To Explain Why Expansionary Austerity Works

The current mantra is that austerity never does work. That the very idea of expansionary austerity is simply wrong.

That is, we should never try to get out of recessionary times by cutting spending – it doesn’t work.

The problem with this is twofold. The original work by Alesina et al never did say what it is said it did. And further, we’ve examples of that expansionary austerity working.

Here from Alesina’s paper:

This paper summarizes the results of a large recent literature
on multi year Öscal plans for deÖcit reduction (austerity). The key
results are that deÖcit reduction policies based upon spending
cuts are much less costly in terms of short run output losses
than tax based adjustments. . On average Öscal adjustment
based upon spending cuts have very samll otput costs and in
come cases they are expansionary. We then discuss which possible
models can explain these Öndings and discuss how the evidence
can disentangle them.

Note what isn’t being said – that cutting spending is the way out of recession. Rather, the statement is rather different. If you need fiscal consolidation – say, we need to restore some sort of relationship between taxation and spending – then cutting spending is a less expensive manner of doing this than raising taxation. The expense here being measured in how much economic growth do we forgo by undertaking the consolidation?

Note, again, what is being said. Not that cutting spending ends the recession. Nor that cutting spending has no costs in foregone economic growth. Only that cutting spending has lower such costs than increasing taxation.

Thus the current shouting that we had austerity (we didn’t, not in the UK at least, spending hasn’t fallen in real terms) but it’s not all perfumed roses now isn’t a killing critique. Because the comparator has to be with well, what would have happened if we raised taxes? Which, actually, we did a bit.

As to why there’s an explanation which does make perfect sense. Imagine, just imagine, that the general level of taxation in an economy is above the Laffer Curve point for that economy. Or some other similar curve, say the one which optimises economic growth rather than merely tax revenue. We can imagine that as being true – politicians surely love to spend our money and the limitation on their doing so is around and about when their taking it screws the pooch. Thus we’d sorta assume that the general state of the economy re the level of taxation is that the bitch is always on the verge of getting screwed. Raise that level of taxation and she will be.

Much the same will be true of spending. Absolutely true that a certain minimal government spending is necessary to have a functioning society in the first place. We need some sort of armed force to keep the Picts in their place at least. Argumentative people the Celts, there are costs to sharing a polity with them. But by the time we’ve got to modern levels of government spending the last marginal parts of it will be sprayed away on projects of the utmost futility. We know that HS2 is going to be wealth sapping – that is, a reduction in the size of the economy – just as we’re pretty sure that the latest level of diversity advisers reduces the future wealth of the country as measured by GDP.

So, marginal increases in taxation are costly as we’re already taking all the easy money. Marginal decreases in spending are much less costly as that’s the bit of state expenditure that we’re pissing away at present.

Thus, if a fiscal consolidation needs to take place then cutting spending is less costly than raising taxes.

As to the other point, it can even work in increasing growth itself, not just be less costly than alternative methods. We have good evidence that this is possible. For the obvious reason that we have two sets of macroeconomic management tools. Fiscal and monetary. So, we can have contractionary fiscal policy and still an overall expansionary policy if, and only if, our monetary policy is more expansionary than our fiscal is contractionary.

Say, raise taxes a bit, cut spending a bit more, then devalue the hell out of the currency. As the UK did in the 1930s by coming off the gold standard. Solved the Great Depression in about 18 months that did. The 25% fall in the value of sterling was a much greater effect than anything they did on the fiscal side.

And standard IMF suggestions incorporate that too. Those standard suggestions being raise taxes a bit, cut spending a bit and depreciate the hell out of the currency. Oh, and here’s a loan to tide you over ’till it works.

Austerity works given the criteria being used to define what works. Everyone shouting about austerity is tho’ deliberately disregarding those caveats, those criteria. Or, as we put it colloquially, lying.

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Quentin Vole
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Quentin Vole

In the quoted section fi-ligature is being rendered as O-umlaut. Some weird unicode glitch, I guess.

Arthur the Cat
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Arthur the Cat

I suspect the original had an fi ligature in it, in whatever encoding was used, and that is rendering as Ö.

Arthur the Cat
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Arthur the Cat

Ignore that, I misread Quentin Vole’s comment.

Gavin Longmuir
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Gavin Longmuir

Let’s remember that those are economists talking. Just like the rest of us, economists tend to focus on how to solve problems with THEIR tools — taxation, spending, currency manipulation. They are missing what may be a much more effective alternative: De-Regulation. Forget the Money Illusion. The real economy consists of people producing goods and services for which other people want to exchange the goods and services they themselves produce. At an appropriate level, regulation is a lubricant of this voluntary exchange of produced goods and service. But we now are far beyond that level, and the excessive regulation from… Read more »