[Don’t] Give austerity a chance

Stephen Kirchner and Robert Carling plead us to give austerity a chance, citing Alesina and Ardgana’s work on fiscal adjustment to show that austerity is as likely as fiscal stimulus to be followed by a period of expansion – a finding which is allegedly incompatible with the so-called Keynesian attitude that austerity is “a formula for a self-reinforcing economic downturn”. Though the empirical portion of Alesina’s work has been relatively solid (though not entirely without issue) the conclusions drawn and subsequently Kirchner and Carling’s interpretation of them range between disingenuous, biased and plain wrong.

In the introduction to their recent paper on fiscal adjustments, Alesina and Ardgana demonstrate from the outset that they don’t understand the modern monetary system:

If agents believe that the stabilization is credible and avoids a default on government debt, they can ask for a lower premium on government bonds. Private demand components sensitive to the real interest rate can increase if the reduction in the interest rate paid on government bonds leads to a reduction in the real interest rate

The authors presuppose here that the interest rate paid on government bonds is reduced by a reduction in the amount of government debt. MMT provides a model for understanding why issuing government debt should in fact quickly cause the interest rate to fall – which, by the way, it does:

The blue line represents the current budget deficit as a percentage of GDP. The red line represents the real interest rate paid on government debt. Observe that the short-term relationship is generally inverse – when the government ramps up spending, the fed funds rate falls almost simultaneously. This is consistent with the MMT assertion that government spending creates more bank reserves to compete for government bonds, pushing the interest rate down in the short term1. It is inconsistent with the idea proposed above that “credible stabilisation” (a fancy term for deficit reduction) will enable market participants to “ask for a lower premium on government bonds” – the reaction is just the opposite.

The paper cites an earlier study by the same authors which examines every period in each of the “major OECD nations” since roughly 1980 of fiscal “adjustment” (deficit reduction) and “stimulus” (running higher deficits, sometimes confusingly referred to as ‘fiscal expansion’) to determine whether they were “successful” (sustained for at least three years) and/or “expansionary” (followed by a period of GDP growth outdoing 75% of the other nations in the study). In their own words, “they define a period of fiscal adjustment as a year in which the cyclically adjusted primary balance improves by at least 1.5 per cent of GDP.”

The “cyclically adjusted primary balance” refers to the yearly government budget deficit (or surplus) before counting interest payments (or receipts), which is then adjusted to negate any changes to unemployment. The purpose of this adjustment is to account for changes in welfare costs and tax revenue that might falsely appear as periods of consolidation or stimulus. It is to avoid selecting periods in which discretionary government spending stays the same but exogenous changes to income or expenditure change the deficit-to-GDP ratio. Alarm bells should be ringing at the idea of abstracting out the effects of fiscal policy on unemployment, but the intent is clear enough. Though a rudimentary and non-standard adjustment for this branch of economics, the authors insist that it is unimportant. They conclude their explanation of the cyclical correction process by saying that “even not correcting at all would give similar results.”

Issues with the mathematical determination of fiscal adjustment notwithstanding, the results seem to be at extreme odds with the conclusion that the authors draw from them. The report finds that “fiscal adjustments on the spending side are almost as likely to be associated with high growth (i.e. a successful episode) than fiscal expansions on the spending side” [emphasis added]. In English, this means that increases to government spending are more likely to be successful at promoting economic growth than spending cuts in the general case.

Though it weakens the argument being presented for austerity, it is not much of a vindication in itself for fiscal stimulus. One reason is that the margin is admittedly close, but more importantly no one is seriously arguing that fiscal stimulus is always the best option for growth. By framing the problem in the broad context of all periods of fiscal adjustment, much of the nuance of the Keynesian argument for fiscal stimulus is lost. Keynes made no general statement about the effect of fiscal adjustment on economic growth; in fact he expended considerable effort detailing the problems with studying parts of the economy in isolation.2 A study in the context of the fundamental problems that stimulus is intended to solve is required to construct a compelling argument for it. The fundamentals for demand-side stimulus include unemployment and the private debt level.

In similar spirit to the deferral of interest rate determination to the exogenous forces of “expectations”, Alesina and Ardgana explain that “politics” and ultimately the expectations of voters are responsible for the fact that 85% of the attempted fiscal adjustments in their study were “unsuccessful” and quickly reversed. The study found just 17 periods of successful fiscal adjustment from a sample of 107 attempts. Far from being a purely political phenomenon, the economics of this trend are simple: if deficit reduction activities damage aggregate demand enough that unemployment rises, the government has simultaneously lost sources of tax revenue and gained new welfare recipients – which has further knock-on effects to aggregate demand. Despite attempting to “cyclically adjust” away the effect of unemployment in their figures the point is not completely lost on the authors, who note with a parenthetical lack of surprise that “the spending cuts which have led to sharper and more permanent debt/GDP ratio reductions are those which have stopped the growth of entitlements”.

None of these mistakes are as egregious or insulting than Kirchner and Carling’s Hoover-esque request that we as voters and commentators should be patient and “give austerity a chance”. It is all too easy to ask those suffering to be patient when you are not among them. For the millions of jobless struggling to make ends meet on inadequate welfare assistance, for the homeowners months behind on mortgage payments facing foreclosure, for the small business owners unable to find enough revenue to continue operating, austerity means one thing: more suffering. The situation can only improve when the people have enough financial security to resume their normal lives. Jobs will only be created after people are spending enough to provide business with the revenue to hire more workers. To a private sector already leveraged to the hilt with debt and increasingly unable to make the payments, the only path to recovery is deleveraging. Austerity can only make this painful process more difficult, a budget surplus makes it virtually impossible. Austerity has had plenty of chances. Let’s try something else.

[1] In the long run, since fiscal expansion may be inflationary, the central bank may respond by raising interest rates. This is the weak correlation between the plotted lines visible over a period of decades.

[2] The concept of the ‘fiscal multiplier’ – sometimes called a Keynesian multiplier – actually has very little to do with Keynes at all. It was first proposed by Richard Kahn in a 1931 publication, and was crystallised in John Hick’s IS-LM model, which was introduced as a mathematical model of Keynes’ central ideas to his General Theory. Hicks’ later admitted that IS-LM was merely one of his own older models, rewritten in Keynes’ unusual (for the time) terminology, but it continues to be representative of “Keynesian economics” today.

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