Fiscal consolidation fantasy

18 Oct 12
Steve Keen

The IMF’s ‘economic counsellor’ believes that ‘fiscal consolidation is proceeding according to plan’. But experience in Greece and Spain suggests otherwise

Whenever I fear that my well of inspiration for this blog might run dry, my Neoclassical mates rush to the rescue with some priceless pearl of wisdom that simply demands a rejoinder. Today’s helping hand was a comment from Olivier Blanchard.

He qualifies as a serial offender on the comic statements front, since when wearing the hat of founding editor of the American Economic Review: Macroeconomics, he uttered the now immortal line that “the state of macro [economic theory] is good” — one year and six days after the financial crisis began.

He was Chief Economist for the International Monetary Fund prior to that gig, and he subsequently returned to the IMF, where he now has the curious title of “Economic Counsellor”. While delivering the baleful news in the latest IMF World Economic Outlook that the global economy is slowing, Olivier noted that:

In most countries, fiscal consolidation is proceeding according to plan.

“According to plan???” .Well, yes, if the plan is to inspire the rise of Fascist dictatorships in Southern Europe, I suppose you could say that. Golden Dawn is, it seems, within striking distance of being the third largest party in the Greek Parliament were an election to be held now. The disastrous impact of the austerity programmes on Greece’s people is the overwhelming reason why this once laughing stock of a party is now within reach of power.

Greece and Spain give the evidence on “fiscal consolidation”—or as much evidence as living and breathing humans should be expected to provide. Those countries have had austerity imposed upon them by politicians (who have followed the advice of delusional Neoclassical economists) and have had by far the worst economic outcomes.

Things are hardly rosy in the rest of the Western world—even Australia’s most recent unemployment figure rose 0.3%—but problems elsewhere are nothing like the catastrophes that are Spain and Greece.

Bizarrely, despite that banal opening line, Blanchard later goes on to show that austerity is not proceeding “according to plan” at all. The “plan”, for want of a better word, was that “fiscal consolidation” would be either neutral or expansionary: that is, that the economy would either be unaffected or would grow more quickly with cutbacks to government spending, than would be the case with government deficits.

This claim was the opposite of the preceding so-called Keynesian argument that a dollar of additional government spending would result in a more than one dollar increase in private expenditure — and therefore that a cut in government spending would result in a still larger fall in aggregate income.

The Keynesian argument, derived in a typical piece of static equilibrium thinking, was that since consumption was a (large) fraction of aggregate income, an increase in government spending would result in a more than proportionate increase in aggregate income.

In words, the “Keynesian” model was that income was consumption plus investment plus (net) government spending, and consumption was income multiplied by a consumption ratio that was less than one. With investment and government spending seen as “autonomous injections” (the former due to the Wild Child of “animal spirits”, the latter to government policy), aggregate income in equilibrium would be these two “injections” divided by one minus the consumption ratio.

The closer this consumption ratio (“c”) was to one, the larger would be the increase in equilibrium income from an increase in government spending.

This bastard Keynesian analysis deserved a riposte for being equilibrium-oriented thinking about a dynamic world, but that’s not the one it got. Instead it copped a Neoclassical rejoinder from Robert Barro (R. J. Barro 1978, 1989a, 1989b; R. Barro 1996), in what later became known as “Ricardian Equivalence”.

This was the proposition that the public would know that an increase in government spending via a deficit would necessitate higher taxes in the future, and the private sector would therefore cut back on spending in response to the deficit. The increase in public spending would thus be cancelled out by a decrease in private sector spending, leading to a “fiscal multiplier” of zero.

The Wikipedia, which normally does a rather poor job of detailing flaws in Neoclassical arguments, does a good job with this one, pointing out that to reach his conclusion, Barro assumed that:

  • families act as infinitely lived dynasties because of intergenerational altruism
  • capital markets are perfect (i.e., all can borrow and lend at a single rate)
  • the path of government expenditures is fixed.

Armed with these ludicrous assumptions, Barro argued that taxpayers today would react to an increase in government spending today by increasing the bequests they made to some future generation to enable it to pay taxes!

That one should even have to discuss these assumptions shows how Neoclassical economics reduced economic thinking to a theatre of the absurd, in which “infinitely lived” agents were assumed to be able to accurately predict the future because of “rational expectations”. But this nonsense passed for wisdom before the economic crisis hit in 2007.

One would have hoped that that crisis was enough to consign delusions like this to the dustbin of intellectual history—and certainly the initial response of Neoclassically-trained US economists (like Tim Geithner and Larry Summers) when the crisis hit was to spend like drunken Keynesians.

But reality never kept a bad ideology down, and once the immediate crisis had passed, Neoclassicals began spouting “Reverse Ricardian Equivalence” as a cure to the crisis—that is, that government surpluses would stimulate private spending.

One might hope that governments had become more wary of trusting economists after this crisis, and you’d be right. But since politicians don’t have any other alternative advice, and austerity sounded like what one might impose on a family budget when spending exceeded income, this fantasy became the intellectual gossamer clothing supporting what has been an economic and political disaster for Europe.

Which brings me to Blanchard’s empirical evaluation of “Expansionary Fiscal Consolidation” later on in the IMF Report. This hinges on the fiscal multiplier: was it zero (or at worst a lot less than one), so that a dollar reduction in government spending reduced GDP by much less than a dollar, as its Neoclassical proponents claimed? Or was it one or more, in which case attempts by governments to reduce their deficits by cutbacks would be to a large degree self-defeating?

Using some fairly straightforward statistics, Blanchard concluded that, while the advocates of austerity assumed a multiplier of 0.5 or below (so that a $1 reduction in government spending would only reduce GDP by 50 cents), “actual multipliers may be higher, in the range of 0.9 to 1.7… the multipliers underlying growth projections have been too low by about 1”. This implies that a $1 cut in government spending could result in GDP falling by $1.50 to $1.70.

This in turn means that one of the objectives of the policy — to reduce the government deficit as a percentage of GDP — is undermined by the policy, since the denominator (GDP) falls by more than the numerator (the government deficit).

If economic policy were driven by results rather than ideology, this should have been enough to end the austerity drives and lead to the reverse policy: increase the government deficit since this might result in a larger rise in GDP.

Instead, both political inertia and the unwillingness of Neoclassical economists to admit they were wrong has made this a race to the bottom: since each round of austerity fails to reach its targeted reduction in the government deficit to GDP ratio, another round of austerity is ordered—and so on till infinitum.

Or Golden Dawn; whichever comes first.

Steve Keen is professor of economics and finance at the University of Western Sydney. This post first appeared on his Debtwatch and Debunking Economics blogs

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