Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 7 May 2017

Underestimating the impact of austerity

There have been many ideas put forward to explain the low growth in UK productivity, but among mainstream accounts the impact of austerity is not usually high up on the list of possibilities. I have talked before about what I call an ‘innovations gap’, and how the UK is currently suffering a particularly large innovations gap. The idea of an innovations gap can link inadequate demand, like austerity, to low productivity growth.

Let me use a very simple example to explain how an innovations gap can arise after a deep recession followed by austerity. Assume that improvements in technology and production techniques are constantly taking place, or being learnt from other firms/countries, but they need new investment to put them in place. This is what economists call embodied technical progress.

Imagine a firm where demand is not increasing. Will that firm invest to become more productive? Only if the additional profits it can make as a result of investing (suitably discounted) is greater than the cost of the investment. For this firm we therefore need quite a big innovation gap before it is worth its while to undertake investment and before its productivity increases.

Now imagine that demand increases. The firm now has to undertake some additional investment to increase its output. It makes sense to invest in techniques that embody the latest technology. The increase in demand leads to both higher investment (what economists call the ‘accelerator’) and higher productivity.

In a normal recovery from a recession, demand recovers rapidly (growth easily exceeds past trends), leading firms to invest in the latest technology. Any innovations gap that might have opened up in the recession is quickly closed. In contrast, a very slow recovery caused by austerity will reduce the need for investment, allowing a large innovations gap to open up.

This idea fits in with some recent work which suggests that productivity growth in ‘frontier’ firms (firms that already have relatively high productivity) has not slowed, and a gap has opened up between these frontier firms and laggards. (See also here.) This would make sense if the frontier firms are growing (because they are the most productive) but the laggard firms are not. Growing firms need to invest to expand, but stagnant firms are not expanding.

The same model could also suggest how wage led productivity growth could occur (see Ben Chu here for example). As most innovations are likely to be labour saving, then higher wages can increase the profits that come from any particular investment, without necessarily increasing the cost of that investment. So an increase in wages caused by an increase in the minimum wage, for example, could increase investment and therefore increase productivity. The other side of that coin is that the period of stagnant wage growth we have had since the recession provided no incentive for firms to invest in higher productivity techniques.

I doubt that this story explains more than a part of the UK’s productivity gap. In the UK investment in plant and machinery fell sharply in the recession, and has not yet recovered to pre-recession levels, but its decline is unlikely to be enough to explain a productivity standstill. (For an account of some other key factors that could explain the UK productivity puzzle, see here.) But if it explains even a little, it makes austerity a lot more costly.

One way of describing what I’m saying is that austerity influences supply as well as demand. You could say austerity ignores the accelerator as well as the multiplier, which is cute but does not capture the idea of embodied technical progress which is crucial to this argument. It is why it is always best to run a high pressure economy (see Martin Sandbu here who links to an interview between Jared Bernstein and Josh Bivens).

As I explain here, I do not use austerity as just another name for any fiscal consolidation, or fiscal consolidation involving cuts to spending. Fiscal consolidation need not reduce output for the aggregate economy if monetary policy is able to offset its impact. But if interest rates are at their lower bound, as they are once again in the UK [1], fiscal consolidation will reduce output and lead to another needless waste of resources. Since Brexit we have a second period of UK austerity. In assessing how costly this will be, we need to look not just at whether it creates a negative output gap, but also how it creates an innovations gap that reduces productivity.

[1] We know this, because the Bank is increasing the amount of QE.


  1. I was expecting to see something about a Venetian merchant traveller, or the Florida senator beaten by Trump in the Republican primary, or the New York Italian restaurant on Oxford High Street - but then I realised I misread the title of the blog as "Mainly Marco" ...

  2. One problem with your thesis is that I don't think it's necessary for demand to increase as a precondition for investment. In a prior life I was an accountant evaluating projects and most were of the cost saving variety rather than being built on the back of increased demand. If a project saves ten people and returns,say, 25% DCF return then it's worth while, whatever the state of demand. Such projects enable firms to lower costs and perhaps capture greater market share.

    Availability of credit may be another factor; banks are more interested in lending on property than machinery.

    Then again does Edith Penrose have an explanation in that management, or more precisely lack of it, is a substantial factor? In dealing with the UK economy many would say that management is a major factor.

    Using austerity as an indirect argument to reduced investment may have some validity, as you say, but I would have doubt that it is the main, or even a substantial, explanation of this phenomenon.

  3. It seems to me that the more productivity increases, the fewer or more poorly paid your customer base becomes, making them less productive as customers. Austerity measures (I.e. fewer benefits to the citizens) act to intensify that process.

    The whole productivity/austerity cycle reminds me of a man cutting off one end of a piece of string and tying it to the other end, in an attempt to make the string longer.

    Noni Mausa

  4. Austerity and the total disconnect between economic policy and science
    Comment on Simon Wren-Lewis on ‘Underestimating the impact of austerity’

    All confusion about economics derives from the fact that there are TWO economixes: political economics and theoretical economics. The main differences are: (i) The goal of political economics is to successfully push an agenda, the goal of theoretical economics is to successfully explain how the actual economy works. (ii) In political economics anything goes; in theoretical economics scientific standards are observed.

    The sole criterion of science is true/false with truth defined as material and formal consistency: “In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum)

    The fact of economics is that neither Orthodoxy nor Heterodoxy has the true theory. Therefore, the economic policy proposals of BOTH orthodox AND heterodox economists lack sound scientific foundations: Walrasianism, Keynesianism, Marxianism, Austrianism is mutually contradictory, axiomatically false, and materially/formally inconsistent.#1

    The discussion about austerity delivers the proof of the utter scientific incompetence of political economists. Until this day, the representative economist has NOT gotten the fundamental concept of his subject matter, i.e. profit, right. To make the argument short, the correct profit equation for the economy as a whole is given here as Qm≡Yd+(I-Sm)+(G-T)+(X-M) which reduces to Qm≡G-T for Yd, I, Sm, X, M = 0. The reduced macroeconomic profit equation says that the monetary profit of the business sector Qm is equal to the deficit G-T of the public sector.

    So, from the standpoint of simple self-interest the 1-percenters and their useful academic spokespersons should argue FOR deficit spending and the 99-percenters and their academic spokespersons should argue AGAINST it. Just the opposite happens since Adam Smith railed at public debt.

    Fact is that the measured increase of the relation between profit and wage income in the past decades has no other cause than the increase of public and private deficit spending. It has NOTHING AT ALL to do with greed, productivity, the smartness of business people, or class struggle. These factors only influence the DISTRIBUTION of overall profit Qm BETWEEN the firms.

    Because neither Orthodoxy nor Heterodoxy has the true profit theory#2 their economic policy proposals are often counter-productive for the social groups/classes they speak for. The fact of the matter is that nobody has done more for the 1-percenters than deficit spending heterodox economists who claim to defend the peoples’ interests.

    Economic disasters happen since 200+ years because political economists lack the true theory.#3 The general public is taken away by good-guy-bad-guy storytelling without realizing that economics has NO scientific foundation at all. Where the true theory should be merely the pluralism of silly models is to be found.

    Egmont Kakarot-Handtke

    #1 For details, references, and proofs see Meta-references
    #2 “A satisfactory theory of profits is still elusive.” (Palgrave Dictionary, Desai, 2008)
    #3 See ‘Mass unemployment: The joint failure of orthodox and heterodox economics’

  5. Imagine that an economy spends a decade-and-a-half off-loading its manufacturing activities to other countries, along with all the problem-solving activity and innovations associated with actually doing stuff. Instead it reports 'productivity' and 'growth' based on importing cheap goods from overseas, (miss)selling each other needless insurance products, trading wrongly-calculated financial products, property speculation etc etc.
    Then the whole sham collapses in, say, 2008. The fictional 'productivity' and 'growth' gains from the previous 15 years just evaporate, and we are left staring at reality.
    Just imagine.
    Or read about it in future history books.

  6. If austerity implies increased unemployment, and we are currently in a 'second period' of austerity in the UK, why is unemployment so low? Are you making a prediction here that unemployment is going to rise?

  7. As I took early retirement due to redundancies and that was the best offer, I found a job for a small engineering company that somewhat underinvested, paid probably the lowest wages you could possibly imagine and had very few skilled employees. The vast majority were trainees of dubious quality.

    I had from time to time made suggestions about the poor state of machines and that CNCs would be a better bet than a traditional lathe, instead of buying new they preferred second hand which were almost as bad as the machines they replaced.

    I once again rocked their little boat and told them as much, then they took me up on my big idea, and bought a brand new lathe from China.

    Companies and this one in point, really like employees that don't know a lot and just jump where ever they are told to, investment can be expensive but old machines correspond to the Bath tub graph principle, but explaining that to people who think spending on investment is just a cost, forget new machines can repay for themselves whereas old ones continue to be a cost.

    From my working experience British Industry doesn't look to the long term, it's and always has been the case, of grab as much profit as you can here and now, it's numbers that matter not quality, and you can always blame the stupid workers when things don't work out well.

    Unfortunately for economists you can't derive a formula for industry that says one thing but then in practice does the other.

    A story I often tell is when I was working for a well known German Brewery in Bavaria in 1969, Herzoglich Tegernseer Brauhaus, I lived with other worker friends in an old part of the Schloss, when one day a friend reading from "Das Bild" said look at this, all British workers are lazy, Britain's products and cars are shoddily built,and I said to him, "you are reading from Das Bild, don't believe everything you read in papers like that", yes he said but they are quoting the daily express, that's an English paper isn't it?" "Yes I said but that paper is as bad as the one you are reading from." I also asked him if he thought I was Lazy being a typical Englishman," No he said.

    A personal deduction of mine from that little encounter was the absolute damage right wing newspapers have done to our industries reputation, I had worked in several German companies before returning home, and in the industrial sector there were some good and some not so good as you would expect, but Germans always advertised that their products were the best in the world, from my experience although limited I saw no better in Germany than here in England, Management was better over there, they didn't play power politics like managers do over here. The workers were much more cooperative than British workers who think they have to compete with everybody else in order to climb the slippery pole, Germans are much more rigid in the manner people progress through the system, each must have the right qualification to move beyond next stage. Here in Britain it's almost a free for all. The highest qualification for advancement is your ability to stab your workmate in the back.

    None of this of course can accounted for in productivity or GDP output. Because no-one will own up to it.

    1. Very interesting. Thanks for that, Mervyn. I am also a redundant engineer. I always advise young people to steer clear of industry and to try and get a government, or government backed, job.

      Prof Richard Werner also comes to mind. He explains the easier access to credit for German firms from the many local German banks - by contrast to the few London based UK banks which cannot be bothered with small loans - other than to housing and real estate speculation of course.

  8. I think you are making a crucial point that I wish was made more often. A couple of years ago there was a related interfluidity post


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