Experiments in Austerity

The big economic policy debate over the last couple of years has been the proper way to respond to the recession, and the budget issues that it has created in advanced economies.  On the one hand, the New Keynesians have argued that, if the country entered the crisis with a relatively low debt burden, could borrow at reasonable rates because of that, and could conduct its own monetary policy, the best way out of recession AND the best fix for its fiscal issues was to use fiscal policy to stimulate growth in the economy.  The other view, which isn't really built on any coherent model that I've seen, is that the government should seek to get its fiscal house in order in the middle of a depressed economy because... that would somehow boost "confidence" so much that the newfound confidence would overwhelm the contractionary effects of cutting demand in a downturn.  It's also worth noting that these same people make the intellectually incoherent argument that we can't afford to raise taxes in a recession... but we can afford to cut spending (really, if anything, we can afford to raise taxes but NOT cut spending, though it's also coherent to say that we can't afford either).

In our case, the US has been following a policy of muddling along.  The Fed was properly aggressive in cutting rates at the outset of the crisis, did another round of monetary expansion (QE2), and since then has been standing pat.  The government passed a small (relative to the size of the economy) dose of stimulus (the net effect wasn't stimulative at all, as much of it went to provide relief for cash-strapped states and a further chunk was tax cuts that weren't spent) and has done a bit of fiscal contraction (contrary to nonsense spouted by a lot of Tea Party people, the number of federal workers has actually SHRANK in the downturn), but nothing dramatic was done.

The best test of the austerity hypothesis came in the UK.  Their situation was quite similar to ours- relatively low debt, their own monetary policy, and low interest rates being demanded by investors to hold their debt.  But when the recession came and administered a shock to their public finances, the Conservative government under David Cameron was elected on a mandate to fix the budget picture.  The Tories have been way more sensible than the American GOP (which is completely nuts at this point).  They were consistent, in the sense that their deficit hawks were actual deficit hawks and not anti-government crusaders.  So they approached the issue by raising some revenue and cutting some spending.  If the New Keynesian view is correct, this would not only harm the economy, but also do nothing at all for the fiscal picture.  If the austerity view is correct, this would have restored "confidence" to the English economy and spurred growth.  So what happened?

Well, Berkeley economist Brad DeLong directs us to David Dayen's post, which reveals that, surprise, England's recovery has stalled.  Less than 1% annualized GDP growth since the year started.  Even worse than the US's performance, and our initial shock was way bigger than theirs.  This should put the silly view that budget consolidation in a downturn is a good idea.  Unfortunately, it won't.  Instead, we'll here a new reason why austerity is good, it will be proved wrong again, and the cycle will start over.