Austerity and Growth

Or, actually, shrinkage.

Watching Europe sink into recession – and Greece plunge into the abyss – I found myself wondering what it would take to convince the chattering classes that austerity in the face of an already depressed economy is a terrible idea.

After all, all it took was the predictable and predicted failure of an inadequate stimulus plan to convince our political elite that stimulus never works, and that we should pivot immediately to austerity, never mind three generations’ worth of economic research telling us that this was exactly the wrong thing to do. Why isn’t the overwhelming, and much more decisive, failure of austerity in Europe producing a similar reaction?

Let me give you a picture, inspired by some of the empirical studies of fiscal policy the Romers describe in their course notes (pdf). In the chart below I compare two measures for European countries. The x-axis shows the change in real government purchases of goods and services from the first quarter of 2008 to the most recent date I could get from Eurostat, measured as a percentage of 2008Q1 GDP. (This means, by the way, that I didn’t catch the full force of Greek austerity). The y-axis shows the percentage change in real GDP from 2008Q1 to 2011Q4. Can we say that there is a clear correlation here, and not in the direction austerity advocates would like to see?

OK, I’m aware of all internet traditions the problems here. To some extent we may be looking at reverse causation, with troubled economies forced into harsh austerity while those doing well (e.g., Poland) can keep expanding spending. Also, austerity programs generally involve sharp cuts in transfer payments and tax hikes as well as declines in real purchases, so you don’t want to interpret the slope of a line through the scatter – around 3 – as a measure of the multiplier.

But it is pretty striking, isn’t it? The truth is that we’ve just had a powerful test of the Keynesian proposition that when monetary policy isn’t available, changes in government spending move the economy in the same direction – and the results of that test say that what has lately passed for policy wisdom is instead almost criminal folly.

© 2012 New York Times

1. Does Austerity Promote Economic Growth?
2. A New European Growth Agenda
3. Will Austerity be ended in Davos?