Self-defeating austerity?


Is austerity – particularly the fiscal consolidation programmes currently under way in most European Union countries - self-defeating?  This question has been thrown into sharp focus by the IMF’s belated reassessment of the magnitude of the “fiscal multiplier” in major industrialised countries during the Great Recession.   New research from NIESR, published in the National Institute Economic Review (£), makes the first attempt – to our knowledge – to model the quantitative impact of coordinated fiscal consolidation across the EU, using the National Institute Global Econometric Model.


The main conclusion is that, while in "normal times", fiscal consolidation would lead to a fall in debt-GDP ratios, in current circumstances, fiscal consolidation is indeed likely to be "self-defeating" for the EU collectively.  As a result of the fiscal consolidation plans currently in train, debt ratios will be higher in 2013 in the EU as a whole rather than lower.  This will also be true in almost all individual members states (including the UK, but with the exception of Ireland).   Coordinated austerity in a depression is indeed self-defeating. The implication is that the current strategy being pursued by individual Member States, as well as the EU as a whole, is fundamentally flawed.  Even on its own terms, it is making matters worse.


Why is fiscal consolidation so much more damaging now?  Under normal circumstances a tightening in fiscal policy would also lead to a relaxation in monetary policy .  However, with interest rates already at exceptionally low levels, this is unlikely or infeasible.   Moreover, during a downturn, when unemployment is high and job security low, a greater percentage of households and firms are likely to find themselves liquidity constrained. Finally, with all countries consolidating simultaneously, output in each country is reduced not just by fiscal consolidation domestically, but by that in other countries, because of trade.  In the EU, such spillover effects are likely to be large.


Taking account of these factors makes a large difference to estimates of  the impact of the actual fiscal programmes announced and enacted for 2011-13 in the EU.  The chart below shows the impact of fiscal consolidation on debt-GDP ratios; scenario 1 shows the impact in "normal" times, while scenario 2 shows the impact under assumptions we consider more realistic in current conditions.




The negative impacts of fiscal consolidation on growth in the second scenario are much larger than in “normal” times; and the result of this in turn is that fiscal consolidation increases rather than reduces the debt-GDP ratio in every country except Ireland.   In both the UK and the euro area as a whole, the result of coordinated fiscal consolidation is a rise in the debt-GDP ratio of approximately five percentage points.


Of course, one argument frequently advanced in support of fiscal consolidation programmes is that they will reduce government borrowing premia in countries with high debt and deficits. But these simulations show that the opposite may in fact be the case: if we were to allow for feedback from the government debt ratio to government borrowing premia, this would in fact raise interest rates, exacerbate the negative effects on output, and in turn make debt-GDP ratios even worse; truly a “death spiral” .


The direct implication is that the policies pursued by EU countries over the recent past have had perverse and damaging effects.  Our simulations suggest that coordinated fiscal consolidation has not only had substantially larger negative impacts on growth than expected, but has actually had the effect of raising rather than lowering debt-GDP ratios, precisely as some critics have argued.  Not only would growth have been higher if such policies had not been pursued, but debt-GDP ratios would have been lower.

It is particularly ironic that, given that the EU was set up in part to avoid precisely such “Prisoners’ Dilemma” type problems in economic policy coordination, it should currently be doing exactly the opposite.   

My Guardian article on this is here.  The paper on which it is based, "Self-defeating austerity?" (Dawn Holland and Jonathan Portes, National Institute Economic Review, no. 222, October 2012), will be published on Thursday 1 November.  


Simon's picture

Another excellent, insightful and highly informative report, which given the nature and impact of its conclusions, should have made headline news and be one of the main debating points among politicians and throughout the serious media. Which leads me onto a question which I hope you are able to answer, if only briefly:
Why, when given all of the extensive empirical data from reliable, independently verified sources, which highlight and prove the folly of the current fiscal consolidation policy, do our politicians (Cameron, Osborne et al) choose to not act on it, and in fact continue to do the opposite, despite the overwhelming evidence in your report, and complete lack of evidence in favour of their views? Linked to this, we know about the negative social and economic impacts, but by pursuing austerity, what is actually in it for Cameron, Osborne and their followers?
Any reply will be gratefully received...

Big Bill's picture

Austerity can be used as an excuse to dismantle the welfare state and the NHS, allowing their American business chums to come in and replace them both with paid insurance services. That's a multi-billion pound market busted wide open. We'll all have worse services we have to pay more for (or no service at all if we can't pay) and Cameron and his chums will be billionaires. It's not rocket science...

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