Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 8 September 2013

Austerity and Living Standards

In my view one of the purposes of blogs by academics is to provide helpful information to economics journalists. I see this as a mutually beneficial trade: they get better information and those of us who read/hear economics journalists have a better experience. Sometimes that involves taking journalists to task for saying something silly. Personally I do this in exactly the same spirit: they get to make less mistakes and I have to squirm less often. Of course this may seem like we are just saying ‘how could you be so silly’. However being a good journalist is hard: you need to cover an area far greater than the scope of any single academic, and often under great pressure, so mistakes are inevitable

So by way of introduction to the main topic of this post, let me sound off about one silly thing which I have heard from good UK journalists recently, following the strong Q2 growth figures. I will not single anyone out, but here is a typical example: “The argument that fiscal austerity would lead to deep recession or permanent stagnation has proved false.” This is a classic rhetorical device: take one side of an existing argument, distort it so that it becomes much more extreme, and then claim that as this extreme version is obviously wrong the argument in general is false. The problem with the sentence above is that it can so easily be read as: recent growth shows critics of austerity were wrong.

As far as I know, no reputable economist has argued that austerity would mean the economy would never start growing again. In terms of basic theory, that would be a crazy thing to do. In a demand led recession, austerity reduces the level of output from what it otherwise might have been. In the simplest case, once we come out of recession output goes back to the level it would have been without austerity. (There is no long term impact on supply.) So austerity leads to some years where growth is less than it would have been otherwise, followed by later years where growth is more than it would have been otherwise.

As I have pointed out before in the context of discussing the Latvian experience, we could close down half the economy for a year. The next year economic growth would be fantastic. Only a fool would argue that this showed that closing down half the economy for a year was a great idea.

There is a quite powerful argument that austerity has additional longer term costs, besides the lost output during the recession, because of hysteresis effects. That argument would be disproved if the recession left no permanent scar, which we would only know if output returned to its pre-recession trend. Again rapid growth as we begin to come out of the recession gives us no information on this.

Unfortunately journalists live in the world of now, and so confusing levels and growth in this way is easy to do. Which brings me to a recent debate in the UK about whether the opposition is right to switch its criticism of the government to focus on the decline in living standards since the last election. It is generally accepted that complaining about fiscal consolidation being ‘too far, too fast’ has limited traction when the government has successfully implanted the false idea that austerity is required because the previous government was profligate. It could and should focus on the level of unemployment, but one of the features of the UK recession is that its impact has fallen on real wages as well as unemployment. So it seems to me both fair and logical that Labour should focus on living standards as a way of re-expressing the ‘too far, too fast’ idea.

Like Duncan Weldon here, I cannot really see why people like Hopi Sen or Chris Dillow have a problem with this. [1] It is just another way of saying that austerity in a recession is a bad idea, but with the advantage that it is one step removed from the Labour profligacy myth, and it provides an effective counter to the ‘look the economy is growing - didn’t we do well’ line.

One good way of knowing that you are on to a good thing is when the other side starts looking worried. So we are beginning to see the idea being discussed that slow growth in UK wages is all about the decline of the West in the face of the emergent East, or some inevitable decline in technical progress. Both are interesting ideas, but I do not think anyone would seriously argue that they explain more than a fragment of the recent stagnation in UK real wages. I’m not sure anybody has a complete explanation for this stagnation, but austerity has clearly played its part, so it is absolutely appropriate for the opposition to focus on low real wages. Indeed, they would be crazy not to.

[1] Hopi Sen also worries that Labour’s response to ‘what would you do about it’ is just a series of pretty small scale measures. At the rhetorical level I see the problem. However at the intellectual level I am a bit less concerned. The Conservative Party campaigned in the last election on a macro programme that promised to do great harm, and kept to that promise. So promising to do not very much would be an improvement! In addition, I suspect good policy is often made up of a large number of small measures. It would be nice, however, if there were some consistent themes that motivated those small measures, and I might have some more to say on this later.


  1. Stephanie Flanders in her BBC blog 19 October 2010 wrote that:

    “If the government follows through on this spending review, public spending in 2014-15 will be 4% lower, in real terms than it is today - but account for roughly the same share of the economy as it was spending in 2005-6. But, the coalition is right that this is not about turning Britain into Hong Kong. It is about reversing a small-ish part of the relentless upward march in government spending since the war. The fact that it should take such a gargantuan effort to achieve even this merely demonstrates quite how relentless that upward march can be, in a rich but now ageing modern economy.”

    Flanders here was measuring from the bottom of the crash in 2010, not the lost output from the GDP peak in 2008.

    Here is Krugman July 23 2010:

    "Whenever I draw a chart comparing actual growth with the pre-crisis’s standard practice to assess economic trends with peak-to-peak interpolation, because the peaks are a reasonable estimate of the economy’s capacity, while other points on the business cycle don’t convey anything like that information."

    Why is this then journalists' standard practice, seemingly, to ignore the lost output?

    1. I do think that she is not being totally transparent in her analysis, but I do not agree with your commentary. I mean, she does not ignore, nor mentions, lost output. I do not think that would have anything to do with what she said in her post.

  2. “As far as I know, no reputable economist has argued that austerity would mean the economy would never start growing again.” Keynes said that economies can get stuck with permanently excessive unemployment.

    But I can’t decide whether Keynes was right or not. I don’t see how Say’s law works effectively in a complex economy. And yet, prior to the days when governments deliberately manipulated aggregate demand (e.g. in the 1800s) economies DID RECOVER from recessions. So I’m confused.

    Can you do a post on that point, Prof.Simon?

    1. You're conflating "permanently excessive unemployment" with "no growth." An economy can grow in a number of ways, only some of which lead to decreased unemployment.

  3. 1. Problem with the present measures is they donot fit in any systematic approach.
    First of all nobody properly defines austerity and anti-austerity. At the end of the day governments spend now more absolute and relative than before. Stimulus whatever that is in this context. Looks to be largely rethoric and that won't help anybody.

    2. Most relevant issue is that the growth seems to be 'isolated' with the very top. The large middlegroups seem hardly to benefit. Simply looks like an unsustainable situation. With relative low growth and increasing public costs (while being less debtfriendly) and no real income growth for the larger middle groups (not even to mention the bottom of the ladder) you are building up a lot of tension in society. Politically you probably can get away with hitting only some relatively isolated groups (you probably have to the cuts have to come from somewhere) but not if it hits 90%+ of your population. No government survives that not even dictators, except the ones that do massive shooting. Will imho nearly certain create a large political mess.

    3. Last post is probably a good example how mass communication goes in say the austerity issue.
    -nobody is going to comvince the other side in this stage. Effectively the austerity discussion is a waist of time if your only focus is the present situation.
    When people have made up their mind it is so difficult to change it again. Discussion simply started way too late.
    -it is not an academic study (logical and that kind of things). Blogs like here on issues that affect people personally only are very limitedly rational it is mainly emotional with a rational sauce thinly spread over it. People go in defence mode and from there they are nearly impossible to move (and sherry pick argumentation).
    Which probably is a good indication how politicians react or journalists. Thin layer of rationality over basically a pseudo religious often but at least emotional issue.
    The public in general however act even more emotional as basically they are most of the time not very rational and on this they miss completely the technical background.
    Important to know who you adress.
    -you get argumentation that is beyond moronic from a pure rational pov. Some unknown entity thinks sonmething, while major market players and say the whole German government think otherwise. Basically an atom vs the universe. However the more unrational discussions become the more these arguments get strength in the discussion. They simply are in line with what people ingeneral think and everything that supports that is a bonus (at least for many).
    If you want to sell it wholesale you cannot use that crap. There will be others who think that if that is where people come up with the rest will also be crap. Look at the global warming discussion they started to oversimplify things and start with dodgy research and at the end of the day the whole issue became f'ed up.

  4. Part2
    The art is to write things that are:
    a) understandable by as much as possible people (very difficult way to write);
    b) cover the complete topic (no sherry picking), but concise (very difficult to combine);
    c) are easily readible (see a, but also most academics like easily written stuff);
    d) include no mistakes from your side (Syria gets wrong on this, it is sold with a truckload of mistakes in the logic/proof by Western governments and interpretation thereof and so the rest of the proof also becomes dodgy as the messenger made himself look like that. Same with global warming btw);
    e) repeated a lot of times;
    f) presented by people who are acceptable at least but preferably seen already as authorities (Kerry is rubbishing his credibility with this and likely will become ineffective for the rest of his career because of that. An obvious organic soybean eater works counterproductive if you have to present it to potential populist voters, Wilders might be completely right you donot let him sell things to a Guardian audience));
    g) touch also emotional levels;
    h) written towards what it means for people themselves;
    i) interesting/amusing even;
    j) focussed on the real decisionmakers. Who makes the decision. With austerity it is basically the electorate. Long term issue, over elections. Plus top of the agenda (decide who to vote for). Hague in the UK is f'ing this up at present rer Syria. Acts as if it is a parliament issue, while it clearly has become an electorate issue (and it is clear what the electorate wants). Completely misses Iraq and Maastricht (voting till approved) in that process as well while the public doesnot.
    Probably good to start with the question what do you want to achieve and how to get there. If it is more serious look at the decisionmaking process not the makers. It more likely gives the real one not the formal one (allthought he latter might be ok to start with).

  5. On western wages:
    They are simply too high to be long term competitive.
    Truckloads of companies consider moving activities.

    You have several important trends:
    -education levels in EMs is rising fast (while in the West it is roughly stable). Middlegroups (educationwise) are now abandantly available in EMs and much cheaper. Low wagesgroups were already longer available in mass. Top end now starts as well (which means that a lot more activities can be done in an EM while also much less oversight is required (from Westeners);
    -markets (buyers) are moving, the West were the markets and had distributioncosts advantages these will simply be lost;
    -automation hits in also in simple services (while outsourcing continues), if manufacturing moves back it will be because of this (so with few jobs attached);
    -West get a demographic problem. Made even worse by the semi or not educated mass immigration. Less workers but also increasingly low end workers (while the market probably demands an other sort);
    -taxes will be an issue. Already very high but to cover especially aging they will have to rise further. Which is simply a disaster competionwise;
    -wages are rising in EMs but nowhere near to Western levels (only different at upper-middle
    level in some EMs);
    -It becomes more and more a worldmarket. In which the general taste will move away from the West. And the average Westerner is p!$$ poor in working with Asian taste. Simply lose the competitive advantage also on that point.

    Being uncompetitive on the workforce is a long term issue. It hits in while the process has already started and is nearly impossible to reverse. Action should be taken now.
    Thinking that other customers will be found is simplistic. You have an increasing low end of the labourmarket (supply side) because of non-Western emigration and no mobility in the aboriginal lower classes (while these groups are the better breeders). While all points into the direction of better skills not less skills.
    All points into the direction of much higher structural unemployment which Western societies seem not be able to afford (next to aging).

    Growth the last few decades was argely created by overborrowing by governments and the private sector. This will be reversed or remain stable at best (deleveraging). Effectively taking away the stimulus effect thereof. Add aging and more costs and less workers/population it is clear that growth levels will structurally be lower than before.

    How much we have to see.
    I off set overborrowing against growth (annual basis, which is of course a question if this is correct and certainly over the whole period) and they were highly correlated. While the overborrowing looked to explain ALL growth (which is worrying). And the multiplier seemed to be very stable and around 1.0 (US).
    Which means with aging, ceterus paribus, for Europe we are negative.
    Hard to see how a temporary stimulus will do the job.

    So imho Europe especially has to do some things and NOW. Simply work at making workers better skilled. Better education and in things employers appriciate. Next to being flexible as a lot can change in a workinglife time.
    And make more stuff with pricing power.

  6. Bad journalism is endemic. Witness today's Guardian:

    "The UK seems to be experiencing a remarkable economic turnaround ..."

    And endlessly repeated on BBC News, etc. All based on one quarter's actual figures and one quarter's predicted figures. Short termism gone mad.

  7. I think you are rigging the argument here by referring to Labour "profligacy". It is simply a fact that from 2002 onwards, Labour were running a Government deficit of roughly 3%, and debt/GDP was marching steadily upwards long before the financial crisis began.

    Since the Government's deficit is the private sector's surplus, this means that Brown was continually applying Keynesian stimulus to an economy that was already growing at between 2% and 4% per year.

    We don't have to use moralistic terms like "profligacy" to see that this is not orthodox Keynesianism. When you keep stimulating an economy that is already growing strongly, and you finance the stimulus with rising debt rather than increased taxation, it's bound to lead to trouble.

    At the very least, you are going to force unemployment down so low that marginal workers are entering the workforce, and you are boosting domestic demand in ways that lead to mis-investment, while as we know all too well, you cause bubbles in markets like housing.

    Mocking a politician for criticising his predecessors is a very familiar meme, but I don't really see Osborne doing anything but pointing out some plain truths.

  8. Another disappointing example of ignoring the points made by Prof. Wren-Lewis and other posts is the article by Chris Giles in Tuesday's F.T.

  9. I first like to take a step back: If austerity is so good, why would you push austerity during high unemployment times versus lower unemployment times? Does a pro-cyclical approach really make sense? Think about how a 'balanced-budget' process would work. Economy slows, tax receipts down, you have to cut unemployment & welfare at the times they are most needed. This makes sense?

    Why was austerity not pushed in the US from 2000-2008? Do you think a McCain or Romney economic team would have pushed for real austerity? They would have cut 'discretionary' spending, yes, but what would they have done to taxes or defense spending?

    People's approaches to austerity are purely political. It's about cutting spending on the things you want to cut, in any way possible. Also, cutting taxes whenever you can too, but that's less relevant now, more an issue when things are going better and that is a more viable option.

  10. Lets be honest - you just hate 'tories' and use a word salad to vent your anger. Why do we pay you?

  11. This is not economics - it is political advice to the Labour party!

  12. The Labour party has never said it is against austerity. In fiscal terms it had similar plans for reducing the deficit to those of the current government. The problem, at which you hint, is that journalists and most other people like things in black and white, even if it's mostly grey.

    The Labour party has to win on PR. It should not oppose austerity itself but focus on a few selective actions, such as student loans, which hit the middle-classes. Having said that, it should not complain too much about those, anyway, rather than focus on positive inclusive messages for the future. The press will always have it's way with the Labour party, in one way or another. You can't fight the press with logic and facts. The party needs another Blair. Someone who smiles when they look as if they're crunching a terd, and all that. The next election is there for the taking; there is just no one there to take it.

  13. The fall in living standards along with our other difficulties are largely caused by by the outflow of productive capital to the emerging markets (part of the globalization process). I have explained the theory in previous comments. At the risk of getting technical, a computer simulation may also help.

    It begins with two regions M and N. M is capital rich, N is capital poor. Assume, an HO type scenario where N can match M in productive efficiency and capital is mobile between regions. We model three sectors, A, B, C. B is labour intensive, C is capital intensive. A is neutral and the numeraire ($10).

    Production functions for M and N.
    A: K^0.5L^0.5
    B: K^0.4L^0.6,
    C: K^0.7L^0.3

    They start with capital/labour ratios of M: 900/30 and N: 30/60. Here are their pre-trade (autarky) positions: (G = Global)

    Output Vectors

    Price Vectors
    M:___10.00___13.85___ 4.61
    G:___10.00___12.88___ 5.78


    Rental Income/Labour Income

    Rentier Share/Labour share


    Trade ensues with the expected results. There is a shift to capital intensive production by capital rich M and a shift to labour intensive production by labour abundant N. There is a wage loss in M - but not too drastic. Both get to share the overall gain in output.

    Output vectors

    Price Vector

    Rents and Wages
    N:____7.28___ 3.43

    Rental Income and Labour Income


    Given that capital is mobile between M and N, greater gains in global output are possible. If M transfers capital to N where capital is scarce those gains can be realized. The difference in rent between the two is driver for this. Rentiers in M will want to shift capital to N where it provides seven times the return. Below is the result after a 200 unit transfer.

    Output Vectors

    Price Vector

    Rents and Wages

    Rental Income and Labour Income


    Results for M:
    1. Wages down 25% from post-trade.
    2. Labour share falls below 30%.
    3. GDP is down 4%.
    4. Rental income has increased by 50%. (Rentiers dine out every night).

    The trade/transfer process terminates with a global (Pareto) maximum. Final cap/lab ratios are M: 480/30, N: 450/60 at which point trade alone equalizes factor prices and capital transfers yield no further global gains (echoes a famous result of R.Mundell).

    Output Vectors

    Price Vectors

    Rents and Wages

    Rental Income and Labour Income

    G:_2901.09 (Global max)

    Final results for M:
    1. Wages down 40% from post-trade.
    2. Labour share falls below 25%.
    3. GDP is down 20% from post-trade.
    4. Rental income has increased by 70%. (Rentiers in M now earn more than half of all global GDP).

    This is a simple static model - but it is all there. From our perspective, in a dynamic context (with capital formation and technology improvements) it translates to slow growth, stagnant wages, stagnant labour productivity, lack of business investment, increasing inequality and a big rise in incomes at the very top of the scale reflecting the rapid growth of rentier income. Everything we see today.

  14. What is your policy prescription? Would capital controls, a German style labour market, and a progressive tax system end the morass?


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