In May 2010, as Britain headed into its last general election, elites all across the western world were gripped by austerity fever, a strange malady that combined extravagant fear with blithe optimism. Every country running significant budget deficits as nearly all were in the aftermath of the financial crisis was deemed at imminent risk of becoming another Greece unless it immediately began cutting spending and raising taxes. Concerns that imposing such austerity in already depressed economies would deepen their depression and delay recovery were airily dismissed; fiscal probity, we were assured, would inspire business-boosting confidence, and all would be well.
On the other side of the ledger, the benefits of improved confidence failed to make their promised appearance. Since the global turn to austerity in 2010, every country that introduced significant austerity has seen its economy suffer, with the depth of the suffering closely related to the harshness of the austerity. In late 2012, the IMFs chief economist, Olivier Blanchard, went so far as to issue what amounted to a mea culpa: although his organisation never bought into the notion that austerity would actually boost economic growth, the IMF now believes that it massively understated the damage that spending cuts inflict on a weak economy.
Meanwhile, all of the economic research that allegedly supported the austerity push has been discredited. Widely touted statistical results were, it turned out, based on highly dubious assumptions and procedures plus a few outright mistakes and evaporated under closer scrutiny.
It is rare, in the history of economic thought, for debates to get resolved this decisively. The austerian ideology that dominated elite discourse five years ago has collapsed, to the point where hardly anyone still believes it. Hardly anyone, that is, except the coalition that still rules Britain and most of the British media.
So it was in 2008-2009. By late 2008 it was already clear in every major economy that conventional monetary policy, which involves pushing down the interest rate on short-term government debt, was going to be insufficient to fight the financial downdraft. Now what? The textbook answer was and is fiscal expansion: increase government spending both to create jobs directly and to put money in consumers pockets; cut taxes to put more money in those pockets.
But wont this lead to budget deficits? Yes, and thats actually a good thing. An economy that is depressed even with zero interest rates is, in effect, an economy in which the public is trying to save more than businesses are willing to invest. In such an economy the government does everyone a service by running deficits and giving frustrated savers a chance to put their money to work. Nor does this borrowing compete with private investment. An economy where interest rates cannot go any lower is an economy awash in desired saving with no place to go, and deficit spending that expands the economy is, if anything, likely to lead to higher private investment than would otherwise materialise.
Its true that you cant run big budget deficits for ever (although you can do it for a long time), because at some point interest payments start to swallow too large a share of the budget. But its foolish and destructive to worry about deficits when borrowing is very cheap and the funds you borrow would otherwise go to waste.
At some point you do want to reverse stimulus. But you dont want to do it too soon specifically, you dont want to remove fiscal support as long as pedal-to-the-metal monetary policy is still insufficient. Instead, you want to wait until there can be a sort of handoff, in which the central bank offsets the effects of declining spending and rising taxes by keeping rates low. As John Maynard Keynes wrote in 1937: The boom, not the slump, is the right time for austerity at the Treasury.
All of this is standard macroeconomics. I often encounter people on both the left and the right who imagine that austerity policies were what the textbook said you should do that those of us who protested against the turn to austerity were staking out some kind of heterodox, radical position. But the truth is that mainstream, textbook economics not only justified the initial round of post-crisis stimulus, but said that this stimulus should continue until economies had recovered.
What we got instead, however, was a hard right turn in elite opinion, away from concerns about unemployment and toward a focus on slashing deficits, mainly with spending cuts. Why?
But he had an answer: Growing analogies to Greece set the stage for a serious response. Greece was the disaster austerians were looking for. In September 2009 Greeces long-term borrowing costs were only 1.3 percentage points higher than Germanys; by September 2010 that gap had increased sevenfold. Suddenly, austerians had a concrete demonstration of the dangers they had been warning about. A hard turn away from Keynesian policies could now be justified as an urgent defensive measure, lest your country abruptly turn into another Greece.
Still, what about the depressed state of western economies? The post-crisis recession bottomed out in the middle of 2009, and in most countries a recovery was under way, but output and employment were still far below normal. Wouldnt a turn to austerity threaten the still-fragile upturn?
Not according to many policymakers, who engaged in one of historys most remarkable displays of collective wishful thinking. Standard macroeconomics said that cutting spending in a depressed economy, with no room to offset these cuts by reducing interest rates that were already near zero, would indeed deepen the slump. But policymakers at the European Commission, the European Central Bank, and in the British government that took power in May 2010 eagerly seized on economic research that claimed to show the opposite.
The doctrine of expansionary austerity is largely associated with work by Alberto Alesina, an economist at Harvard. Alesina used statistical techniques that supposedly identified all large fiscal policy changes in advanced countries between 1970 and 2007, and claimed to find evidence that spending cuts, in particular, were often associated with economic expansions rather than recessions. The reason, he and those who seized on his work suggested, was that spending cuts create confidence, and that the positive effects of this increase in confidence trump the direct negative effects of reduced spending.
The answer, it turned out, was that it wasnt very good statistical work. A review by the IMF found that the methods Alesina used in an attempt to identify examples of sharp austerity produced many misidentifications. For example, in 2000 Finlands budget deficit dropped sharply thanks to a stock market boom, which caused a surge in government revenue but Alesina mistakenly identified this as a major austerity programme. When the IMF laboriously put together a new database of austerity measures derived from actual changes in spending and tax rates, it found that austerity has a consistently negative effect on growth.
Yet even the IMFs analysis fell short as the institution itself eventually acknowledged. Ive already explained why: most historical episodes of austerity took place under conditions very different from those confronting western economies in 2010. For example, when Canada began a major fiscal retrenchment in the mid-1990s, interest rates were high, so the Bank of Canada could offset fiscal austerity with sharp rate cuts not a useful model of the likely results of austerity in economies where interest rates were already very low. In 2010 and 2011, IMF projections of the effects of austerity programmes assumed that those effects would be similar to the historical average. But a 2013 paper co-authored by the organisations chief economist concluded that under post-crisis conditions the true effect had turned out to be nearly three times as large as expected.
http://www.theguardian.com/business/ng-interactive/2015/apr/29/the-austerity-delusion
Inspired by the Greece thread and our poor poor Britains. Id recommend reading the whole thing. Yes, it is very long.
Another good article
https://www.foreignaffairs.com/articles/2013-04-03/austerity-delusion