It´s not about “austerity”

Larry Summers scribbles “Britain and the limits of austerity”. It´s a rather long and rambling defense of fiscal stimulus in the face “Secular Stagnation”:

The British economy has experienced the most rapid growth in the G7 over the last few months. It increased at an annual rate of more than 3 percent in the last quarter — even as the U.S. economy barely grew, continental Europe remained in the doldrums and Japan struggled to maintain momentum in the face of a major new valued added tax increase.

Many have seized on Britain’s strong performance as vindication of the austerity policy that Britain has followed since 2010, and evidence against the secular stagnation idea that lack of demand is a medium-term constraint on growth in the industrial world.

Interpreting the British strategy correctly is crucial because of the political stakes in Britain, the question of future British economic policy and, most important, because the British experience influences economic policy debates around the globe. Unfortunately, when properly interpreted, the British experience refutes the austerity advocates and confirms John Maynard Keynes’s warning about the dangers of indiscriminate budget cutting during an economic downturn.

Start with the British economy’s current situation. While growth has been rapid recently, this is only because of the depth of the hole that Britain dug for itself.

So let´s do that. The first chart shows a measure of “comparative austerity”. The US has been far more “austere” than the UK. But that hasn´t stopped the US performing better than the UK, as stressed by Summers and illustrated in the RGDP growth chart.

UK Austerity_1

Take a look at the next chart. The reason for the better performance of the US economy, despite bigger “austerity”, is that in the US nominal spending growth (NGDP) didn´t fall when “austerity” kicked in in 2010. Despite less “austerity”, in the UK nominal spending growth fell to zero. But note, as soon as NGDP growth in the UK turns back up real output growth “roars” back!

UK Austerity_2

Lesson: The central bank can (and does) offset (even if only partially because of fears of “financial instability”) fiscal “austerity” (or fiscal “profligacy”). So let´s concentrate on what can really make a difference: Monetary Policy!

3 thoughts on “It´s not about “austerity”

  1. Egads. When Market Monetarists are not fencing off right-wing nuts we have to deal with left-wing kooks.

  2. Larry Summers:
    “…Start with the current situation of the British economy. While growth has been rapid very recently, this is only because of the depth of the hole that Britain dug for itself. Whereas in the United States gross domestic product is well above its pre-crisis peak, in Britain GDP remains below previous peak levels and even further short of levels predicted when austerity policies were implemented. Not surprisingly, given this dismal record, the debt-to-GDP ratio is now nearly 10 percentage points higher than was forecast, and the date when budget balance will be achieved has been pushed years back to the end of the decade…”

    Presumably this is relevant because, unlike the UK, the US has done no fiscal austerity at all. Except that of course such a claim would be ridiculous.

    In my opinion the most objective way of measuring fiscal policy stance is the change in the general government cyclically adjusted balance, particularly the cyclically adjusted primary balance (CAPB). The cyclically adjusted balance takes into account any changes in the general government budget balance due to the business cycle. Thus changes in the cyclically adjusted balance are mostly due to discretionary fiscal policy (tax changes as well as spending changes), and consequently may be taken as a proxy for the degree of fiscal stimulus. The CAPB goes a step further, factoring out changes in net interest on government debt and thus ensuring that practically all of the changes in fiscal balance are discretionary in nature.

    Estimates of the CAPB for the Advanced Nations can be found on the bottom half of Table 2 in the IMF Fiscal Monitor:

    http://www.imf.org/external/pubs/ft/fm/2014/01/pdf/fm1401.pdf

    Between calendar years 2009 (before David Cameron became Prime Minister of the UK) and 2014 the US, the UK and the Euro Area increased their CAPB by 4.0%, 6.8% and 3.5% of potential GDP respectively. So yes, the UK has done more fiscal austerity than the US, but the US has done more than the Euro Area, which is itself no model of real economic growth.

    Moreover, although real GDP (RGDP) growth has been weak in the UK, year on year CPI inflation was consistently above the the 2.0% target from December 2009 through December 2013.

    https://research.stlouisfed.org/fred2/graph/?graph_id=120740&category_id=

    This is in part because the rate of change in aggregate demand (AD), or nominal GDP (NGDP), has been relatively strong. Here is NGDP in the US, the Euro Area and the UK scaled to 100 in 2008Q2:

    https://research.stlouisfed.org/fred2/graph/?graph_id=118595&category_id=

    As can be seen UK NGDP is up 11.9% as of 2013Q4 compared to 15.3% for the US and only 3.7% for the Euro Area.

    So both the US and the UK have had experienced significantly faster AD growth than the Euro Area despite doing more fiscal austerity. This no doubt has something to do with the fact both the US and the UK have done substantial amounts of QE, whereas the Euro Area has done precisely none.

    Larry Summers:
    “…Two additional points about Britain’s growth experience require emphasis. First, the acceleration in growth has less to do with austerity spurring growth than with a slowdown in the pace at which policy became more austere. The pace of fiscal contraction has slowed over the past two years. Slowing fiscal contraction means the decrement to growth caused by fiscal policy becomes more attenuated. Other things equal, this would be expected to produce more favorable growth performance. Ironically, the greater the fiscal multiplier, the greater would be the predicted turnaround when the pace of contraction slowed. So the turnaround in growth over the past 18 months is as much evidence against austerity as for austerity…”

    The UK’s Office of Budgetary Responsibility’s (OBR) estimates of the impacts of fiscal austerity on the level of RGDP can be found in Chart 2.26 on Page 54:

    http://cdn.budgetresponsibility.independent.gov.uk/FER2013.pdf

    If you read the surrounding text you’ll note the graph depicts the varying effects of each type of fiscal policy change, including both spending and revenue, on level RGDP by fiscal year. (Fiscal years in the UK run from April 1, through March 31.) *The estimates in this chart are comprehensive and fully account for the lagged effects*.

    The chart shows that fiscal policy is estimated to have the following effects on level RGDP in percent by fiscal year:

    FY——-RGDP
    2009-10-(+0.5)
    2010-11-(-0.5)
    2011-12-(-1.2)
    2012-13-(-1.5)
    2013-14-(-1.4)

    Since these are *level* effects we need to convert them to *changes*:

    FY——-RGDP
    2010-11-(-1.0)
    2011-12-(-0.7)
    2012-13-(-0.3)
    2013-14-(+0.1)

    Now let’s turn to the actual NGDP and RGDP growth and inflation as measured by the GDP implicit price deflator:

    https://research.stlouisfed.org/fred2/graph/?graph_id=176344

    Estimates of 2014Q1 RGDP only just came out and are not reflected in the above link. NGDP and deflator estimates are not yet available for 2014Q1 but both can be estimated from nominal gross value added (GVA) data which was released at the same time as the RGDP data. Here are the resulting growth rates by fiscal year:

    FY——-NGDP-RGDP-Deflator
    2010-11–4.6–2.0-2.6
    2011-12–3.1–0.8-2.3
    2012-13–1.4–0.3-1.1
    2013-14-4.0-2.3-1.6

    Note that when the OBR estimates that fiscal austerity was most deletorious to economic growth, AD (NGDP) growth was actually at its fastest, and as fiscal austerity was progressively decreased in each of the two subsequent fiscal years, both NGDP and RGDP growth nevertheless decreased. Note also that in the just completed fiscal year RGDP growth was faster than in any of the three previous fiscal years, but since NGDP growth was not as fast as it was in FY 2010-11 this is due more to the fact that inflation has slowed than it is to faster AD growth.

    In other words, the timing of the economic effects of fiscal austerity does not at all match the actual pattern of aggregate demand (AD) growth. Moreover the recent superlative RGDP growth is more due to a subsiding of negative aggregate supply (AS) shocks than it is to outstanding AD growth.

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