Expansionary Austerity and Policy-Induced Recessions

Austerity policies – typically cutting government expenditures, but may include tax hikes – are a politically-charged area of macroeconomics. In particular, the question of “expansionary austerity” was hotly debated in the aftermath of the Financial Crisis. In this section, I will large side-step what was debated historically, and just cover more basic questions about austerity and recessions.

(Note: this is an unedited draft of a section from my upcoming book on recessions.)

I greatly distrust the usual justifications for austerity policies, rather I argue that austerity policies are an attempt to achieve a political economy objective: shrink the size of government, and in particular, the welfare state. Currently, political divisions in the developed countries are largely related to views about the size of government, and so it is no surprise that this would work its way into discussions of fiscal policy.

Expansionary Austerity

I will put aside my suspicions and outline the basic thesis of “expansionary austerity.” I am taking the article “Austerity in 2009-13” by Alberto Alesina, Omar Barbiero, Carlo Favero, Francesco Giavazzi and Matteo Paradisi.[i] In this article, they look at the post-crisis episode to defend the “expansionary austerity” thesis from critics (like myself). They led off their conclusions with these observations.

   The conventional wisdom is first that fiscal austerity was the main culprit for the recessions experienced by many countries, especially in Europe and, second, that this round of fiscal consolidation was much more costly than the past ones. The contribution of this paper is a clarification of the first point and, if not a clear rejection, at least it raises doubts on the second.
   On the first point our main finding is that, as in the past, in the recent episodes there has been a very big difference between TB [tax-based] and EB [expenditure based] fiscal adjustments. The former have indeed been very costly in terms of output losses. The latter much less so. These results are very similar to those obtained by many authors who have studied the effects of fiscal adjustments preceding the period 2010–13. Comparing our results on these recent adjustments and the ones obtained using pre-crisis data – that is up to 2007 – we did not find strong evidence against the hypothesis that fiscal multipliers – large tax multipliers and very small spending multipliers – were stable across the two sub-samples.
   Our results, however, are mute on the question whether the countries we have studied did the right thing implementing fiscal austerity at the time they did, that is 2009–13. [Emphasis mine.]

  Once we consider the final observation that they do not defend the actual policies undertaken, I am unsure how much I can argue with those points. Their key argument is that cutting expenditures historically created less of a shock to the economy than tax hikes. Although this is convenient politically for people who want to shrink the size of the state (i.e., shrinking the government appears less costly than expanding it) this could also be explained by the possibility that politicians treat tax hikes differently than expenditure cuts. (For example, I am not aware of many examples of governments focusing tax hikes on high incomes in the post-1980s era, which theoretically would be the optimal way to increase revenue with the least economic disturbance.) So long as we assume that different types of expenditures and taxes have different multipliers, such outcomes are not implausible.

This exposes the weakness of the desire for austerity policies in the first place for floating currency sovereigns. Since such governments do not face financial constraints rather real resource constraints, we should not be analysing fiscal policy in terms of currency units, rather their effect on the real economy. The simple statistical methodology those authors use – which only looks at budget balance data – cannot hope to capture those issues.

“Success” Stories

 
The chart above shows a pair of key examples of expansionary austerity cited by Alesina et al.: Canada and Spain in the 1990s. The figure shows general government (that is, all levels of government) expenditures as a percentage of GDP, taken from the IMF World Economic Outlook. During the 1990s, both countries lowered their expenditures, and avoided recession during that period.[ii]

However, one might note that these countries also were boosted by the external sector during this period: the weakened Canadian dollar boosted the trade balance, and Spain entered its “euro convergence boom.” We should not be too surprised if that an economy can absorb government expenditure cuts if the private sector is entering a boom for other reasons. In my view, these other factors are far more important than the textual analysis of policymakers’ speeches (“the ‘narrative’ method pioneered by Romer and Romer”).

The debate about their methodology used by Alesina et al. is beyond the scope of this text. Nevertheless, we must concede that is indeed possible to tighten fiscal policy without triggering a recession. That said, it is unclear whether that is a trivial observation: any advanced economic model will have “automatic stabilisers” that return growth to some form of a steady state trajectory, beyond fiscal policy. These include:

• monetary policy (to what extent we believe in the effectiveness of monetary policy),
• the action of the external sector (slower consumption growth should reduce imports), 
• forward-looking behaviour in the capital markets,
• the fact that expenditures are measured on a pretax cost basis, while taxes will “recover” some of those expenditures (e.g., government employees pay taxes on their income and often on their consumption via value-added taxes)[iii],
• forced dis-saving by households who have lost employment.

Once we add up all of these factors, we should expect a low multiplier on fiscal policy that attempts to push growth rates away from “steady state” growth; that does not mean that the multiplier for impulses towards steady state are similarly small.

 If the fiscal tightening is gradual, it is yet another factor that affects our near-term economic forecast. We would normally expect gradual fiscal tightening in a currency sovereign, as politicians are normally concerned with self-preservation. The uncertainty about the effect of fiscal policy is likely to be less than the uncertainty about fixed investment (which is the focus of upcoming chapters). As such, the focus should normally be on the private sector.

Predictable Disaster

That said, when we move away from the idealised state of currency sovereignty, the possibility of fiscal policy-induced recessions rises. The chart above shows the policy vandalism inflicted upon the Greek economy by European policymakers. Such a decline in nominal GDP in a developed country was presumably unthinkable to the generation that declared that modern policymaking tools ushered in “The Great Moderation.”

I highlight this as this creates an exception to my argument that recessions are hard to forecast. Sufficiently stupid policy can ensure a highly predictable recession. The challenge is to identify which policies meet that criterion. One can imagine any number of disastrous outcomes that result from policy choices; austerity policies were just the flavour du jour in the recent past. Any study of history tells us that humans have an amazing capacity for folly. However, predicting such disasters is more of a question of political analysis rather than economic analysis.

Footnotes:

[i] “Austerity in 2009-13”, by Alberto Alesina, Omar Barbiero, Carlo Favero, Francesco Giavazzi and Matteo Paradisi, Economic Policy, pages 385-437. July 2015.

[ii] The Canadian recession bars are from the C.D. Howe institute, previously referenced. The Spanish source is: Spanish Economic Association (2015), “CF Index of Economic Activity”, Spanish Business Cycle Dating Committee. URL: http://asesec.org/CFCweb/historical-archive-of-the-spanish-business-cycle/

[iii] Imagine that the (general) government pays an employee a $1000 wage, and the average tax rate paid is 30%. This means that the net cost to the government is $700. (In places like Canada, the taxes may be collected by other levels of government, so there is effectively some inter-governmental transfers that result.) Cutting that worker’s job implies only a reduction of income to the private sector of $700, which is less than the headline cut in expenditures ($1000). This reduces the measured multiplier from expenditure cuts to output.

(c) Brian Romanchuk 2019