Austerity and Growth

Recently we have seen too very different approached to the recession: big government stimulus efforts versus sharp austerity measures.  Rober Shiller weighs in on the evidence for austerity:

Jaime Guajardo, Daniel Leigh, and Andrea Pescatori of the International Monetary Fund recently studied austerity plans implemented by governments in 17 countries in the last 30 years. But their approach differed from that of previous researchers. They focused on the government’s intent, and looked at what officials actually said, not just at the pattern of public debt. They read budget speeches, reviewed stability programs, and even watched news interviews with government figures. They identified as austerity plans only those cases in which governments imposed tax hikes or spending cuts because they viewed it as a prudent policy with potential long-term benefits, not because they were responding to the short-term economic outlook and sought to reduce the risk of overheating.

Their analysis found a clear tendency for austerity programs to reduce consumption expenditure and weaken the economy. That conclusion, if valid, stands as a stern warning to policymakers today.

But critics, such as Valerie Ramey of the University of California at San Diego, think that Guajardo, Leigh, and Pescatori have not completely proven their case. It is possible, Ramey argues, that their results could reflect a different sort of reverse causality if governments are more likely to respond to high public-debt levels with austerity programs when they have reason to believe that economic conditions could make the debt burden especially worrisome.

That may seem unlikely – one would think that a bad economic outlook would incline governments to postpone, rather than accelerate, austerity measures. And, in response to her comments, the authors did try to account for the severity of the government’s debt problem as perceived by the markets at the time that the plans were implemented, finding very similar results. But Ramey could be right. One would then find that government spending cuts or tax hikes tend to be followed by bad economic times, even if the causality runs the other way.

Another potential problem for such analysis is controlling for market perceptions of the governance and reliability of countries - if they can be trusted to meet their debt obligations.  In other words is it more important for Greece to show that it has its fiscal house in order than it is for the UK?  In my opinion, yes it is.  I worry about skimping on investments in education, for example, catching up with countries 10 to 20 years down the road.  The causal link will never be completely evident, but could be very important.