...against fictions and other tall tales

Sunday, 13 January 2013

Fiscal austerity: A solution looking for a problem

Since the release earlier this month of the paper by IMF economists Olivier Blanchard and Daniel Leigh, I've noticed a lot of comments on blogs and news websites suggesting that the IMF economists and their inability to properly measure the size of the fiscal multiplier earlier are to blame for making political leaders believe that fiscal austerity could be expansionary and for misleading them into enacting austerity measures within their respective nations.

That's nonsense.  As if the decision to go down the road of austerity depended on a technical detail such as the potency of the fiscal multiplier.  Such a statement is as implausible as suggesting that some of the ill-advised military interventions in the Middle East during the last decade would have been prevented had those leaders who decided to enter those wars had been provided better intelligence.

Those looking to blame someone for the current disaster created by fiscal austerity should instead turn to the real culprits, the politicians themselves, as well as their horde of political aides who recommended a course of action that flies in the face of both common sense and empirical evidence.

As I discussed in an earlier post, the case against expansionary austerity was well established even before nations decided to enact austerity measures.  And amazingly, the empirical evidence against expansionary fiscal austerity stems from one of the most highly circulated economics papers of 2009, which, ironically, was branded as supporting the case for expansionary fiscal austerity.

This paper is the study by Alberto Alesina and Sylvia Ardagna, which found that the combination of austerity and growth occurred in 25 percent of the relevant episodes recorded by the OECD between 1970 and 2007 (2009, Data Appendix:Table A2).

In other words, the study demonstrated that the odds of successfully reducing public debt levels and achieving increased growth through austerity were 1 in 4.  As far as empirical support in favor of expansionary fiscal austerity goes, that's pretty weak.  With such information available, going ahead with austerity was tantamount to someone deciding to intentionally leave their umbrella at home knowing that there is a 75 percent chance of rain that day.  So much for the theory of the rational decision-maker!

And now economists are to blame?

The bottom line is that the disaster of austerity is not about economists getting it wrong.  Rather, it is a typical example of a policy-making failure: policymakers making decisions without regard for the facts.  But, more importantly, fiscal austerity was a prepackaged "solution to a problem" that fits with today's dominant policy-making ideology, which holds that governments have little or no purpose other than catering to financial interests and leaving the path clear for free-market actors to find solutions to every problem facing society.

To conclude, fiscal austerity is simply another example of a "solution looking for a problem", an empty and empirically ineffectual idea with no clear rationale other than giving the appearance that "something is being done".  In this sense, fiscal austerity joins the list of other well-known solutions looking for problems that have been tried and failed in the last thirty years such as deregulation, privatization, supply-side economics and so on.

References

Alesina, A and Ardagna, S., "Large Changes in Fiscal Policy: Taxes vs Spending", NBER Working Paper No. 15438, October 2009

Blanchard, O. and D. Leigh, "Growth Forecast Errors and Fiscal Multiplier", IMF Working Paper WP/13/1, January 2013

7 comments:

  1. A short yet strong piece. I have only small nitpick concerning your point on the ideological bias of policy makers. I would say that the US breed during the last decade has shown remarkable openness on the employment front (I dare to include the Greenspan Fed in there too).

    In passing, I enjoy your work very much.

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    1. Huh, really? Is this the same Greenspan who wanted to privatize social security and who's responsible for blowingup the global economy with his freemarket vision for America??

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  2. @Tim: Thanks for your comments. I appreciate the kind thoughts.

    @Anon: You're right on the regulatory side and social security but I'm with Tim on Greenspan's monetary policy. AG's record on interest rate policy was pretty good.

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    1. Cicuit, that is correct. On another topic(my last one-very briefly), I would argue that deregulation also had its merits in that it opened up some industries to greater competition from smaller and sometimes more dynamic firms. One drawback of a highly regulated market is that regulations sometimes impede entry from other players. In Canada, the deregulation of the telecommunication industry is a fitting example.

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  3. I liked this post but I am a bit confused. You say that fiscal adjustment is imposed on purely political grounds.

    But there must be more to it. Surely, these politicians believe that spending cuts will bring real economic benefits.

    Take the UK, David Cameron always explains his budget policies using economic arguments(lower interest payments, fiscal sustainability, etc). Don't you think economists are behind that?

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  4. It's a great post. It's savvy to entertain that there's more to austerity than just bad politics, but the reality seems to be that most economists have persistently cautioned against the type of fiscal restraint that the IMF was promoting.

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  5. @Neil, thanks for your comment. I don't deny that politicians justify their policy actions based on economic reasoning. Nor am I saying that economists didn't play a role in propagating the belief that austerity would have beneficial effects.

    All I am saying is that many nations find themselves governed by a class of politicians that read into the economic literature what they want to hear. I consider going ahead with a strategy that has only proven to succeed in 25% of the cases between 1970 and 2007 (and, in many instances, under far better economic conditions) to be a gamble. The paper that I refer to in my post was very highly circulated. It is doubtful that these leaders would have been unaware of the risk involved.

    Too many leaders believed that if only they were really serious about deficit reduction, they could pull-off a scenario similar to Canada's in the 1990s (for more, see my December 2 2012 column). David Cameron is a perfect example of a leader who believed in this Canadian myth. He was even advised by a former Canadian Minister of Finance to assist him in the process of devising a deficit reduction strategy.

    Latly, my point about the fiscal multiplier is not to say that it is unimportant. Not at all. I think it's extremely important for the future to have a more exact account of the fiscal multiplier. Rather, I am questioning whether a different multiplier would have made much of a difference in convincing those politicians that were/are already predisposed to believe in the myth of expansionary fiscal austerity.

    I hope this clarifies somewhat my thinking on this.

    @KP: Thanks!

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