Paul Krugman’s Predictions about “Austerity” Aren’t Aging Well

Paul Krugman’s arguments do not fare well against evidence in a new book written by economists Alberto Alesina, Carlo Favero, and Francesco Giavazzi titled, “Austerity: When It Works and When It Doesn’t.”

In August 2008, economist Olivier J. Blanchard published a paper titled “The State of Macro.” In it, he wrote that

For a long while after the explosion of macroeconomics in the 1970s, the field looked like a battlefield. Over time however, largely because facts do not go away, a largely shared vision both of fluctuations and of methodology has emerged.

Does Federal Spending End Recessions?

According to The National Bureau of Economic Research (NBER), which published Blanchard’s paper, the US economy was, at that time, already nine months into a recession that would last another nine months, until June 2009. The same happened elsewhere as Britain and much of the eurozone also fell into deep and prolonged recessions. As economies shrank, budget deficits soared and government debt skyrocketed. And, when recovery came, it was the slowest on record.

Blanchard’s consensus shattered in the face of these events. Economists began shouting at each other in bitter terms. Some advocated for more government spending to boost aggregate demand, saying deficits and debt were problems for another day. Others argued that these explosions of red ink were a threat to the economy, not a cure.

Perhaps the most vocal proponent of the first view was Paul Krugman. In his 2012 book End This Depression Now!, he argued that “we don’t need to be suffering so much pain and destroying so many lives. Moreover, we could end this depression both more easily and more quickly than any imagines.” All we had to do, Krugman argued, was ramp up government spending. “A burst of federal spending is what ended the Great Depression,” he wrote, “and we desperately need something similar today.”

Krugman was scathing about the “Austerians,” those who argued that rapidly rising government debt posed a clear and present danger to the economy. Of the British government, which enacted “austerity” to get its deficit under control after the conservative takeover in 2010, he wrote:

The result is an economy that remains deeply depressed. As the National Institute for Economic and Social Research, a British think tank, pointed out in a startling calculation, there is a real sense in which Britain is doing worse in this slump than it did in the Great Depression: by the fourth year after the Depression began, British GDP had regained its previous peak, but this time around its still well below its level in early 2008.

And at the time of this writing, Britain seemed to be entering a new recession.

One could hardly have imagined a stronger demonstration that the Austerians had it wrong.

But economists on the other side of the battlefield kept working. A new book titled Austerity: When It Works and When It Doesn’t by economists Alberto Alesina, Carlo Favero, and Francesco Giavazzi both summarizes the subsequent research and makes new contributions of its own. Krugman’s argument does not fare well against this new evidence.

The Confidence Fairy

Krugman’s argument in favor of higher government spending to boost aggregate demand was based on the theory that fiscal multipliers were large. If a spending multiplier is greater than 1, an increase in government spending increases private expenditure so that total output rises by more than the increase in government spending. If a multiplier is smaller than 1, however, then increases in government spending are accompanied by decreases in private expenditure so that total output rises by less than the increase in government spending.

Krugman cited research on the impacts of military spending, particularly in wartime, to argue for large multipliers. The idea that spending cuts would signal that better times lay ahead was, Krugman claimed, like believing in “the confidence fairy.”

The authors of Austerity examine a much broader range of estimates and note that in “a synopsis of studies estimating multipliers for government purchases…Most of the values range between 0.6 and 1.5.”

In other words: not much GDP bang for the deficit buck.

The argument that austerity could be expansionary—that government spending cuts could be followed by increased GDP growth—was pilloried by Krugman. “[E]xpansionary austerity was highly implausible in general, and especially given the state of the world as it was in 2010 and remains two years later,” he wrote. The belief that spending cuts would signal to individuals and businesses that better, more fiscally prudent times lay ahead was, Krugman claimed, like believing in “the confidence fairy.”

Is Austerity Expansionary?

But as Austerity’s authors show, in some cases austerity was expansionary. And, in large part, it happened for exactly the reason Krugman denigrated. Where austerity is based on spending cuts rather than tax increases, “private investment rises within 2 years,” and by the third year is above the previous level. Contra Krugman, Alesina, Favero, and Giavazzi attribute this to increased business confidence.

So, if spending is less effective and deficits and debts more onerous than Krugman argued and austerity can, in some circumstances, be expansionary, should it be based on tax increases or spending cuts?

The authors of Austerity are clear on this point.

Tax-based plans lead to deep and prolonged recessions, lasting several years. Expenditure-based plans on average exhaust their very mild recessionary effect within two years after a plan is introduced…

The component of aggregate demand that mostly drives the heterogeneity between tax-based and expenditure-based austerity is private investment

That “confidence fairy,” in other words. Investment responds positively to spending cuts and wilts in the face of tax hikes.

Krugman’s Prediction Was Wrong

Britain, Krugman’s “demonstration that the Austerians had it wrong,” has, in fact, shown the opposite.

The Conservative government implemented a program of budget cuts. Over a 5-year period exogenous fixed measures amounted to almost three percent of GDP, two-thirds expenditure cuts, and one-third tax hikes. It was harshly criticized by the IMF, which predicted a major recession. The latter did not materialize and the IMF later publicly apologized. The UK grew at respectable rates.

Austerity is less reader-friendly than End This Depression Now! and is unlikely ever to have “New York Times Bestseller” emblazoned across its cover. This is a shame because it is a far more meticulous bit of work. It is, simply, the best and most in-depth book on this subject.

Over time, the main subject of economic debate shifts here and there. In the early 2000s, people worried about globalization. Then it was the crash and slow recovery. Now, the focus has moved on to income and wealth inequality. But the topics covered in Austerity will be back. They were, indeed, largely retreads of the debates between Keynes and Hayek in the 1930s and between Malthus and Say a century before that. And when the subject does return to austerity, we will be able to thank Alesina, Favero, and Giavazzi for such a thorough treatment.

Source: https://fee.org/articles/paul-krugman-s-predictions-about-austerity-aren-t-aging-well/