Thursday, November 27, 2014

The Flawed Origins of Expansionary Austerity

CAMBRIDGE – Several of my Harvard University colleagues have recently been casualties in the crossfire between fiscal “austerians” and fiscal stimulators. The economists Carmen Reinhart and Kenneth Rogoff have received an astounding amount of press attention since it was discovered that they made a spreadsheet error in a 2010 paper that examined the statistical relationship between debt and growth. They quickly conceded their error.

Soon after, the historian Niall Ferguson – also at Harvard – received much flack when, asked to comment on Keynes’ famous phrase, “In the long run we are all dead,” he “suggested that Keynes was perhaps indifferent to the long run because he had no children, and that he had no children because he was gay.” Ferguson, too, quickly apologized.

But Reinhart and Rogoff’s estimates in 2010 had already been superseded by a 2012 paper that they wrote with Vincent Reinhart, which used a more extensive data set that did not contain the error. And “some of Ferguson’s best friends” are gay, while Keynes actually tried to have children.

Clearly, as the austerians’ barricades have weakened under the continuing onslaught of facts (most notably the recessions in Europe, and now Japan’s conversion to expansion), the stimulators have found the missteps of Reinhart/Rogoff and Ferguson to be convenient weapons. But they are the wrong weapons.

Neither controversy bears on the Keynesian claim that under conditions of high unemployment, low inflation, and low interest rates (which hold in rich countries today, as in the 1930’s), fiscal expansion is expansionary and fiscal contraction is contractionary. The Reinhart/Rogoff papers’ basic finding continues to hold up: growth tends to be lower on average among countries with debt/GDP ratios above 90%. But that finding, like the policy advice that they offered in the aftermath of the 2008 financial crisis, was not intended to support the proposition that a recession is a good time to undertake fiscal contraction.

The Ferguson controversy is even less relevant, because Keynes’s phrase concerning the long run was not about fiscal policy when he wrote it, and it was not an argument against deferred gratification. Nor was Keynes in favor of uninhibited fiscal stimulus, regardless of economic conditions; rather, he argued that “the boom, not the slump, is the right time for austerity at the Treasury.”

But research by yet another Harvard colleague, Alberto Alesina, does bear much more directly on the proposition that austerity is appropriate under today’s conditions. Alesina’s influential papers with Roberto Perotti in 1995 and 1997, and with Silvia Ardagna in 1998 and 2010 suggested that fiscal contraction is not contractionary, and that it may even be expansionary.

It is true that sometimes a country may have no alternative to fiscal “consolidation,” if its creditors insist on it, as has been the case with Greece and some other eurozone members. But that does not mean austerity is expansionary, especially if the currency cannot depreciate to stimulate exports.

As with Reinhart and Rogoff, the Alesina papers themselves are much more measured in their conclusions than one would think from the claims of some conservative politicians that such academic research finds fiscal austerity to be expansionary in general. Nonetheless, the conclusions seem to leave little room for doubt: “Even major successful adjustments do not seem to have recessionary consequences, on average,” while “several fiscal adjustments have been associated with expansions even in the short run.” Moreover, “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns.” Most recently, a May 2013 paper with Carlo Favero and Francesco Giavazzi reports that “spending-based adjustments have been associated, on average, with mild and short-lived recessions, in many cases with no recession.”

Alesina’s recent policy advice is that the US should cut spending right away. By contrast, the advice of Reinhart and Rogoff leans more toward financial repression, postponement of fiscal adjustment (trim entitlements in the future, but increase infrastructure spending today), or, in more far-gone cases like Greece, debt restructuring.

A new attack on Alesina’s econometric findings comes from an unlikely source. Perotti, his co-author on two articles, has now recanted, owing to methodological problems (which also affect Alesina’s later papers with Ardagna). Under the dating scheme that they used, the same year can count as a consolidation year, a pre-consolidation year, and a post-consolidation year, and it turns out that some of what they treated as large spending-based consolidations were, in fact, never implemented. Currency devaluation, reduced labor costs, and export stimulus played an important part in any instances of growth (for example, the touted stabilizations of Denmark and Ireland in the 1980’s).

Perotti concludes that “the notion of ‘expansionary fiscal austerity’ in the short run is probably an illusion: a trade-off does seem to exist between fiscal austerity and short-run growth.” As a result, “the fiscal consolidations implemented by several European countries could well aggravate the recession.”

This is a more powerful indictment of the reasoning behind recent attempts to justify spending cuts during a recession than is a spreadsheet error or a flippant remark about Keynes’s sexuality. Neither misstep supported the case for austerity, and reality has been far more damaging to it.

Read an extended version of this argument in Jeffrey Frankel’s blog post, “On Whose Research is the Case for Austerity Mistakenly Based?”

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    1. CommentedClaudio Migliore

      All this bickering between partyers and party poopers, alive and well so long after Keynes passing, amazes me considering the characters a) are all grownups, b) have played with the same micro and macro paraphernalia while at school and c) know each other personally and should expect no one can have the silver bullet or the last word.
      Discussing about the merits or demerits or debt is just a proxy for the discussion on spending, i.e. partyers vs. party poopers.
      The real issue is, in my view, not so much one of aggregate demand as one of resource allocation. On the surface, the expansionaries might seem to be the wastrels and the austerity-minded the thrifty, but in reality a tax reduction could be just as as wasteful as a subsidized bridge to nowhere. Actually, the austere probably want to save their favourite bridges by choking everyone else’s, while the expansionaries prefer to do it by carpet bombing money around.
      When the discourse is able to shift to what spending (wasteful) should be cut, the world will make a huge step forward. There is probably reason to believe that private sector allocation is more efficient, and hence an argument for smaller government, but public spending allocation is where the action is.
      Italy and company probably need a smaller government, but more than that, they need less paid loafers, less padded government contracts and a market flexibility that moves factors to sectors that are more productive. That will neither be achieved by spending less nor by spending more.
      Studying debt with all the econometric tools is certainly worthwhile, but the economic profession is doing a disservice if it allows clouding of the policy discourse with white noise.

    2. CommentedKathy Holland

      Keynesian economics would have been based on a few fundamental assumptions that have either been moved or removed. John Maynard has been dead for over 67 years. Did he not have a prodigy to follow/adapt his work to minimize the flaws to desired outcomes?

    3. CommentedJoshua Ioji Konov

      the Frank O'Callaghan statement that the austerity's only accomplishment was the accelerated concentration of wealth "succeeding" an over all disaster is the right conclusion: new approaches in economics should be use such that would build up a working market economy not just based on industrialization or even high produsctivity... sorry of being erethic

    4. CommentedROBERT BAESEMANN

      R-R have been eviscerated because of several important flaws in their work ranging from the heterogeneity of their data to their failure to understand the difference between structural equations and reduced forms. Their Brookings paper was superseded by the AER paper in 2010. The AER paper was superseded by another revision in 2012 which is referred to here. Nevertheless, the fundamental flaws remain.

        Portrait of Jeffrey Frankel

        CommentedJeffrey Frankel

        To Robert Basemann:
        I actually am pretty sure that Reinhart and Rogoff understand the difference between structural equations and reduced forms. I guess what you really mean is that you consider the endogeneity of the debt/GDP ratio to be a "fundamental flaw." I don't think anyone disagrees that slow growth raises the debt/GDP ratio; the recent experience of euro periphery countries is a good example. But do you really think there is no causality running also from high debt to subsequent on-average slow growth over a period of time.
        I do agree with your response to Pingfan Hong that governments often do undertake fiscal consolidation during booms, even if not as often as they should. Fiscal policy among advanced countries has in the past been countercyclical on average, even if less so since 2000.
        A good example is the policies enacted by the Clinton Administration, especially in 1993, which turned budget deficits into budget surpluses.
        It was unfortunate that the Bush Administration did the opposite ten years later. The large debt that resulted made Congress reluctant to respond to high unemployment with fiscal stimulus. This is one example of how high debt can lead to slower subsequent growth. Europe has gone through that same cycle.

    5. Portrait of Pingfan Hong

      CommentedPingfan Hong

      "the boom, not the slump, is the right time for austerity at the Treasury.” Long live Keynes! How many governments take austerity measures during a boom?

    6. CommentedMatt Stillerman

      In a Project Syndicate piece published on May 21, Robert Skidelsky had this to say about Reinhart and Rogoff's paper:

      An even more spectacular example of a statistical error and sleight of hand is the widely cited claim of Harvard economists Carmen Reinhart and Kenneth Rogoff that countries’ growth slows sharply if their debt/GDP ratio exceeds 90%. This finding reflected the massive overweighting of one country in their sample, and there was the same confusion between correlation and causation seen in Alesina’s work: high debt levels may cause a lack of growth, or a lack of growth may cause high debt levels.

      So, the principal error was not a minor spreadsheet bug, but methodological problems. And, by the way, the claim that excessive debt causes reduced economic output is repeated in their 2012 paper, and is highlighted in the abstract of that paper.

    7. CommentedSid Knight

      To the extent that your proposed exculpation of R-R and Ferguson succeeds at all, it does so by showing that academic debates are so vicious because the stakes are so low.

      Your take-down of A-A demonstrably indicates that the stakes were higher than your exculpation admits.

    8. CommentedProcyon Mukherjee

      Let me take an analogy from the micro area, how do firms react in the crest and trough of business cycles?

      I have found quite a distinct and consistent strategic intent in Mitsubishi Corporation nurtured and carefully crafted over long decades where the crest of the business cycles have been used for consolidation while the troughs have added fodder to acquire assets at relatively cheap prices; the animal spirits if only they could be tamed to get the maximum when businesses are down (weak quarry) while making them grow when the times are better has been missed out by most enterprises. No wonder Mitsubishi continues to be active in the current times (acquisition of Pratt & Whitney, Port Bonython Fuels, KH Automation, etc), while it was relatively quiet in the period 2004-2007, when it was priming its reserves for the times to follow.

      In the Macro area we find just the opposite, when economies do well, animal spirits lead us to believe that we need not sequester part of the gains for any eventual downturn and the risk taking further increases the possibility of such events, when we have very little real 'savings' to bank upon.

    9. CommentedZsolt Hermann

      When a child breaks an expensive vase at home, he tries to explain that it was not him breaking it, but the wind, the dog, the cat or the long deceased grandmother.. the more poor child tries to escape his guilt, the more complicated and more dreamlike the stories get.
      In other words when we try to stubbornly explain, justify something unnatural, at the end we so overcomplicate and cloud things that even those explaining do not understand anything any longer.
      The basic situation is simple: there is no further quantitative growth possible in today's global, integral, interdependent human network within a closed and finite natural system.
      The human resources are already exhausted (unemployment, social inequality, unsolvable debt burden, depression, drug and alcohol abuse, emptiness, loss of future prospects...) and the natural resources are not far behind.
      We need to leave behind the present framework, methodology, tools and thinking and build new ones based on our new conditions, more adapted to natural necessity and available resources instead of the excessive, artificial overconsumption model.

    10. CommentedStamatis Kavvadias

      Oh dear.... Prof. Frankel, when something is not simple, it simply means you do not understand it well!

      These are not arguments, and they cannot hold in the political discussion of eurozone situation. These are for economist brainstorming, till they understand better the problem!

      The eurozone problem is that the lenders force a trajectory, where borrowers only have the choice of becoming export economies, when the distribution of wealth in eurozone weighs to the side of the lenders. This means that the borrowers have to reduce social state to or close to zero, in order to follow the lender doctrine! This is the effect of fiscal austerity via spending cuts! And because this is not enough (or fast enough), southern countries have to *also* increase taxes, at least till they get to primary surplus.

      The plan of "economists" and lenders is to first bailout the rich and the private sector, by reducing taxes once governments achieve primary surplus. The reason is, of course, this is what *markets* want to lower interest rates. This is all literally *backwards* for the interests of southern eurozone societies, and will have long lasting effects.

      So, the only reasonable argument is why should they stay in euro, since the choices are always biased to the interests of the richer countries? Default is far better. Austerity with a large debt burden is only for the rich. A policy reversal is needed, or taxes and default should be their answer.

      The answers are monetary (have to do with money --or credit-- allocation). There is conspicuous lack of a eurozone-wide fiscal authority. If banks is the only thing eurozone countries can find in common, let them set up a eurozone public bank, with european institutions and nationalized profits (and fix the transmission mechanism, as well!). The initial creation of all money in the private sector and the allocation by the private sector (i.e., in and by banks), is killing western sovereigns one after the other. If Germany is too "narrow minded" (read well-off) to accept it, insistence in failed institutions should be answered by exits from the currency and defaults. Europe's south should not buy it anymore! Common currency is not only for the rich countries, especially in the worst circumstances.

        CommentedStamatis Kavvadias

        By the way, if politicians in the US pretend to follow these "arguments" it is only because they are in the interests of those they serve or their ideological preconditions; not because these are strong arguments.

    11. CommentedFrank O'Callaghan

      Austerity has failed to do what it was supposed to do; tame debt and end the crisis in the economy. It has succeeded in doing what it was expected to do; move more wealth to a tiny minority of the already hyper-rich.

      Keynes was correct in the context of a closed economy. Open and small economies tend to export much of the stimulus.

      Austerity is implemented in ways that add to the problem. In Ireland there are efforts to increase productivity in the public service. Late and desperately needed it is the wrong policy for the time. A better approach would be to cut hours and increase numbers. The previous French suggestion of shortening the working week is ultimately the best option for cutting unemployment.

      A core systemic cause of the crisis is widening inequality. The gulf between the rich micro-minority and the rest can only be addressed by huge redistribution. There has already been redistribution over the past thirty years but in the wrong direction. Without redistribution the question will degenerate to one of the continued existence of the micro-minority. The question will be asked; can the world afford to lavish so much wealth on so few? Austerity will press the great majority into answering no. The "New Deal" averted this in the US.

      A recession is the only place for expansionary policy. A global and co-ordinated action is called for. There is need for recycling of the resources held in the oil monarchies, financial markets, corporations, derivative and bond markets, sovereign wealth, and other concentrations of wealth. Work, wealth, leisure, responsibility and power must be better distributed.

      When the boom returns to the whole population rather than to a minority it will then be time for a contraction in the policy. At the moment expansion is bestowed on the rich and stoked by low taxation on extreme wealth.

      As for Ferguson, Reinhart and Rogoff? Perhaps Galbraith was prescient; "If all else fails, immortality can always be assured by spectacular error".

        CommentedStamatis Kavvadias

        Perhaps Galbraith was prescient; "If all else fails, immortality can always be assured by spectacular error".

        I agree 100% with Galbraith! (do not know about Ferguson, Reinhart and Rogoff though).