Fiscal austerity is bad – there are no qualifications

I know people like to dream and Latvians are apparently no exception. Their latest collective dream, or at least, those of the elites that fancy wining and dining in style in Brussels, is to join the Eurozone. The Latvian government has now formally requested the EU to undertake a “Convergence Report assessment” of the Latvian economy to facilitate membership by January 2014. The opinion polls do not necessarily support the intent of the Government. But the conservatives are out in force with supporting narratives. One such attempt at making the impossible argument was from on Anders Aslund, who is one of Peter Peterson’s stooges and has co-written a book with the Latvian Prime Minister. He wrote a Bloomberg Op Ed (January 8, 2013) – Why Austerity Works and Stimulus Doesn’t – which turned out to be a major revision of all the known facts and concepts that almost everybody else (apart from the pro-austerity spivs and their hangers-on) would by now have to share. I made a few graphs. Fiscal austerity is bad. There are no qualifications.

Mr Aslund seems to think that Greece has gone easy on its fiscal consolidation – with “half-hearted austerity or, worse, fiscal stimulus”. He thinks they have fallen prey to the “predominant Keynesian thinking” which “has been tested, and it has failed spectacularly”.

News to me. In the graphs below, Greece is the observation that is associated with the greatest fiscal shift. It has gone big – nothing “Keynesian” about it.

Anyway, I have been putting together a database for sometime (since December 2012) and here are some graphs that might be of interest.

The data comes from the – IMF Fiscal Monitor Database – and contains information on the shift in fiscal position for selected countries. The only complication with this dataset (see Figure 15 in the Fiscal Monitor) is that the revenue shift (between 2009-12) is expressed in terms of the proportion of GDP, whereas the expenditure shift is expressed in terms of Potential GDP.

I can use output gap estimates to convert them both into the same GDP measure but I haven’t time today. So the total fiscal shift modelled here is a little mismatched and will understate the degree of overall shift because the expenditure side is expressed in terms of a larger denominator than the revenue side. So this should be interpreted as the best case scenario in an appalling set of circumstances.

The GDP and public debt data series: the percentage change in real Gross domestic product 2008-2011, the percentage change in real Gross domestic product per capita 2008-2011, and the percentage point change in General government gross debt 2008-2011 – were constructed using the – IMF World Economic Outlook dataset – as at October 2012.

I used the change for 2008-2011 because the recession really hadn’t started impacting until 2009 and the IMF figures for 2012 are still estimates. And, as you know, the IMF always inflates its growth estimates and downgrades its contraction estimates because then their recommendations of austerity do not seem to have as bad a consequences as actually turns out to be the case.

The unemployment rate data comes from Eurostat’s standard labour force survey data. The variable I constructed was the change in the unemployment between 2009 and 2013.

So real GDP growth and unemployment are real variables which measure prosperity. The proponents of fiscal austerity claimed that growth would return and the unemployment rate would fall if only austerity was imposed.

There are all sorts of issues with endogeneity in this sort of exercise – that is, what is driving what. We expect the fiscal position to show a contraction when a nation is growing strongly because of the impact of the automatic stabilisers. But this dataset is the actual shift in the fiscal position over the period noted.

The first graph shows the relationship between the shift in fiscal position (negative is a contraction – that is, austerity) and real GDP growth over the period noted above.

The relationship is very clear – austerity damages real GDP growth.

The second graph shows the relationship between the fiscal shift and the growth in real GDP per capita. Not much joy for the Austerians there. In general, the weight of evidence is that nations that undergo larger fiscal shifts make their population poorer on average.

The third graph shows the relationship between the fiscal shift and the percentage point change in the unemployment rate. Note the dataset includes fewer nations given the Eurostat labour force coverage.

Once again, there are no secrets here. Consistent with what happens to real output, the other side of the coin is that employment growth collapses when austerity is imposed and unemployment rises.

Now, what has all this fiscal contraction been for?

In relation to the obvious real losses that economies imposing larger fiscal contractions are enduring, Paul De Grauwe and Yuemel Ji in their recent article (February 21, 2013) – Panic-driven austerity in the Eurozone and its implications – suggest:

Some will say that this is the price that has to be paid for restoring budgetary orthodoxy. But is this so?

They show that there is a “strong positive correlation” between “the austerity measures and the subsequent change in the debt-to-GDP ratios”. They conclude:

The more intense the austerity, the larger is the subsequent increase in the debt-to-GDP ratios. This is not really surprising … those countries that applied the strongest austerity also saw their GDP (the denominator in the debt ratio) decline most forcefully. Thus, it can be concluded that the sharp austerity measures that were imposed by market and policymakers’ panic not only produced deep recessions in the countries that were exposed to the medicine, but also that up to now this medicine did not work. In fact it led to even higher debt-to-GDP ratios, and undermined the capacity of these countries to continue to service the debt. Thus the liquidity crisis that started all this, risks degenerating into a solvency crisis.

The following graph shows the relationship between the fiscal shift and the percentage point change in government debt ratios over the period noted. My analysis is over a longer period than that conducted by Paul De Grauwe and his associate (they used the period 2011-12).

The data supports their finding. Fiscal contraction when the non-government sector is not inclined to fill the aggregate demand gap created by the deficit reduction does not even succeed in terms of the principle target – a reduction in the public debt ratio.

Conclusion

Conclusion – the pro-austerity clan lie.

I have had very little time today – full of meetings. So a quick blog to show you some of the characteristics of this dataset. I am doing more intense (econometric analysis) of it which is confirming the casual empiricism that we are engaging in here.

Sometimes, simple eyeballing is misleading because there is complex causality. But in other cases, such as here, what you see is what is. Your eyes are not deceiving you.

Austerity is bad.

The correct stance for those who promote it is not to lie about the consequences but to tell their electorates etc the truth and then try to justify why they would want to damage and retard real GDP growth, render the population increasingly poorer, cause the jobless rate and related costs to rise, and, when it all comes down to it – increase the public debt ratio.

That is the sort of narrative that would be interesting to hear. Of-course, these spivs know full well that if they told the truth there would be a total revolt in the streets and their chances of dining swell down in Brussels would evaporate.

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.