Thursday, 1 November 2012

The impact of austerity in the UK and Eurozone


When I wrote this recent post on the impact of austerity in the UK, I was slightly nervous about the numbers. I suggested that the 2011 and 2012 cuts in spending on goods and services alone would have reduced GDP in 2012 by between 1.25% and 2.5%, but this was a back of the envelope calculation using simple aggregates and static multipliers, and it left out the impact of important tax increases and transfer cuts. However luckily we today have a rather more systematic analysis from Dawn Holland and Jonathan Portes at NIESR. This adds in the impact of tax increases and transfer cuts, and comes to a figure of over 4% for the impact of 2011 and 2012 austerity on UK GDP in 2012. 

Now at this point I should declare an interest of sorts. Holland and Portes use the Institute’s global econometric model NIGEM. I built the first version of this model. However that was so long ago, and I’m sure that the improvements subsequently made by Ray Barrell, Dawn Holland and others mean that nothing is left of my original construct.

What is especially interesting about the NIESR study is that they also do the analysis for the Eurozone economies. If we extend the calculations to 2013, Greek GDP in 2013 is over 13% lower as a result of 2011-13 austerity, Portugal’s GDP nearly 10% lower and Spain’s 6.7% lower: UK GDP is ‘only’ 5% lower. Now a cut in average incomes of 5% or more is a big deal, and it is why I keep saying that the welfare costs of these measures dwarf other considerations. But we know that this pain is not evenly spread: many people are not much affected by austerity, while others are receiving much larger cuts in their incomes.

The key point, which the NIESR study also puts numbers to, is that this pain is not in any way inevitable. It comes because austerity is being undertaken when monetary policy can do very little to counteract these effects. In more normal times, which means once the recovery is sufficiently underway such that interest rates begin to rise again, this scale of austerity will have a much smaller impact on GDP. In principle, its impact could be completely offset by monetary policy. So the argument that these large income cuts are inevitable because debt has to be brought down at some point is simply wrong.

However the NIESR study does miss one thing out of its calculations. Nowhere is there a confidence fairy that will magically persuade the private sector to spend because government debt is coming down. (As the NIESR study shows, the debt to GDP ratio actually rises because GDP falls by more than debt, but hey that’s a detail – GDP will recover one day, probably.)  Now to believe in fairies you need pretty good evidence, and that is just what we do not have. A few economists think they saw some in the data, but that is not enough - nothing like enough - to justify inflicting this scale of pain on so many. (Others, of course, saw nothing (e.g. pdf).) Unfortunately too many people just wanted to believe in the confidence fairy. Normally we find those who really do believe in 'real' fairies either rather amusing or rather strange. Unfortunately some of those who believed in the confidence fairy were put in charge of running our economies.  

8 comments:

  1. I'm not sure I read right. I could swear you are talking about Govt debt coming down. Er... And you talk about fairies.

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  2. The NIESR study models the impact of cross-country austerity and compares this with the impact of austerity if enacted unilaterally. The paper does not model debt to GDP ratios for the UK if consolidation was carried out by other European countries but not by the UK. So no conclusions about the impact of UK austerity given the policies adopted by other countries can be drawn. Is this not correct? I.e. there is no modelling of the impacts of the policy choices taken by the UK government.

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    1. Reply to Anonymous: Of course the report is valid and provides clear cut conclusions:
      Namely, that the UK government's act of undertaking austerity whilst many other countries are also executing very similar austerity policies has been shown to be completely misguided and a failure. ie. austerity as a policy choice by Cameron & Osborne has been proved by extensive empirical data not to work when other countries are doing the same. Of course the NIESR study "does not model debt to GDP ratios for the UK if consolidation was carried out by other European countries but not by the UK" because the UK HAS CARRIED OUT fiscal consolidation (austerity), at the same time as other European countries. Why would the NIESR study model even consider debt to GDP ratios for the UK if consolidation wasn't done by the UK, when this isn't what is happening in reality?

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    2. I agree that the article provides strong evidence that European wide austerity has been self defeating. The point that I was trying to make was that in order to assess the UK government's policy choice, we need to compare current policy to the relevant counterfactual. The relevant counterfactual when assessing UK gvt policy is the case where other countries did austerity but the UK didn't. Hence why I said that this scenario had to be modelled if the results were to allow us to draw conclusions about the policy choice made by the UK government.

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    3. This is something I did consider discussing in my post, but I did not for the following reason. NIGEM, like many macromodels, has imports as a function of total GDP. In reality, the import content of government spending is significantly lower than average. So my concern is that NIGEM will overestimate the importance of the coordinated fiscal action, and underestimate the importance of unilateral action. This point is made for Ireland in John McHale's recent post: http://www.irisheconomy.ie/index.php/2012/11/01/a-comment-on-hammond-and-portes/ (see also a subsequent reply from the authors). I also share John's concern about the self defeating point, which is why I made light of it in my post. The key point, which the paper focuses on, is that postponed austerity is less painful.

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    4. I see your point Anonymous, and if it were possible to accurately model the scenario you describe the results would be very interesting. But as we can see, I think our host has explained the reasons for the modelling decision above, which seems to make. perfect sense.

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    5. Professor, I wonder if you can throw some light on a question I've also posted to Jonathan Portes:
      Why, when given all of the extensive empirical data from reliable, independently verified sources, which highlight and prove the folly of the current fiscal consolidation policy, do our politicians (Cameron, Osborne et al) choose to not act on it, and in fact continue to do the opposite, despite the overwhelming evidence in the NIESR report for example, and the near complete lack of evidence in favour of their views? Linked to this, we know about the negative social and economic impacts, but by pursuing austerity, what, if anything, is actually in it for Cameron, Osborne and their followers?
      Whilst this may appear to be a naive question - its politics, and they can't admit such a huge mistake or u-turn etc, I'm thinking there must be other motives? Or not??

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  3. "Now to believe in fairies you need pretty good evidence"

    No, you don't. You only have to believe! Don't let Tinker Bell die!

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