Austerity: When It Works and When It Doesn't

"This book takes a very different perspective than Krugman’s book. It’s a more recent book by three Italian economists, one of whom, Alberto Alesina, recently died. The other two are professors at Bocconi University. Importantly, also, these are people that are or have been extremely influential in the political debate. Alesina and Giavazzi have frequently contributed to the policy debate in Italy’s main newspaper, Corriere della Sera . Francesco Giavazzi was an important adviser to the former prime minister, Mario Draghi, so this is a person who had a lot of influence on the conduct of fiscal policy. Their argument is very different from Krugman’s. They argue that austerity—which is the deliberate conduct of fiscal policy to reduce the government deficit—is by no means the cause of economic recessions. They argue that the picture is much richer than that, and that, on the contrary, there are some instances where reduction in the government deficit may increase growth of the economy. What this book does is present a statistical analysis by the authors, which leads to their conclusion that episodes of austerity may lead to very different economic outcomes. The key variable on which these outcomes depend is whether austerity is conducted on the revenue side of the government budget or on the expenditure side. Their argument is that you can reduce the deficit in many ways, but if you do so by increasing taxes, this tends to make recessions worse. On the other hand, if you conduct austerity by reducing government expenditure, in line with what the UK has done, this is much less costly and can lead to improvements. This is the argument that they make. This is the core of the book. “The human cost of a recession is very high” In addition, they present the data that they have collected and put together to address these questions and put it in the context of the macroeconomic theory behind the possible effects of austerity. They present the theory of the Keynesian side—such as the one underlying Krugman’s arguments—alongside the opposing theory, which emphasises the effects of changes of fiscal policy on the supply side of the economy (the supply side is how much households are willing to work and how many goods firms are willing to produce, rather than how much consumers and governments consume and spend). This is the argument that they make and the framework that they present. People have very different views and these are the two sides of the debate. The reason why these views have not been settled is that from a statistical perspective, or, more precisely, an econometric perspective, it’s very hard to pin down the effects of these policies, because of a well-known problem in economics—the technical term is endogeneity—which is that we do not have access to a lab. If you’re trying to determine whether giving more food to mice makes them bigger, it’s relatively easy to do so in a lab. You take a hundred mice. You select these mice randomly. To fifty you give one type of food; to fifty you give another type of food. One month later, you weigh them, and you check which one is bigger. With economies, you cannot really do that, thankfully. It’s not the case that you can take 100 countries, implement a policy in 50 of these countries, and implement another policy in the other 50 countries, and check later on. Typically, fiscal policy and austerity take place in a given context. Governments decide, ‘The economic situation is such that now we think we should do austerity.’ It’s very hard to distinguish the consequence and the cause. All sorts of statistical methods and creative ways of dealing with the data have been developed by economists to try and answer this question. It’s very important but it’s very difficult to answer. That is a contribution of this textbook. These are renowned economists who have studied these questions. They propose their empirical method and present results that suggest austerity is not contractionary; it depends a lot on how austerity is conducted. They also make the point that there are instances where austerity leads to an expansion of the economy instead of a contraction as Krugman would argue. That’s a very important point. In the textbook, their main object of analysis is aggregate output. The question they address—’What are the implications of aggregate output?’—is already a difficult question. It’s clear that the distributional implications of these types of policies may be very diverse. I think that was seen in the UK, where inequality is high and has been trending upwards. Many people have argued that austerity policies and changes in welfare policies have contributed to that. Their main focus is on the behaviour of aggregate variables. That’s not because they don’t think that distributional issues are relevant, it’s just that it is so hard to pin down the effects on aggregate growth that maybe it’s worth focusing on that one first and then moving on to address the other question. It’s not because it’s not important, but because it’s even harder to address. In addition, you could argue that you shouldn’t use debt and deficit to solve the issue of inequality, but address it instead with reforms and policies that do not lead to greater government spending than fiscal revenues."