A defence of austerity

Is there anything to be said in defence of the coalition's fiscal austerity? Martin Wolf and Jonathan Portes think not. And the Tories' usual defences of their policy seem inadequate. The idea of expansionary fiscal contraction has come as close to being refuted as any macroeconomic idea can be - at least in terms of its relevance here and now. The government's claim to be "fiscal conservatives and monetary activists" is undermined by Osborne's failure to change the inflation target. And the idea that austerity is necessary to retain the faith of bond markets is, at best, an unproveable counterfactual and at worst ("we could have been like Greece") mindless drivel.

So, what can be said for austerity? If I were a Tory, I'd try the following.

The focus of policy should be upon long-term prosperity, not the here and now.

One reason for saying this is that complaints about current high unemployment are mere crocodile tears. If Labour really were concerned about the costs of short-term downturns, it would have used its 13 years in power to improve risk-pooling - either by increasing out-of-work benefits or by encouraging the development of macro markets. It didn't do so, and voters didn't want them to. This tells us that the public behave like Lucasians (pdf), in thinking that the costs of downturns are small.

What's more, the very fact that real bond yields are low tells us that future income is very valuable, relative to present income. We should therefore try to maximize it. And austerity raises long-term growth.

This is partly because there can be a trade-off between stabilization policy and longer-term growth. One overlooked reason for this is that a counter-cyclical fiscal expansion would merely involve spending on unproductive boondoggles that burden future generations. As Britmouse says: "I doubt the Pembury road will ever get priority over the expensive white elephants."

More importantly, though, there's some evidence - not as much as Amity Shlaes pretends, but some - that lower government (pdf) spending can raise long-term growth. Granted, that evidence comes mainly from cross-country research of questionable validity. But two mechanisms make the link plausible.

One is Baumol's cost disease. Government, by its very nature, has low productivity growth. This means that having a big government condemns us to low growth by simple maths. Worse still, the rising relative cost of government over time will crowd out the private sector - and the bigger government is, the sooner it will do so.

The other is that, in the long-run, social norms matter. The persistence of big government threatens to create a norm in which young people to look for safe public sector jobs in sclerotic hierarchies, which would divert talent away from the private sector towards low-productivity-growth work. This could choke off future growth. Also, prolonged austerity now is creating low or negative real interest rates. This will encourage youngsters in future to take on more debt - because macroeconomic conditions in our formative years shape our behaviour (pdf) throughout our lifetime. In this sense, austerity today will encourage borrowing in future - maybe for consumption but maybe too to set up businesses. This too should raise future growth.

As for why we should cut now, there are two reasons. One is that it's what the public want: Labour's offer of (slightly) smaller and later spending restraint was rejected by the voters.The other is that the sooner we start cutting, the easier it will be in future - partly because the objections will be out of the way, and partly because once we get into habits, it's easier to stick to them.

Now, I suspect this sort of argument makes more sense than the standard Tory ones - though that's a low bar. As for how much sense it makes, I'm not sure.

Comments

[Lee Griffin]

"Labour's offer of (slightly) smaller and later spending restraint was rejected by the voters."

Was it? I know Lib Dem plans weren't exactly the same as Labour, but in reality over 50% (just) voted for a more Labour style plan as opposed to the Tory style plan. *shrugs*

[UnlearningEcon]

Your Cost Disease argument is questionable. BCD implies that state spending has to rise to maintain the *same* level of public service provision, so cutting the state won't help - it will just decrease the level of public services.

Also, the services the state provides are still low productivity growth even if provided by the private sector.

[gastro george]

"Also, prolonged austerity now is creating low or negative real interest rates. This will encourage youngsters in future to take on more debt ..."

Like that would be such a good thing ... next bubble hear we come ...

[gastro george]

duh ... hear = here ...

[Metatone]

You're far too kind about the papers you linked to in support of the Amity Schlaes position.

They all seem to rely on studies that correlate "rate of growth" with "size of government" - only they don't do any controlling for economic maturity. Not to mention that in the modern age you can throw in China's economy which really upsets their apple cart...

As for Britmouse, I'm not sure that he's proven HS2 is a white elephant, rather than just asserting it. Worth noting that while the economics literature contains quite a few attempts to quantify the value of transport projects, the record of economists in this area is not very good at all.

[Account Deleted]

I think the Tories would be hoping for something a bit snappier.

One simple argument they could make is that Germany's current success owes much to a decision to impose austerity a decade ago under Gerhard Schroder, prompted by a need to reboot the economy following the pains of reunifaction. Wage restraint and welfare reforms should be music to Tory ears, even though at the time they were essentially Blairite.

Where the argument breaks down is the larger manufacturing base, the resilient 'mittelstand', the investment in technical education, low household debt, and the devaluation benefits of the Euro vs the DM.

Mind you, the press can boil the choice down to whether UK electors would like to be more like the Germans or more like the French.

[Richard]

I would argue that austerity is a painful but necessary way of purging the economy of bad investments made during the boom. If we start splurging money into the economy it may cause a short term recovery but will create long term problems. There is no guarantee that the businesses in receipt of the stimulus money will stay afloat once the stimulus is withdrawn. But then I'm something of a fan of the "crackpot" Austrian School.

[Luke]

Negative borrowing cost now will lead to younger generation being more willing to borrow to set up businesses?

Won't recession and joblessness make them over cautious? I think that idea comes from an earlier post of yours (I know you're being devil's advocate).

[gastro george]

"... purging the economy of bad investments made during the boom."

I just love the way that these trite statements are asserted without context.

What "bad investments"? What "boom"?

Unlikely to be government "bad investments" as, until the Brown era brought mild relief, government investment was continually suppressed. More likely bad private investments brought about by a debt bubble promoted by under-regulation. Which then had to be bailed out by the government.

Yes the solution (because the Austrian "solution" is predicated by it's assumptions) is always "less government".

[gastro george]

Double duh ... yes = yet

[UnlearningEcon]

Yeah, Richard: the problem with that story is that there's no standard for what is and isn't 'fake' or a 'good' investment. I mean Austrians sued to appeal to the natural rate of interest but they have basically conceded Pierro Sraffa's criticisms that show it doesn't exist in a monetary economy.

[Luke]

Arse to elbow - didn't german austerity take place while the rest of Europe was doing ok, and doesn't that make a difference?

And why are we doing all the work of knocking down straw men that chris has set up?

[Account Deleted]

@Luke, Indeedy. Likewise, the imposition of austerity in Canada in the mid-90s (a precedent quoted by the Tories) benefited from a booming economy (and numero uno export market) in the USA, as well as an expansionary monetary policy.

The lesson is that "austerity in one country" works, because the "virtue" of one is paid for by the "vice" of others. But it cannot work across a whole region (NAFTA or the EU), let alone globally.

In retrospect, the pressures that reunification caused allowed Germany to get its austerity in early, at a time when it could be supported by the buying power of the rest of the EU.

Of course, only a cynic would suggest that the Germans spotted the opportunity that the Euro presented of a boom in the South coupled with devaluation in the North.

I think what Chris is stimulating is less the knocking down of strawmen and more the testing of assumptions. That's no bad thing.

[Simon]

Germany didn't really do austerity in the traditional sense.

West Germans put up with a decade of zero wealth growth to pay for the massive investment in East Germany. In the mean time, German banks lent loads of cash to the rest of Europe so they could buy German goods.

Any argument for austerity now would apply many fold during the next boom, and "labour were crap, so it's ok if we are too" - this is the sort of thing that passes for thinking on the right?

[Britmouse]

Metatone - sure, I was being glib. A commenter on my post prompted me to look at the breakdown of capital spending in 2009. Two examples:

MOD, £9bn
Health, £6bn

Who wants to argue that our politicians will prioritise additions to the UK capital stock in a way which, say, most effectively improves long-run productivity?

[Richard]

"More likely bad private investments brought about by a debt bubble promoted by under-regulation"

I don't deny for a second that there were bad private investments but I would argue this was due to artificially low interest rates.

"Yes the solution (because the Austrian "solution" is predicated by it's assumptions) is always "less government"."

Actually a lot of Austrians believe in using government force to outlaw fractional reserve banking! It is theoretically possible to believe in having a social democratic mixed economy while subscribing to Austrian business cycle theory (although in practice it rarely happens).

[Greg]

I suspect the average Tory policy-maker on being presented with the above argument would see (or hear) "...[grey blur] ... habits".

Even if a particularly able Tory could follow and make the above argument, he would never do so, for he well knows his fellow Tories would not understand it, and making it would cause him to be viewed as dangerously intellectual and therefore susceptible to apostasy or at least heresy, and so to be eased off the promotion fast track.

(Sexism used advisedly.)

[Account Deleted]

@Simon, Germany embarked on "traditional" austerity in 2003 in the form of cuts to welfare spending and labour market reforms known as the "Agenda 2010" plan. See:
http://en.wikipedia.org/wiki/Agenda_2010

Real wages were flat during the 90s as the costs of reunification were borne, however they then started to decline in the 00s, as the Euro ushered in a policy of internal devaluation. See:
http://www.diw.de/sixcms/media.php/73/diw_wr_2009-28.pdf

[Sam]

Was it? I know Lib Dem plans weren't exactly the same as Labour, but in reality over 50% (just) voted for a more Labour style plan as opposed to the Tory style plan. *shrugs*

I think in reality the last election was a stunning victory for "anyone but Gordon" rather than an endorsement of any particular policy. Basically, the public looked at the offerings, thought "you're all crap", and just enough people voted against Gordon to give a yellow/blue win.

[Keith]

Thinking about the euro crisis as a effect of a trade imbalance between Germany and the southern european states financed by German and french savings clarifys why there is lots of talk but not much effective action about the crisis. The underlying logic from a keynesian point of view is that Germany should increase demand massively so as to run a trade deficit with the rest of the euro zone financed by the ECB. Otherwise the former investments of the french and germans become worthless. We have recreated the problem of reparations post world war one in a new form! Its beggar thy neighbour all over again. Without the possibility of exporting to Germany how can the pigs pay back the capital that financed the boom in the south? Price deflation only worsens the effect of the debt over hang. There are no transfer mechanisms to redistribute income and demand automatically between states, as none were created.

As for abolishing fractional reserve banking such a policy is only possible if the state replaces the credit creating activity of the private banking sector. Why it is assumed that this policy involves a reduction of state activity is a mystery to me. No one really would wish to abandon credit creation in some form. One must create money and credit for the economy to grow. The same problem of economic management exists if you abolish private banking or Nationalised all the banks. There is always a need to plan the growth of credit and money by some one. The financial crisis is the proof that there is no wisdom in hoping for an invisible hand to make monetary and credit growth turn out just right. In other words economic planning is not such a bad idea. The crunch is what you get when no one tries to plan any thing at all and just hopes profit will guide economic actors to the decisions that are optimal for the macro economy.

[George Carty]

Keith, since you are making the comparison between today's Eurozone and interwar Europe, what do you consider to be the equivalent of World War I itself (ie the massive expense that destabilized the European economy in the first place)?

Would the cost of rebuilding Eastern Europe after 40 years of Soviet misrule count?

[Woj]

From Peter Boettke (Coordination Problem) today:
"What the economics of illusion does is continually paper over economic disturbances with short run policies that provide the appearance of economic viability, but with the cost of distorting incentives for long run economic growth. This was hidden for a few of the decades after WWII because of technological innovations. As I have repeatedly argued here and elsewhere, if the Smithian gains from trade, and the Schumpeterian gains from innovation continue to outpace the stupidity of government policies, then economic growth will continue to happen to such an extent that tomorrow's trough will be higher than today's peak. But tomorrow's prosperity will not be as great or as generally shared as it otherwise would have been. In short, the economics of illusion just kicks the granade down the road."

Those who argue for austerity now (generally) do not maliciously wish to raise unemployment or increase inequality. The argument for austerity is that some economic pain is inevitable, but it is far better to get accept a little pain today than a lot of pain tomorrow.

http://bubblesandbusts.blogspot.com/2012/05/valuing-future-over-here-and-now.html