Fiscal consolidation and growth: what’s going on?

Yesterday the Office of Budget Responsibility published its annual Forecast Evaluation Report.

Post Date
10 October, 2013
Reading Time
4 min read

Yesterday the Office of Budget Responsibility published its annual Forecast Evaluation Report. It didn’t get much attention – this is a shame, because it is commendable that the OBR should look back systematically and explain why its forecasts (like all forecasts, very much including ours) are wrong.  The highlight for most people was the OBR’s reaffirmation of its tentative view, (set out first in last year’s FER) that while fiscal consolidation had definitely reduced growth, it wasn’t the main explanation of why growth had turned out so much worse than they (and others, including again us) had expected in 2010:

We remain of the view that fiscal consolidation could have had a bigger impact on growth than we anticipated in June 2010, but that this still does not look the most obvious explanation.

This is not new. But what is new is that they have for the first time set out exactly what they think the impact of fiscal consolidation on GDP has been in each year, in this chart.

What does this show? Note that the chart shows the impact of fiscal consolidation (divided into the effects of the different years in which different consolidation measures took place) on the level of GDP, not the growth rate. So what this means is that fiscal consolidation is actually, according to the OBR, having a (small) positive rather than negative impact on growth right now (of a couple of tenths of a percentage point).

How can this be? Surely “the cuts” are continuing? Yes, although more slowly on most measures (as Robert Chote, the head of the OBR, has put it, “deficit reduction appears to have stalled”). But that’s not the main reason why. The key point is that all macroeonomists, regardless of their views on the impact or merits of fiscal consolidation in the UK, think that the impact of deficit cuts is all or mostly temporary – sooner or later, unemployed resources, human and otherwise, are reallocated and the economy bounces back.  Simon Wren-Lewis explains this in non-technical terms here.  To the extent that there are permanent impacts – because of “hysteresis” effects, such as an increase in long-term unemployment, that may do permanent damage – we generally don’t model them very well, and the OBR doesn’t model them at all.

So the bounceback in the level of GDP – and hence the positive impact on growth – simply comes arithmetically from the fact that fiscal consolidation had a significant negative impact on GDP in 2011-12 and 12-13, and those effects are fading out – producing a boost to growth.  You can see exactly the same effect in NIESR’s modelling exercise here, although we think the actual impacts are larger.

What does this mean?  First, it shows that the Chancellor was, once again, ignoring the analysis of the OBR and misrepresenting the arguments of almost all credible macroeconomists when he argued

proponents of the ‘fiscalist’ story cannot explain why the UK recovery has strengthened rapidly over the last six months.  The pace of fiscal consolidation has not changed, government spending cuts have continued as planned, and yet growth has accelerated and many of the leading economic indicators show activity rising faster than at any time since the 1990s.

This is just wrong.  Let’s suppose the OBR is wrong and we – the “fiscalists” – are right, and fiscal consolidation has had a bigger impact than the OBR estimates. Well, in that case, the bars in the chart should be larger. So the negative impact of fiscal consolidation in the past would be larger (consistent with the weaker growth we actually saw) and the positive impact now would also be larger (also consistent with stronger growth now).  As Simon Wren Lewis puts it

In the textbook case austerity implies a deeper recession but then a subsequent recovery that is stronger as a result. So in that case rapid growth provides evidence in favour of the ‘fiscalist’ case, not against it. 

In other words, both we and the OBR are saying very clearly that fiscal consolidation had a negative impact on growth up to 2013-14 and isn’t now; and indeed, we agree that the fact that consolidation damaged growth earlier may be having a positive impact on the strength of growth now.  Where we differ is on the size of those impacts.

Simon sums it up:

So the amazing thing is how the idea that the emergence of growth after years of stagnation proves austerity was just fine could gain a moments traction. Do not get me wrong. There are some arguments in favour of austerity that should be seriously debated. But this is not one of them. Instead the argument is just silly. So how can people get away with making it?