There’s Austerity and Then There’s Austerity

This article was originally published in the National Review

Austerity means different things to different people. For some people, austerity means adopting a debt-reduction package made of a mix of spending cuts and tax increases. For others, it means adopting a package made mainly of spending cuts — including reforms of social programs. The lack of a distinction between the two meanings of the word — and hence, the distinction between two different debt-reduction policies — is unfortunate. It could also explain the confusion over the apparent failure of the British government’s “austerity” measures to address their financial problems. (The Economist has a piece that explains why the claim that the U.K. is going into a double-dip recession maybe overstated.)

The two important questions in my mind are:

• Which of the two types of “austerity” measures successfully reduce the debt to GDP ratio?
• What is the impact of “austerity” measures on economic growth?

Here is what economists have said successful debt-reduction packages look like.

First, they are made of spending cuts rather than a mix of spending cuts and tax increase. (See, for instance, Alisina and Ardagna, Andrew Biggs, Kevin Hassett, and Matthew Jensen).

Second, the successful fiscal adjustments are rooted in reform of social programs and reduce the size and pay of the government work force (Think Germany).

Third, the data show that 80 percent of the attempts to reduce the debt-to-GDP ratio are failures.

Now let’s look at the effects of large fiscal-adjustments episodes on growth. While the impact of budget cuts on growth is far from being settled, a few lessons have emerged.

First, tax cuts are more expansionary than spending increases in the case of a fiscal stimulus. This is consistent with the work of former Obama Council of Economic Advisers chairman Christina Romer and her economist husband, David Romer. Their research shows that increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP. Also, fiscal adjustment achieved through spending cuts rather than tax increases are less recessionary than those achieved through tax increases.

Second, spending-based fiscal adjustment accompanied by the “right polices” (easymonetary policy, liberalization of goods and labor markets, and other structural reforms) tend to be less recessionary or even have a positive impact on growth. (See this recent piece by economists Alberto Alesina and  Francesco Giavazzi)

Okay, now let’s take a look at what the U.K. has done. At first the Cameron government announced that it would engage in tax and spending cuts as well as serious reform of social programs. That was the plan. What actually happened was different. Faced with opposition, Cameron quickly gave up on reforming social programs, and in the end the government barely cut spending (projected nominal spending is going up, real spending is flat), and while it did talk about cutting income-tax rates, it also increased other taxes quite substantially (the VAT, taxes on banks and oil companies, etc.). 

In other words, the Cameron austerity packages were insufficiently focused on spending cuts and relied too heavily on increasing tax revenue. Remember, Alesina and others have found that these are the type of packages that tend to fail. .

As for the impact these will have on growth, I guess the jury is still out. Much of it will depend on how well targeted and appropriate the Bank of England’s policies turn out to have been. But it is difficult to see how an “austerity” package that fails to reduce the debt can have a very positive impact on growth.

Moreover, it is important to note that real austerity measures are important independent of their short-term impact on growth. In fact, austerity measures should be pursued, not because we hope for a quick economic-growth payoff, but because they are desirable from a structure standpoint and they may — even though it is hard to test — help avoid future fiscal crises.