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Use—and Abuses—of Austerity

Economists revisit an unsettled economic policy.

January-February 2019

Illustration by Matt Kenyon


Illustration by Matt Kenyon

Precious few words in economics evoke emotional responses of any kind. But austerity, the reduction of government deficits through tax increases or pared-down spending, is an exception. Discussions of austerity quickly devolve into moralizing—between supporters, who see austerity as a kind of virtuous self-denial, and opponents, who portray it as self-defeating, self-flagellating nonsense. Ten years after the Great Recession pushed many European countries with precarious finances to embrace austerity measures, the debate continues.

And worse, it remains deeply unsettled. Now Ropes professor of political economy Alberto Alesina seeks to rectify that with his matter-of-factly titled Austerity: When It Works and When It Doesn’t, co-written with Carlo Favero and Francesco Giavazzi of Bocconi University. Their book focuses painstakingly on proving a single proposition: austerity achieved through tax increases tends to trigger recessions and worsen a country’s debt load, whereas austerity accomplished through government spending cuts has only a limited impact on economic output.

If this doesn’t seem like a page-turner, that’s because it isn’t. Among the general public, only macroeconomic fiends will pick it up—and even they might not. Alesina has advocated the central thesis for nearly a decade; his influential study on the topic (with then Harvard economist Silvia Ardagna), published in October 2009 at the height of the financial crisis, made much the same point. The analysis in the new book is more rigorous—it rests on details of 200 austerity plans in 16 rich countries before and after the financial crisis—but the ultimate finding is the same: belt-tightening through tax increases is ultimately much more painful than slashing spending.

That remains a provocative assertion because it flies in the face of basic Keynesian logic. That influential macroeconomic model focuses on movements in aggregate demand—the total of public spending, consumption, investment, and net exports. Although higher taxes will reduce consumption a bit, the theory predicts that reduced government spending has an outsize effect on the economy. Cash spent by public programs becomes income for individuals, who spend a portion of it, generating economic activity, which generates further activity, and so on.

George Box, the great British statistician, once quipped that “all models are wrong but some are useful.” Keynes’s basic model was certainly wrong—it did not consider the supply side of the economy or the importance of incentives. Later economists have updated the model to account for these deficiencies, but their conclusions remain the same: government spending should have a larger impact on output (i.e., be a larger “fiscal multiplier”) than taxes.

The entire game in settling the debate lies in figuring out the magnitude of these fiscal multipliers. Yet the repeated estimates put forth by economists on this fundamental number vary widely enough to allow individuals to continue believing what they wish. In Alesina’s analysis, a reduction in spending on the order of 1 percent of gross domestic product (GDP, the broadest measure of national output) is associated with a loss in GDP of less than 0.5 percent; a tax increase of similar magnitude tends to decrease GDP by 3 percent—and the ensuing recession tends to last for several years. The differences matter at times of economic stress or when policymakers try to rein in profligacy (in an attempt to stave off still worse depressions to come.)

The underlying reason, Alesina and his coauthors explain, is investor confidence. Immediate tax increases reduce the incentive for investment, while spending cuts—especially to government programs with ever-inflating budgets—signal the possibility of eventual tax cuts. Relative to tax-based austerity, spending-based austerity spurs private investment and mitigates the recessionary result predicted by Keynesians. The theory is controversial. Paul Krugman, a prominent and vitriolic critic of austerity programs, has pooh-poohed this explanation as belief in the “confidence fairy.”

There are also more technical critiques of Alesina’s results. The relative outperformance of spending-based austerity programs could be explained by other factors. This is a central barrier to knowing anything with confidence in macroeconomics: experimental evidence is nonexistent. If monetary policy kicks in at the same time to stimulate the economy through reduced interest rates or expansion of the money supply, then spending-based austerity might look better than it does. The International Monetary Fund made this point in a biting critique of Alesina’s work published in 2012. A weaker currency, which promotes exports and thus GDP growth, and labor-market reforms that often accompany austerity packages (such as deregulating hiring and layoffs), could also be influential factors. Alesina thinks that none of these defeat his theory, but they provide enough ammunition for skeptics who do not wish to be convinced.

 

All this theoretical back-and-forth does not change the fact that austerity is an unpopular and dirty word. After the Great Recession, Britain began a years-long austerity program—slashing day-to-day departmental spending by 16 percent per person—that it is only now reversing. As Alesina and his colleagues recommend, David Cameron, the prime minister, and his chancellor of the exchequer, George Osborne, went the cut-spending route rather than the tax-raising one. Indeed, the British experience is cheered in the book.

But look also at what that has wrought. Doctors in training, university lecturers, even public defenders have gone on strike to protest benefits cuts. The Labour Party, firmly in the grip of its hard-left leader Jeremy Corbyn, has converted disaffection with austerity—especially among the young—into a potent political force. Should Theresa May’s tenuous hold on government slip, Corbyn could easily take control in the next general election and introduce spendthrift policies that eliminate whatever good the austerity did.

The paradox is that if fiscal policymaking were left to prudent hands, austerity would almost never be needed. The authors do not deviate from the economics orthodoxy that governments should run surpluses in boom times and deficits in lean times. The German allergy to deficits of all kinds, in a show of Teutonic “moral superiority,” is rejected by Alesina as “bad economics.” But the same goes for countries that run up debts “for no good reason.” Take Greece. The country radically expanded public spending during years of strong economic growth, while neglecting to crack down on tax evasion, and accumulated a colossal debt load, which threatened to upend the entire Eurozone.The unwinding of the crisis remains painful (unemployment has persisted at Great Depression levels, and even under optimistic forecasts, Greece will be paying off its debt until 2060)—and gives ample opportunity to populists on both the left and the right.

Or look no further than the American economy. Despite a record-low unemployment rate and decade-long recovery, Congress has passed an enormous tax cut without an accompanying plan to pay for it. The budget deficit has swollen 17 percent at precisely the time it should be reduced. In the fiscal-policy kit, austerity ought to be a rare tool. Instead, it promises to become recurrent. 

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Courtesy of the Alan Mason Chesney Medical Archives of the Johns Hopkins Medical Institutions

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Click on arrow at right to see uncropped image
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©2019 Estate of Pablo Picasso/Artist Rights Society (ARS), New York. Image from the Bridgeman Art Library

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