The austerity-leads-to-growth evidence is missing

The three most cited examples of fiscal austerity in the face of economic contraction as the preferred strategy to restore economic normalcy are Ireland, Latvia, and United Kingdom.

A year on after it received a 67.5 billion euro bailout, Ireland represents a very mixed macroeconomic picture though the social impact of austerity has been much more damaging. In 2010, Ireland passed the most austere budget in the country’s history, and public sector pay cuts were a centerpiece of the government’s reform effort. Though green shoots of economic growth are back, exports have been rising, and deficit is shrinking (it fell from 32% in 2010 to estimated 10% for 2011), public debt burden far from plateauing and declining has been rising, albeit slower than earlier, and bond yields have been climbing. Most damagingly, unemployment rates are climbing and nearly 40,000 Irish have fled the country this year alone in search of a brighter future elsewhere.



More worryingly, as this Times report indicates, the platform for sustaining short- to medium-term growth looks shaky.

"Salaries of nurses, professors and other public sector workers have been cut around 20 percent. A range of taxes, including on housing and water, have increased. Investment in public works is virtually moribund... government is announcing an additional 3.8 billion euros in tax increases and spending cuts for 2012 that will affect health care, social protections and child benefits. Retail sales fell 3.8 percent in October from a year earlier as spending was down even on things like school textbooks, shoes and other basic goods... welfare payments have steadily been reduced even as the unemployment rate has ticked up to 14.5 percent, and is forecast to remain high at least through next year."

In this context, as Paul Krugman has repeatedly pointed out, the experience of Iceland, which went against conventional austerity, is instructive. Faced with a unsustainable external debt, run up by its reckless banks, Iceland let its bankers go bust and even expanded its social safety net. It also imposed capital control. Instead of internal devaluation through wage freezes, Ireland devalued the kroner. While, like others, it did suffer sharp output contraction, it has managed to keep unemployment rates from getting out of control.



In fact, this direct comparison of the Latvia and Ireland, is very stark. Even on output contraction, the austerity experiment appears a relative failure.



Admittedly, Iceland had its currency and could manage an external devaluation, and regain competitiveness and put the economy on recovery path. The Eurozone economies do not have that and other sovereign instruments to tide over such crises. But United Kingdom has the option of currency devaluation and other regular instruments, and still choses austerity.

More than a year on into its austerity program involving cutting 600,00 public sector jobs, the British economy appears no close to recovery. Early last week, the British chancellor of Exchequer has admitted that growth would be slower than forecast and "debt will not fall as fast as we’d hoped". This meant additional austerity measures, including pay freezes for two more years beyond 2015. The initial plan to eliminate budget deficts has been pushed back by two more years to 2017 and Britain would now require to borrow an additional £111 billion, or $172 billion, through 2015.

A report by the Office for Budget Responsibility has forecast that the British economy will grow 0.9% his year, less than the 1.7% predicted earlier, 0.7% next year, and 2.1% in 2013. It also predicted that debt as a share of GDP would peak at 78% in the fiscal year ending in 2015, higher than the 71% initially predicted. The output gap is expected to persist well past 2017, and the November 2011 estimate shows it worsening since the March 2011 estimate.



The austerity and the squeeze on public spending is expected to take a heavy toll on the GDP growth, as seen by this graphic. The contributions of government compensation, procurement, and investment to the economic growth is set to decline strongly in the years ahead.



Given the inevitability of output contraction and the difficulty of accommodation due to fiscal space, the only immediate political economy issue of concern is how to mitigate adverse consequences of the the slowdown on the nation's population. Atleast on this count, all the aforementioned experiences show that austerity fails.

For more on the social impact of savage austerity, see this report on Lithuania. It achieved a fiscal adjustment of 9% of GDP by cutting public spending by 30% (incluing slashing public sector wages 20-30% and reducing pensions by as much as 11%), raising corporate taxes to 20% from 15%, value added tax from 18% to 21%, and also taxes on a wide variety of goods. In Britain, the wages of austerity are taking an increasing toll and the winter of discontent appears to be making a comeback with nationwide strikes and protests.

Update 1 (2/2/2012)

The FT writes that "after the initial stimulative boost, fiscal policy began to steadily contribute less and less to growth until finally becoming a drag for most of last year and part of the prior year. That’s why the federal contribution to growth is roughly a wash during the recovery."



The CBPP graphic hilights the true magnitude of the austerity. In fact, the cuts backs in state and local government spending make it the worst period since 1944. As CBPP writes, "state and local governments have cut deeply their spending on schools and other public services for three straight years. In fact, economic output from state and local governments fell by 2.3 percent in 2011 — marking the steepest drop since the wartime economy of 1944. By reducing economic activity, these cuts have slowed the economic recovery."



David Leonhardt maps the evolution of the US economic growth over the past four years with respect to the trends in private and public sector consumption growth rates.