Osbourne’s Discredited Theory of ‘Expansionary Fiscal Contraction’

When Osbourne first came into office the fashionable paper was this one from Alesina and Ardagna which argues that

fiscal adjustments..based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases.

This idea was christened ‘expansionary fiscal contraction’ or ‘ ‘expansionary fiscal austerity’ the idea that austerity could raise growth levels more effectively than traditional Keynesian stimulus through deficit spending.

There is one problem – the idea has been torn to shreds and the research it was based on largely discredited by subsequent work.

Christina Romer in a recent paper

Despite what I feel is overwhelming and compelling evidence that fiscal stimulus is expansionary, and fiscal contraction is, well, contractionary, many politicians claim the opposite is true. …But even more striking are the number who assert forcefully that fiscal austerity—getting the budget deficit down immediately—would be good for
unemployment and growth…This is practically the only view one hears in Europe. George Osborne, the Chancellor of the Exchequer in the United Kingdom, is a firm believer in expansionary fiscal contraction, and the U.K. is currently in the midst of a radical austerity program. German policymakers also believe this strongly.
Now economists have helped feed these notions. A very influential paper by Alberto Alesina and Silvia Ardagna found that fiscal austerity was generally expansionary
What Alesina and Ardagna did was to get budget data for a large number of advanced countries over the past 35 years. They identified large fiscal consolidations by looking for times when the cyclically-adjusted budget deficit fell sharply. They then looked at what happened to output after these episodes. They find that output tended to rise on average after these consolidations, particularly those focused on reductions in government spending. And everyone has been citing it.
Unfortunately…Some of their fiscal consolidations weren’t deliberate attempts to get the deficit down at all. Rather, they were times when the budget deficit fell because stock price booms were pushing up tax revenues. Stock prices were a big omitted variable. They were driving the deficit reduction and were likely correlated with rapid output growth. This omitted variable made it look as though deficit reduction was expansionary, when it really wasn’t

This was shown in a study by of all bodies the IMF

Our estimates imply that a 1 percent of GDP fiscal consolidation reduces real private consumption over the next two years by 0.75 percent, while real GDP declines by 0.62 percent

Now it could be argues that the UK has not seen an absolute fall in debt/GDP, in fact overall debt levels have been rising.  The causes in the rise are the costs of unemployment.  The OBRs latest forecast is that national debt peaks a year at 78pc of GDP in 2014-15, a year later and 8% higher than previously forecast by Osbourne.  Hoewever that does not mean that fiscal policy is not contractionary.

The post-keynsian analysis uses the following forumla for aggregate demand

Spending = Income + Net Change in Debt

So if the overall level of debt is rising each year, then aggregate demand exceeds income by the surplus. But  if we have a bubble of debt busting and enter a debt-deflation spiral then  aggregate demand falls short of income, by the amount of debt repayment or debt writing off, such as in bankruptcy. This will trigger a  drop in aggregate demand.

Indeed, a fall in the level of debt is not necessary – even a slowing in the rate of debt growth causes a drop in aggregate demand (relative to the higher borrowing year).

Michael Biggs, economist at Deutsche Bank,  introduced this idea in Nov 2008 and, by analogy with the well known concept of fiscal impulse, defined “credit impulse” as the “the change in new credit issued as a % of GDP”.  The idea was expanded in a paper with Mayer and Pick in 2009.   This is what has been happening in the uk, a fall in the credit impulse leading to a fall in aggregate demand.

Steve Keen has called this rate of change of debt the credit accelerator 

In a well-functioning economy, periods of acceleration of debt would be followed by periods of deceleration, so that the ratio of debt to GDP cycled but did not rise over time. In a Ponzi economy, the acceleration of debt remains positive most of the time, leading not merely to cycles in the debt to GDP ratio, but a secular trend towards rising debt. When that trend exhausts itself, a Depression ensues—which is where we are now. Deleveraging replaces rising debt, the debt to GDP ratio falls, and debt starts to reduce aggregate demand rather than increase it as happens during a boom.

The theory of expansionary fiscal contraction is that despite a fall in government debt this will be offset by a rise in private consumption, investment and debt caused by a combination of lower interest rates (less ‘crowding out’) and raised expectations -that by raising households’ expected future disposable income and by increasing the confidence of investors, fiscal contraction can stimulate private consumption and investment even in the short term,

Richard Murphy tears up the latter assumption

He really does think we should all be dancing in the streets and borrowing money to spend now to celebrate the fact that he’s going to give us tax cuts with absolute certainty in the future even though he’s being coy enough to not say when.

It is this theory that suggests why he thinks that cutting public sector jobs will result in the creation of private sector jobs straight away because we will all be spending the anticipated savings now. And it is this theory that explains why his budget forecasts a considerable increase in private borrowing over the next few years – borrowing that he thinks we will all undertake in anticipation of his tax cuts that will follow which will allow us to repay the borrowing.

The concept of ‘crowding out’ only applies if the economy is operating at full potential.  The private sector already has resources ready to invest, but lack of confidence makes them unwilling to do so.

Of course with a double dip and gloomy forecasts extending beyond the next election consumers and firms are not spending and investing, they are keeping their wallets shut anticipating further tax rises to pay for the contraction caused by austerity.

A nu,ber of case studies have been used by Osbourne to justify expansionary fiscal austerity, Ireland in the 1980s, Sweden and Canada in the early 1990s.  In these cases cuts occurred at times of string economic growth internationally, were supported by falling interest rates and depreciating currency.  At a time of zero real interest rates and international recession is it difficult to see how this could be replicated.

As Paul Krugman says

 what’s happening in Britain now is that depressed estimates of long-run potential are being used to justify more austerity, which will depress the economy even further in the short run, leading to further depression of long-run potential, leading to …

It really is just like a medieval doctor bleeding his patient, observing that the patient is getting sicker, not better, and deciding that this calls for even more bleeding.

And the truly awful thing is that Cameron and Osborne are so deeply identified with the austerity doctrine that they can’t change course without effectively destroying themselves politically.

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About andrew lainton

International Urban Planner

Posted on December 4, 2011, in political economy. Bookmark the permalink. Leave a comment.

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