I tend to think the Austerity debate is so hopelessly mixed up with left-right politics that it is highly unlikely that even the blogosphere will come to clarity, let alone the wider policy community.
Nonetheless, I’ll try to make a few points.
Generally speaking “austerity” is an attempt to reduce structural budget deficits. To do this a government will attempt to increase the growth rate of structural revenues and decrease the growth rate of structural outlays. Outlays here include not just what we would think of as government consumption and investment but transfer payments, such as Social Security in the United States.
Both of these effects, an increase in the growth rate of revenue and a decrease in the growth rate of outlays will tend to be contractionary.
Indeed this is the entire point.
Let me say again because there is much confusion here. The point of austerity is to be contractionary. If Austerity is not contractionary it cannot work.
Why?
Well, because the idea is to allow private sector investment to grow. But, for the private sector investment to grow it must have “room.”
Who determines how much room the economy has to grow?
The central bank does.
So, austerity works by contracting the overall economy through increasing the growth of revenues and decreasing the growth of outlays. This allows the Central Bank to decrease the path of interest rates. A reduction in the path of interest rates increase total investment.
In this way the economy has shifted away from consumption and towards investment. This shift is what makes austerity, austere. You do with less now to have more later.
Once we see this we can see why austerity would be highly controversial from a macroeconomic standpoint right now. Here in the United States there is a major debate over the Fed’s reaction function. My interpretation of their actions is that the reaction function is asymmetrical. That is, the Fed will move to speed up the economy if it slows down, but will not move to slow down the economy if it speeds up.
Ben Bernanke insists that the reaction function is symmetrical but also admits that it damped. That is, the Fed will nudge the economy towards the long run equilibrium that it wants rather than slamming on the gas or the breaks. It is clear that the Fed is not slamming on the gas now and Bernanke argues that if inflation were running at over 3% the Fed would not be slamming on the breaks.
Instead they seek a smooth glide path towards their long term goals.
This implies that fiscal policy has limited but real effects in America. Expansionary fiscal policy could push the country closer to and even above the Fed’s long run growth targets and then the Fed would react slowly to slow down the economy.
Notably Austerity in the US could take the form of cuts in government spending as happened at the State and Local level or increases in taxes as is the threat with the so called “fiscal cliff”
In Europe the effects of austerity are even more extreme because the monetary union is not a smooth market. Austerity in Spain for example should take some mild pressure off the ECB to increase rates. However, that would promote investment all over Europe and because of the fractured banking system, mostly likely investment in Germany.
However, the contractionary effects would happen in Spain. This is why Spain gains nothing from austerity. It makes “room” for private sector investment but has no means to achieve increases in private sector investment. Thus there is simply a whole in the economy.
Now finally there has been some debate over whether or not one should correct for inflation when looking at spending cuts. It depends on what you are trying to figure out. If you are trying to figure out whether or not the cuts are contractionary, then you should ask whether the growth rate of spending went down.
If it did then its contractionary, because the growth rate of something else would have to increase or else the growth rate of NGDP will fall.
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Thursday ~ May 10th, 2012 at 12:54 am
curtd59
RE: “I tend to think the Austerity debate is so hopeless mixed up with left-right politics that it is highly unlikely that even the blogosphere will come to clarity, let alone the wider policy community.”
You could always propose a program that consists of:
a) Tax cuts (that you’ve already recommended)
b) Spending (on infrastructure: roads, nuclear power, and a new grid, not ‘new programs’ or ‘new bureaucracies’)
c) Departmental closure (The department of ed, and HUD – ask for both take one.)
d) Trade Policy (Protectionism designed to move high tech manufacturing back to the states)
e) Job training (significant educational subsidies for trade schools, community colleges and undergraduate study.)
f) Investment (the supercollider, the space program)
That will sell. You can put it together. And the effect will be dramatic. But you have to give everyone something.
Curt
Thursday ~ May 10th, 2012 at 1:31 am
curtd59
(Karl. Do you ever sleep?) 🙂
Thursday ~ May 10th, 2012 at 8:00 am
Blog of Rivals
[…] Karl Smith also has some comments on austerity. […]
Thursday ~ May 10th, 2012 at 8:38 am
BSEconomist
Great post. A related point I like to make is that technology destroys jobs, in fact that that is the point of “technology”. Anything that can be viewed as a positive technology shock would be contractionary.
Just to be quick (for anyone who reads this and is skeptical), the reason is that technology is what allows you to do more with less, makes goods cheaper, etc (Solow residual). But that means that you can hire fewer workers and meet the same orders or you have to sell more goods (in real terms) to meet your old outstanding debts. So without an increase in AD (i.e. offsetting easing by the central bank) the technology shock is putting downward pressure on employment.
I don’t really have anything new to say about that, except that I have this hunch that what confuses people about austerity is basically the same conceptual problem that they have when trying to think about technology as contractionary. If austerity can be counted as a beneficial technology shock and people sense that (rightly or wrongly), they have difficulty thinking that what is good for the long run is bad in the short run.
Thursday ~ May 10th, 2012 at 11:03 am
Mr. Meanor
Seems your explanation only works if interest rates are significantly above zero. In that case, fiscal austerity could allow a central bank to reduce interest rates. However, when interest rates are close to zero, austerity doesn’t have a mechanism to create increased private sector growth, at least in the short run (and probably in the long run as well). Unless you’re counting on QE or some other “extraordinary” measure.
Friday ~ May 3rd, 2013 at 5:47 pm
annoporci
I’m interested in the topic but I don’t understand your reasoning at all… are you assuming an economy operating at full capacity? what do you mean by austerity? By and large, austerity means spending cuts with no increase in taxes (you seem to imply that tax increases are part of the “austerity” creed but they are not). In a depressed economy, public spending cuts (whether outlays or transfers, btw, because of the high mpc of the transfer recipients) would depress demand further with interest rates stuck at the zero lower bound. Now whether investment will respond to any policy depends on expectations about the next few years and if austerity doesn’t help the economy (and why would it?), potential investors will not raise their expectation of future profitability and so it’s hard to see why they would raise their current investments. I don’t understand the “smart” remark about the point of austerity being to contract the economy (you don’t say if contraction operates on the supply side or demand side in your story, but in the economy I have in mind demand drives supply so there is no need for “room” there is plenty of it already). I suggest you make a rewrite of this post in the future.
Monday ~ May 6th, 2013 at 10:18 pm
curtd59
Anno..
I don’t think he’ll update this post because it’s a matter of common knowledge. I’ll take a moment tho…
In contemporary macro, the government needs to SPEND money in order to force money to move in the economy. By not spending money, the government engages in ‘austerity’. The government has two tools: (1) interest rates and (2) spending. Interest rates alone have not been sufficient to encourage people to spend. (They have too much debt, and are too uncertain about the future). And the only way then, to force money to move in the economy is through borrowing and spending.
So you intuit correctly that the use of the term ‘austerity’ in macro used as a relative convention – and a pejorative one – meant to criticize ‘foolish’ politicians who do not spend when the economy needs it most, and overspend when it doesn’t. It isn’t an absolute measure, but a relative one.
Unfortunately (a) our political system provides politicians precisely these incentives: to spend when prosperous and demonstrate austerity when not. (b) Spending favors the left side and spending is used to reward political allies so the other side always fights against it. (c) as I argued fervently, conservatives (myself included) have been trying to bankrupt the state for over thirty years, and this is a strategic opportunity that I doubt will be missed. (d) too much of the population doesn’t trust our government, and won’t tolerate new taxes. This means that political austerity is so useful that the politicians will use it.
Curt Doolittle
Kiev
Sunday ~ March 8th, 2015 at 3:46 am
fredgi
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Tuesday ~ March 10th, 2015 at 11:54 am
Eula Mcnamara
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Monday ~ March 23rd, 2015 at 6:46 am
Amalia Ricotta
I tend to think the Austerity debate is so hopelessly mixed up with left-right politics that it is highly unlikely that even the blogosphere will come to clarity, let alone the wider policy community.Joel Fitzgibbon HCG drops
Wednesday ~ April 1st, 2015 at 3:22 am
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Wednesday ~ April 1st, 2015 at 4:36 am
Curt Doolitlte
You are empirically correct as usual Karl. But austerity is evidence of morality, not utility: the requirement for cooperation in all humans is the prohibition in free riding. We could not evolve cooperation without it. And we cease cooperation in the presence of it. We must.
Democratic politics is a moral, not rational or empirical process.
I realize that economically harmful policy appears quantitatively arational. But it isn’t.
Humans punish free riding. And as Kahnemann and Haidt and Pinker will tell you, we will pay extraordinary costs to punish free riders.
Cheating violates our most primitive instincts. It has to. Or we could never evolve cooperation.
Hence why nationalism is the optimum political order. And why monarchy under rule of law is the optimum government.
The temporary asymmetries of the past 200 years masked many rules of human cooperation. But that unique circumstance has passed.
Man is a moral animal.
Friday ~ May 22nd, 2015 at 8:34 am
georgejileres
Once we see this we can see why austerity would be highly controversial from a macroeconomic standpoint right now. Here in the United States there is a major debate over the Fed’s reaction function. My interpretation of their actions is that the reaction function is asymmetrical. That is, the Fed will move to speed up the economy if it slows down, but will not move to slow down the economy if it speeds up. follow us
Friday ~ May 29th, 2015 at 5:07 am
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Saturday ~ June 20th, 2015 at 7:30 am
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So, austerity works by contracting the overall economy through increasing the growth of revenues and decreasing the growth of outlays. This allows the Central Bank to decrease the path of interest rates. A reduction in the path of interest rates increase total investment. george