Friday, June 19, 2015

The 2013 Austerity Debate

Scott Sumner went into the issue of the 2013 austerity debate some more, at Econlog.

Here is some of what, Russ Roberts, Simon Wren-Lewis, and Paul Krugman, have added.  Others have weighed in.

This whole episode began in early 2013, when Krugman said: Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens... Sorry, guys, but as a practical matter the Fed - while it should be doing more - can't make up for contractionary fiscal policy in the face of a depressed economy.
This was in response to the sharp fiscal consolidation that was legislated in late 2012.  Here is a letter, signed by 350 economists at the time, which included the following comments:
As Great Britain, Ireland, Spain and Greece have shown, inflicting austerity on a weak economy leads to deeper recession, rising unemployment and increasing misery....Public outlay for jobs and recovery come first, growth is restored, and revenues follow...We can also stimulate recovery without increasing deficits by increasing taxes on the wealthy and pumping the proceeds directly into the economy...At the end of the year, we face a congressionally-created "fiscal cliff," with automatic "sequestration" spending cuts everyone agrees should be stopped to prevent a double-dip recession.

Suffice it to say, after significant fiscal consolidation was indeed put in place, economic and employment growth in 2013 pushed ahead at about the same pace that they had been.  The market monetarists took a victory lap.  But, Krugman's response was:
Incidentally, these other factors are why I don’t take seriously the claims of market monetarists that the failure of growth to collapse in 2013 somehow showed that fiscal policy doesn’t matter. 
In Krugman's latest post on the matter, he says:
And while it’s true that there was limited direct evidence on the effects of fiscal policy 6 or 7 years ago, there’s now a lot, and it’s very supportive of a Keynesian view.
Here is a close-up graph of the periods, using Quarter-over-Quarter GDP growth (annualized).  Below is a picture of long term GDP growth (real and nominal, Year-over-Year) and the Federal budget deficit.  One can easily see how worrisome the 2013 budget would be to anyone who believed that it would have a strong effect on growth.  Many of the changes in the fiscal budget in the past have been the product of shocks in GDP.  It looks to me like this is an unprecedented incidence of a sharp contraction in the Federal budget during a period of stable GDP growth.  And the contraction was, indeed, very sharp.


The quarter-over-quarter numbers are a bit noisy, so there has been some argument over start and end times, but, basically nominal GDP growth had been between 3 1/2% and 4 1/2% since 2010 and has continued at that pace during and since the sharp consolidation period.  Krugman implies that there was some exogenous factor that would have made growth in 2013 more like 5% to 6 1/2% in 2013, which I guess implies a multiplier of about 0.4, since the consolidation was about 3.5% over 2 quarters.  Actually, annualized GDP growth was around 5-6% in 2013 3Q and 4Q, but as I said, the quarterly numbers are noisy.

Wren-Lewis produces this chart, where the "no austerity" counterfactual is based on 2% growth in federal expenditures, and he assumes a multiplier of 2, which produces a hypothetical growth rate similar to the pre-recession level.  Presumably, this means that Wren-Lewis thinks that NGDP growth would have jumped to 11% in 2013, if not for the sharp fiscal consolidation.  (edit: Wren-Lewis has a new post up, calling Sumner a liar.  It looks like Wren-Lewis is using a multiplier of 2 for government consumption and investment, and a 0 for taxes and transfers.  That's why his counterfactual looks so straight through 2013.  So, by this model, there was nothing special about 2013, since most of the consolidation was from transfers and taxes.  So, I guess Wren-Lewis' position is that "austerity" in 2013 was not really any different than the previous couple of years.  This would seem to be a third position, different from both Sumner and Krugman, since by this measure, there wouldn't be anything particularly definitive about 2013.  So, Wren-Lewis would apparently object to some taxes on fairness grounds, but not on cyclical grounds.)

Much of the consolidation was from tax increases.  So, maybe those who think the test failed don't think that tax increases are as damaging as spending cuts.  But, then, why were they so worried to begin with?

But, keep in mind, on the argument of federal expansion vs. contraction, this suggests that both spending and tax changes are subject to monetary offset.

If we look at inflation over the post-recession period, it seems to corroborate the monetary offset point of view.  During QE1 and QE2, treasury rates rose as QE was implemented, mostly due to higher expected inflation.  Then, with some lag, consumer inflation would also rise.  Then, as each QE was phased out, inflation, expected inflation, and treasury rates would subside.

I was taking a short bond position when QE3 was implemented.  But, I didn't fully account for the effect of austerity.  Here we can see how fiscal consolidation might explain the difference between QE3 and the earlier QEs.  Inflation expectations rose during QE3, pretty much as they had with QE1 and QE2, but actual inflation was flat, and treasury rates remained flat until 2013 Q3, when treasury rates suddenly rose.  That just happens to be when consolidation stopped and the federal deficit settled in at the new, lower level.  The missing inflation during QE3 is right about 1.5-2% compared to QE2, which is about how much of a fiscal drag Krugman seems to have been expecting.

Even if there was monetary offset here, a question might be whether the Fed would have done QE3 anyway.  So, maybe we are seeing monetary offset, but if the fiscal consolidation hadn't taken place, we would have been looking at 5-6% NGDP growth in 2013 and 2.5% rates on 5 year treasuries.  Maybe we would be off the zero lower bound by now, if that had been the case.  Sumner points out that the Fed is tightening now, even in the face of recently declining inflation and GDP growth, so it seems unlikely that they would have continued with a strong QE3 policy if NGDP had risen above 5%.  Home prices were appreciating by 5% to 10% annually during QE3.  If fiscal accommodation would have pushed that up higher and if consumer price inflation had been higher, it seems likely that they would have pulled back on monetary accommodation sooner.

Could the outcome here have been any more in line with market monetarist expectations?  And, looking at the first large graph above, is there any justification for saying that holding the fiscal deficit at nearly 10% for 5 full years as an economic stimulus has undeniable empirical support?

Here are two posts by Mark Sadowski on the issue, and some more of his analysis, via Scott Sumner.  A while back, I looked at some IMF data that suggested the main issue regarding the fiscal balance was having a positive budget level before the recession with a follow up showing the difference between Euro countries and the rest of the developed world..


  1. "Much of the consolidation was from tax increases. So, maybe those who think the test failed don't think that tax increases are as damaging as spending cuts."
    Curious to know what the rationalization is for Wren-Lewis et al. arguing that tax increases/transfer payment cuts don't count as 'real' austerity. Since transfers go overwhelmingly to the lower classes, who have a high marginal propensity to consume, almost all of what is spend in transfer payments probable ends up being spent on consumption, so shouldn't it be about as 'stimulatory' as gov spending (if one buys into the theory of course)?

    And to argue that tax increases aren't really that fiscally contractionary is basically to argue that the people whose taxes are going up would have otherwise saved almost all of their money, and spent very little of it. I guess I don't see why tax cuts and transfer payments would be much less of a stimulus than government spending, or that the opposite (tax increases and cuts in transfers) would be much less a form of fiscal austerity than cutting government spending. Especially in the US where the savings rate is pretty low.

    1. Yes. It's all very convenient. And the more I've thought about W-Ls model (multiplier of 2 for spending and 0 for taxes and transfers), the more it looks like an economics version of a perpetual motion machine. With balanced budgets, G approaches a limit of 50% of GDP. You want a bigger GDP? Increase G.

      And with no efficiency issues to discuss on taxes and transfers, the argument about redistribution can be purely based on normative and fairness grounds. How lovely.

      In that world, only immoral goons would object to fiscal stimulus. Makes you wonder if we are immorality goons for even doubting the model, doesn't it?

    2. My favorite hypothetical on the matter illustrating why I distrust most estimates of the G multiplier: government pays one guy $100 to dig a ditch, pays a second guy $100 to fill it with dirt again. G (and therefore GDP) has increased by $200. But of course no value was actually created and the two diggers' labor was wasted. So even if the multiplier were 2, since 100% of the original expenditure was just waste, that would still mean that it was only just 'worth it' to do the dig and fill project. If the multiplier is less, then we have spend $200 to produce ultimately <$200 worth of goods and services. It seems to me that the multiplier, to accurately reflect things, should have to take into account the proportion of the money spent that is effectively wasted (we can reasonably assume I think that when the gov spends $100, they generally get less than $100 worth of goods and services for it, just due to inherent inefficiency).

      By that reasoning, transfer payments or ta cuts actually would have an advantage over government spending, since at least they money money just given to people would be spent in a way that maximizes the utility it generates for the people spending it. I guess in the extreme scenario of the ditch digger and ditch filler,if the gov just gave them each $100, they would go and spend it, causing 'stimulus' but then they might also use at least some of the otherwise wasted labor time (digging and filling ditches) to do actual productive labor, in which case the economy would in reality benefit more from just giving them the money. So depending on what proportion of government spending you think is waste, it does not seem to me that it necessarily has an advantage over tax cuts or transfers. Or so it seems to me at least.

      Of course, all of us here are clearly immoral goons ;)