Why the jury is still out on austerity measures

Fri, Nov 23, 2012, 00:00

With yet another painful budget in the offing, now is a good time to revisit the austerity debate. Last April, I wondered why so many people take such strong positions on the matter.

There is no doubt that tax cuts and more public spending boost growth in the near term, while austerity dampens it. But because of the inherent difficulties in disentangling the causes of economic growth/contraction, it is very hard to say how big austerity effects are. That, however, has not led to calm debate.

Ireland’s experience over the past half decade can be, and has been, used by both sides. Since 2008, Ireland has endured more austerity than any other country in the Organisation for Economic Co-operation and Development. At the same time the domestic economy has contracted massively and almost uninterruptedly. Public debt continues to rise.

Ergo, say the fiscal stimulators, austerity isn’t working.

But correlation does not prove causation, retort the fiscal consolidationists. What’s more, they say, there isn’t even a strong correlation between the size of annual budget adjustments and changes in output and employment in each corresponding year.

Besides, they add, the purpose of painful adjustments is to prevent even more painful measures in the event of a complete loss of fiscal control. With the budget deficit shrinking, the plan is working, argue its advocates.

Further afield, Greece has long provided the best supporting evidence for the anti-austerity case. Although the worst may be over, the bailouts have meant enormous pain with little gain.

Among those who favour front-loading adjustments, the booming Baltic economies are proof that taking all the medicine early on makes for the fastest recovery.

With the Mediterraneans still sinking and the Baltics surging, both sides have good examples to support their respective positions.

Alas, things do not become clearer cut when a larger group of countries is considered. For the pro-stimulus camp, the UK and US provide the best evidence to support their case.

As the chart shows, Britain’s domestic economy has stagnated since 2010 when a new government made clear its intent to cut. The US recovery, though feeble by historical standards, has bested all other G7 economies precisely because, the Keynsians claim, it has avoided austerity. The consolidationists warn that the US is risking a loss of confidence because it has made little progress in shrinking its huge deficits.

In continental Europe, those who fear the effects of profligacy talk of timing issues. The Spanish and Italian domestic economies went into sharp decline well before either introduced any real cuts.

Germany and France started their consolidation processes this year, but both economies have been slowing since last year. The Dutch have yet to start consolidation, but their domestic economy is sinking almost as fast as those of the peripherals.

The jury remains out. Don’t expect the austerity debate to end any time soon.

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