careful review of the historical evidence, they find that, typically, a 1 percent of GDP fiscal consolidation reduces real private consumption over the next two years by 0.75 percent, while real GDP declines by 0.62 percent.

They do allow that the drag on GDP coming from spending cuts can sometimes be offset by positive confidence and interest rate effects if a country is facing an acute fiscal crisis, and that the effects of fiscal contraction can also be offset by a weaker exchange rate, as was the case for Canada under Chretien and Paul Martin.

But, as a rule, the Keynesian position that reduction of government spending reduces short-term effective demand and thus growth and employment is found to be supported by a less selective reading of the evidence than that of Alesina and other right-wing economists.

For Canadians this is surely sobering. We face no fiscal crisis – our net debt is far below the OECD average. Austerity cannot produce lower interest rates – short term rates are near zero and the 10 year Government of Canada bond rate is at a near historic low of under 3%. And, with the dollar hugely over-valued and the US teetering on the edge of another downturn, there will be no offset to fiscal contraction from higher exports this time around.

As we begin the 2012 federal Budget debate, Flaherty must be asked why his planned cuts do not risk derailing an already very fragile recovery.

27 comments

  • GDP in the UK was pretty dismal today, so if we need more evidence that that the economic fairies of expansionary austerity are mythic, then go and have a look at the UK.

    Kind of brings me back to Grimm’s fairy tales- the shoe maker and the elves. Maybe we should in the evening just lay out our leather and in the morning all our economic problems will just be gone in the morning. Sadly we are just making them worse.

    The scary point of this exercise- I do think the powers that be know that this austerity is a bust but just keep moving it forward anyway. Until some kind of Egyptian spring happens, potentially the decay and destruction will just keep moving along.

  • I think this post exaggerates things a bit. First, Flaherty’s cuts are small in macro terms. It’s not like trying to close a double-digit GDP gap in a few years or something. Second, “close to zero” interest rates are still not zero, there is still some room for traditional monetary policy if things slow down a bit. Third, if the US collapses then Canada having cut a few billion will not be the deciding factor on which direction our economy goes.

    Of course, if you believe that Canada is currently in a liquidity trap, like the CCPA AFB 2011 does, then obviously the government is not just “risking” recovery but is actively working against it. I’m a bit skeptical how you would explain 3% inflation then, though.

  • For Donald Hughes@10:52:

    Core inflation rose 1.3% between June 2010 and June 2011. The higher headline rate is due to supply side factors (and probably sales tax increases), not demand side. So decreasing demand by lowering federal spending is the wrong way to go.

    It’s true a few billion is small in the macro economy but it will result in unnecessary program cut-backs and macro-wise goes in the wrong direction, especially in the face of excessive unemployment at home and austerity in countries we export to, as Andrew points out.

  • Donald – while the reduction of the federal deficit from 1.7% of GDP this year to 1.1% in 2012-13 and to O in 2014-15 is not dramatic, austerity extends to the provinces as well. The OECD forecast that the overall Canadian fiscal deficit will shrink by 1.4% percentage points of GDP between 2011 and 2012, more than the OECD average of 1.1 percentage points.

    I agree with Keith re inflation

  • But Carney is predicting (obviously) that they’ll hit the inflation target moving forward, and he has some wiggle room for monetary stimulus if he’s a bit off. So for modest spending cuts to be “in the wrong direction” in any significant way then you’d have to believe that the inflation projection is wrong or the overall inflation policy is wrong. Both seem to require a pretty big explanation.

    The entire Alternative Federal Budget, on that note, is premised on the need for a large stimulus. But this would probably have to include a sea change in monetary policy in Canada, although there is virtually no discussion of this in the AFB. Likewise, the Good Jobs for All CLC policy paper advocates a large stimulus but monetary policy only gets a brief mention and it isn’t framed with references to theory.

    It seems to be a consensus around here that a new stimulus would be welcome but I would like to read more of the reasoning behind this.

  • Donald:
    30-day Treasury bills: 0.88%
    5yr GoC bonds: 2.15%
    10 yr GoC bonds: 2.89%
    How will lowering the overnight rate by, say, half a point, create the additional spending the economy needs to reduce unemployment by any appreciable amount?

  • I think the reasoning at bottom is that jobs are far more important than a little bit of inflation, which really shows no signs of becoming a significant issue.

  • and might I add onto PLG, some good jobs.

  • The issue is that the BoC is projecting hitting their inflation target without further stimulus. This implies an economy that is returning to capacity. If Flaherty put a large stimulus in the pipeline, Carney would raise interest rates to choke that out and meet his inflation target. To suggest otherwise – as I understand it – requires a different model or information than Carney is using, which entails an argument. The presence of unemployment we all dislike is not a prima facie argument in favour of a new stimulus. If you say we ought to tolerate more inflation in order to sustain a lower unemployment rate, as far as I know this implies a very different conception of monetary policy than what governs the Bank of Canada.

    It seems fairly basic to me that any coherent proposal (like the AFB or CLC papers) would have to hash this out in fairly minute detail in the document itself or point to where the supporters of this document came to a consensus around such policies. I mean, I admit I’m not an expert on any of this, and I’d love if there were some “cheap” way to ratchet down unemployment, I’m just skeptical.

  • not a problem Donald, just wait till the dollar stay above 1.05 and heads towards 1.10, you will see some stimulus come back into the discourse real quick, and you won’t need much modelling to figure it out.

    How about transitioning the economy with a growth strategy that includes good jobs, and less reliance on resource extraction. When oil comes down or alternatives are forced upon the world, our goose laying the golden barrels will just not be enough.

    If you do not see that and feel we can only implement some kind of cheap way to ratchet down employment, then I am sorry but I am not sure consensus could ever be reached coming from that perspective.

  • From Donald@11:31am:
    ”The presence of unemployment we all dislike is not a prima facie argument in favour of a new stimulus.”

    I guess it depends on how much we dislike unemployment. Neo-liberals have a high tolerance for it and consequently eschew active fiscal policy. The severity of the recent and still on-going economic crisis forced them to accept it, more or less. Normally they rely on monetary policy and grudgingly on the automatic stabilizers (EI, welfare) to bring the economy back to higher employment levels after a recession.

    Charts 14 and 15 of the BoC Review of July 2011 are titled ”Material excess supply remains in the Canadian economy” and ”Labour market indicators suggest significant slack in the labour market”, so the Bank agrees there’s plenty of slack in the economy. It expects a return to a zero output gap by the middle of next year, meaning it is accepting high unemployment for a year, along with all its associated social pathologies:poverty, family breakdown, stress, depression, etc.
    The BoC does not reveal the NAIRU it incorporates into its output gap calculation, but one can safely assume it includes a high level of unemployment since in the past when it said there was no output gap, or the gap was positive, we were actually at quite high levels of unemployment (headline ca. 6% and all inclusive between 9 and 10).

    Essentially our economy has been running at a partially depressed level over the past 30 years as a result of these policies. That has succeeded in keeping inflation low but at the cost of of high unemployment and the absence of the services we should be providing ourselves such as high speed trains between major centres, daycare, homecare for the elderly, etc, etc.

    Paul Krugman recently dealt with the issue of who benefits from a very low tolerance for inflation at his blog- he did two on ”rentiers”. Take a look at http://krugman.blogs.nytimes.com/?s=rentier.

  • I’m confused about your point that the central bank is “accepting high unemployment for a year” within its own framework. With the policy lag, the effect of any new stimulus would hit when the economy is already nearing potential, and it would contribute to missing its own inflation target. Beyond that, that wasn’t Andrew’s original point: He implied that Flaherty was risking the economic recovery due to new spending cuts over the next few years on the scale of a fraction of a percent of GDP. In any case, it seems a bit harsh to blame the Bank of Canada for everything from family breakdown to the lack of high speed trains.

    Krugman thinks the US is in a liquidity trap, with nominal interest rates at the zero lower bound, unemployment still more than 3 points from where he predicted NAIRU and possibly a large amount of excess capacity waiting to be employed. Canada is not at the zero lower bound, estimates of NAIRU tend to be somewhat higher, the unemployment rate is lower, and the economy is returning to potential.

    The CLC call for a new jobs program obviously leans on Andrew Jackson’s anti-NAIRU position. But the CLC jobs paper (and the 2011 AFB) never really discusses this pivotal issue and treats it as common sense. The thing is, it is a small minority position among macroeconomists, and it seems to me the average progressive leader is wholly unprepared for wading into such a technical debate. It seems to depend on insinuating to progressives that the existence of unemployment proves that job creation is possible, which is a position that is intuitive but not widely held.

    I’m not even sure there is agreement among people who want a second stimulus. For example, Keith suggests that a 6% rate of unemployment is “quite high.” But the Alternative Federal Budget doesn’t promise to bring the rate below 6%. So, according to Keith, Policy Alternatives supports a policy of high unemployment and a partially depressed economy. But I doubt Keith believes the report he contributed to has the aim of retaining the social pathologies of high unemployment that he enumerated. This is part of why stripping out some of the talk of vicious motives might be useful.

  • Stripping out the talk of vicious motives wouldn’t be accurate. It’s quite clear that the broad economic school of which the BoC is a part does not in fact regard unemployment as a problem, but rather as a tool to ensure “workforce flexibility”. When nobody who would be offended appears to be around, the discussion on this point is often quite frank.

    I suppose I’m not erudite enough to be in this discussion, but on the face of it I find myself wondering what “approaching capacity” is supposed to mean when unemployment and underemployment remain high. What is the definition of “capacity” if it can be reached when there are many people capable of doing productive work and willing to do it but not actually working, and there is much work that needs doing but is not being done? All the more questionable when there are perfectly effective production facilities closing down but not being replaced by more competitive ones (in this country, at least).
    No doubt there is a definition of “capacity” that allows for all this. At which point for me the question is, what is the point of worrying about a “capacity” defined in such arcane terms, along with various other oh-so-important angels-on-heads-of-pins measures, if they don’t represent anything very closely related to the actual prosperity of actual Canadians?

  • Re Donald @ 8:33:

    I guess I have been unclear. I ascribe no motives to neo-liberals, including those at the BoC, but observe that they have a greater tolerance for unemployment and its consequences than I have. Do you think that is not the case?

    Unemployment is not theoretical or remote to me as I do recall having been unemployed myself at one time and currently have family members and neighbours who are unemployed or underemployed.

    I find it extremely unfortunate that we have 1.5 to 2 million people who are ready and able to work, and lots of things for them to do, and yet they remain unemployed – casualties in the war against inflation.

    I recommend again you read the two Krugman articles regarding who benefits most from this policy choice.

  • Thinking of vicious motives, it should perhaps be noted that at the level of first principles, neoliberalism posits that a vicious motive is in fact the only motive people possess–neoclassical economics is based on the assumption that the only human motivator, or at least the only economically relevant one, is greed.

    It strikes me as weird that people backing these economic models get all huffy any time anyone accuses them of being motivated by greed in their analyses. What, they’re saying that if there was money in peddling falsehoods about economics, they wouldn’t take it, because it would be intellectually dishonest? So in short, they’re motivated economically by something other than greed and so their whole theory is blatantly wrong?

  • I don’t pretend to be erudite enough to debate neoliberal arcana here either.

    I just don’t have any respect for the policies and theories that have been so completely worthless for so long.

    I wouldn’t know how to debate with pre-Copernican astronomers about their various spheres either, but I don’t have to.

    If Carney thinks that unemployment can’t be raised without spoiling his nonsensical theories about inflation targets, he should be fired.

    In my opinion, making the Governor of the BOC immune to democracy has been a catastrophic failure.

  • Keith, saying they have a higher tolerance for unemployment implies a misunderstanding of the bank’s position. Their position is that there is no long-run obvious, stable and exploitable relationship between inflation and unemployment. They aren’t choosing high unemployment to get low inflation (in their model).

    Krugman would disagree with Andrew’s model. Krugman believes that fiscal policy is largely ineffective in the absence of the specific condition of a liquidity trap. The case that the US is in a liquidity trap seems stronger than Canada. I don’t think the possible existence of a natural rate of unemployment is contingent on how close to our hearts the burdens of unemployment are.

  • They aren’t choosing high unemployment to get low inflation (in their model).

    War is peace. Freedom is slavery.

    They’ve been doing nothing but choosing high unemployment (or worker insecurity) to get low inflation. They have been for decades. The stability of their savings are more important than the increasing poverty and indebtedness of the bulk of the population.

  • I am never a fan of debates where there is no contract curve for resolution.

    Making the statement that there is no long run happy balance between inflation and unemployment is complete garbage.

    They are choosing high inflation and have been since the 70’s. A full employment policy is a whole lot different than what we are seeing right now. NAIRU is a joke as well. There is so much slack in the economy, and untapped innovative capacity within the asset base that full employment and inflation are so far off, that only a political fascination of a class war could keep the BOC consistently focused on inflation during a time where we still have not recovered and the head winds will soon make this thread look like a joke.

    Its coming, great recession part 2 unless of course we all accept this new low in equality and lack luster labour markets as the norm.

  • Rentier Fungicide

    Never mind the 2011 CLC jobs paper, I think Andrew Jackson pretty much demolished the NAIRU as a theory in:
    “The Perverse Circularity of NAIRU-Driven Economic Policy in Canada,” Canadian Business Economics (July 2000). And we have an economic crisis because all the so-called “conventional” economists (actually far fewer in number than supposed, but still in control of the levers of power in government and the academies, and above all in editing journals) are just trained seals.

  • Let’s monetize this. You guys get the business plan and economic model together that shows you can consistently out-guess every other actor in the entire global financial sector and I’ll start looking into places to leverage that information into billions. We’ll show these trained seals who’s right!

  • Donald,

    Why don’t you look at the decades of increased poverty, household and public indebtedness, worker insecurity, and increasing inequality that the geniuses produced and pause for some inner reflection.

    You have no credibility okay? None. Sorry if your mathematical models haven’t told you that, but it’s true.

  • The many problems associated with neoliberalism do not have any necessary bearing on the validity of mainstream economic theory as such. You can think that the Bank of Canada has a pretty good grasp on monetary theory and still think that social programs and transfers should be expanded and that workers should try to gain more control over their workplaces. Jack Layton and the NDP, for example, promised to keep central bank independence and not to introduce a second stimulus. So I think the NDP was correct to reject the position of some of their professional advocates in the CLC and CCPA.

  • What the NDP promises and indeed does when in office provincially, and what the NDP thinks would be the best thing to do if they could get away with it, are two different things. NDP official policy is ruled by fear of the press–they do what they think will not get them denounced as dangerous radicals, softheaded looneys etc.; this necessarily entails a lot of rejection of solid good sense, because the press is solidly right-wing corporate.
    So yeah, that’s a bit of a red herring.

    As to making money off it . . . well, it’s all about timing. Many left-ish economists predicted the bursting of the housing bubble. For all I know some of them made money in the process. But economies are chaotic and affected by random and effectively-random events; one can have a solid basis for predicting that a recession’s gonna come sometime in the next year or two, but not for predicting that the US Congress is going to trigger it a year early by causing a minor game of legislative chicken to turn into a US debt default. Financial titans make their money with a combination of very short-term predictions, insider knowledge, and using their muscle to create the results they bet on, reducing the randomness of the events by cheating.
    I’m not sure the system is set up for making money predicting the vague future. Can you get an option for “Some time in the next three years”?

    Actually, I believe one of the less-basic but still serious problems with mainstream economic theory as such is precisely that it is linear, does not grapple with chaos theory.

    Another problem with it is that it’s this body of stuff that continues to get treated as the basis of economics even though as near as I can make out, if you go up to the higher levels of the profession nobody actually believes in it. Everyone is doing different bits of stuff for which they had to depart markedly from “mainstream economic theory”, but none of it gets re-integrated into the basic texts. It’s as if in astronomy every astronomer had to wait until grad school to learn that actually, the earth isn’t the centre of the universe and with the cool Copernican stuff they can get rid of epicycles. And the ones who actually start to study individual planets then get to learn that Saturn has moons and that there are things further than the Moon which are imperfect. But the ones studying stars never find out about that part. Nobody except the astronomers actually studying Mars get to learn that Mars doesn’t actually have canals . . . and if you ask an astronomer for public comment they’ll generally base their comment on Ptolemaic earth-centred astronomy because really, things work more or less *as if* that were true, and it’s better for the lay folk to keep on believing it. That’s how “mainstream economics” works.

  • Keeping interest rates higher than they should be, and privileging anti-inflation over anti-unemployment is neoliberalism and that appears to be what Mr. Goldman Sachs Carney is doing.

  • seems like the banks do what they want anyway, the rate creep away from the overnight rate is at its widest, so it seems like Carny is only playing catch up with the banks, (when he raises rates).

    We need a new direction now, that will balance development in this country. Resource extraction models do not have much of a base to operate from once the resources are gone. And if the planet has a future one day the oil in those sands will be forced to stay put and 2/3 of the resource extraction economy in Canada is gone.

    So what we need is a monetary policy and a fiscal policy that promotes a renewal in our economic direction. I am not sure why that is so difficult to understand. Yet nobody except progressives seem to be pushing such issues.

    A lower dollar with some targeted investment into a sustained focal point of change and industrialization is the future that we need, and that is exactly the opposite of what is happening.

  • At the Donald

    “Their [BoC] position is that there is no long-run obvious, stable and exploitable relationship between inflation and unemployment. They aren’t choosing high unemployment to get low inflation (in their model).”

    Please clarify how you think they think higher rates effect the workings of the macro-economy? Is this Rowean Jedi stuff where they think they are just trying to discover the natural interest rate and thereby discover the natural rate of unemployment? Pretty kooky definition of natural.

    Incidentally Donald I think you are right about Krugman.

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