Expansionary fiscal contraction and the emperor’s clothes

George Osborne's policy of "expansionary fiscal contraction" is based on an economic myth. Britain's current economic circumstances mean it won't work.

George Irvin is a retired professor of economics and is currently (honorary) Professorial Research Fellow in Development Studies at the University of London, SOAS; he is author of “Super Rich: the rise of inequality in Britain and the US”

Various eminent economists – amongst them, Paul Krugman, Joseph Stiglitz and Robert Skidelsky – have attacked ‘deficit hysteria’ as based on weak economic evidence and poor theory. In other words, ‘economically illiterate’. The right-wing of the profession – not just in Britain but in Frankfurt and Washington – has struck back, digging hard into the literature to support their case. The result is the popularisation in Britain of the phrase ‘expansionary fiscal contraction’ – meaning that closing the budget deficit (fiscal contraction) is expansionary. That is to say, the high road to private sector-led growth. Personally, I find the phrase an oxymoron – but let’s examine the evidence.

Advocates of expansionary fiscal contraction (aka, deficit hawks) argue that cutting the public deficit – either by raising taxes or cutting spending or some mix of the two – will free the necessary private sector resources for growth. The shift to private sector led expansion comes about through a combination of lower interest rates boosting private investment, lower public borrowing boosting consumer confidence and, in response to lower interest rates, a lower exchange rate which boosts net exports.

Strong proponents of this position include Harvard’s Alberto Alesina, who has published numerous papers arguing that fiscal contraction can be expansionary even in the short run, and Broadbent and Daly who have recently produced a comprehensive survey paper for Global Economics at Goldman Sachs.

The IMF has reviewed the work by Alesina and comes to the opposite conclusion, namely (in keeping with Keynes) that fiscal contraction makes things worse. First, some of the outcomes examined by Alesina involve fiscal shrinkage in a downturn which is ‘built in’ – i.e. not a matter of deliberate policy. The IMF study looks only at policy driven cases, and finds only two cases (Denmark in 1983 and Ireland in 1987) which support the Alesina thesis.

The IMF concludes:

“Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point. Domestic demand—consumption and investment—falls by about 1 percent.”

The more recent paper for Goldman Sachs covers a wider sample. Its authors examine 44 cases of fiscal adjustment in OECD countries over 35 years. Their central argument is that in the 11 cases out of 44 that involved mainly spending cuts, expansion resulted because sharply lower interest rates meant bond yields fell, in turn causing equity prices to rise. The implication is that an asset price rally (stock market, house prices, etc) resulting from lower interest rates restores consumer confidence, boosts investment, and leads to growth. This is the economic logic behind Osborne’s spending cuts and those of other ‘deficit hawk’ governments. More generally, it is the logic behind loosening monetary policy to boost growth while imposing a fiscal contraction.

Having identified the mechanism – economists will recognise it as ‘Ricardian equivalence’ in another guise – one needs to ask hard questions about whether such a mechanism will work under current circumstances in Britain. One objection to the Goldman Sachs view (GS) is pointed out in the excellent piece by Dean Baker cited above. Namely, that in most of the 11 cases, the countries were operating close to potential output (i.e. close to ‘non-inflationary full employment’, or what some economists like to call NAIRU). In Baker’s words:

“In only 6 of the 29 fiscal adjustments that were tax driven was the gap between potential and actual GDP even as large as one percentage point. In only two instances, Netherlands (1983) and Norway (2004-06), were the gaps more than two percentage points of GDP …

“The story is a bit different with the expenditure-driven adjustments. In five of the ten adjustments for which there is data, the output gap was more than one percentage point of GDP at the beginning of the adjustment. In [only] four of these five cases the gap was more than two percentage points of GDP .. Finland (1996-2000), [The] Netherlands (1996), Norway (1994-95), and Sweden (1994-98).”

The first problem, therefore, is that in Britain the output gap is high. A recent Treasury estimate is 5-6%, while Martin Wolf suggests a 4-5% output gap estimated for 2009 by the Office of Budgetary Responsibility was “weird“. But even 5% is a good deal higher than the output gaps existing at the beginning of fiscal adjustments considered by Goldman Sachs. To put it in laymen’s terms, the UK economy is operating at lower capacity than any of the ‘successful’ adjustment cases cited by the Goldman Sachs study.

Another problem with the GS study is that, in contrast to the historical cases cited, the UK has little room for manoeuvre with monetary policy. The fiscal adjustments in Finland, the Netherlands, Norway and Sweden cited above all took place in the mid to late 1990s when world growth was buoyant and interest rates could be lowered. Reviewing the Finnish experience, for example, a Bank of International Settlements policy paper says:

“The decline in the interest rate level has been associated with a rise in asset prices. At the beginning of the recession, asset prices – in particular housing and other real estate prices – fell to an exceptionally low level. The rise in asset prices has strengthened private consumption and fostered a pick-up in construction investment.”

Much the same was true of the Netherlands in 1996 where a dramatic increase in house prices was fuelled by lower long term interest rates which had stood at 8% when adjustment was initiated. In Norway in 1994, fiscal adjustment essentially took place when the economy was growing, fiscal receipts from oil had increased and non-oil exports experienced a boom. In Sweden after 1992, a 5.5% cut in interest rate by the Rijksbanken over four years led to a significant fall in the real exchange rate and led to export-led growth.

By contrast, the Bank of England has kept its reference short-term interest rate at nearly zero (0.5%) for 20 months, while pushing down the long-term interest rate using Quantitative Easing (QE). More QE may be on the cards, but it is likely to boost share prices rather than spur the real economy. In contrast to (say) Finland, nobody would claim that house price levels before the recession in the UK were at exceptionally low levels. In contrast to Norway and Sweden, after a 26% fall since early 2007 in the UK’s trade-weighted real exchange rate, an export boom has yet to happen.

However, recall that the Goldman Sachs case rests on the assumption that falling interest rates will also boost the stock market, in turn boosting confidence and reigniting consumer spending. Largely because of early QE, the FTSE-100 has been buoyant for some time, rising by around 27% in 2009/10. But with UK unemployment standing at 7.7% (ILO definition) and rising as the ConDem budget cuts bite, it is most unlikely that consumer confidence will be restored. Indeed, for 2010 to date, the trend in the NOP consumer confidence index has been downward despite a recent uptick.

Given that the UK economy is already operating well below capacity, that the spending cuts of ConDem government will withdraw about 8% of GDP from aggregate demand over four years, that interest rates at the outset of this fiscal adjustment are already very low, that sterling has already fallen with no appreciable impact on net exports and that consumer confidence is falling while unemployment is rising, it is very difficult to see how massive fiscal contraction can be expansionary in Britain today.

In truth, the academic counter offensive launched by the deficit hawks has gained no credible ground in the case of Britain. In line with the Keynesian economists cited at the outset, it is difficult to avoid the conclusion that Emperor Osborne has no clothes.

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34 Responses to “Expansionary fiscal contraction and the emperor’s clothes”

  1. False Economy

    RT @leftfootfwd George Osborne's policy of "expansionary fiscal contraction" is based on a myth http://bit.ly/a8syH4

  2. Other TaxPayers Alli

    RT @leftfootfwd George Osborne's policy of "expansionary fiscal contraction" is based on a myth http://bit.ly/a8syH4 (via @FalseEcon)

  3. merthyr_bill

    university of london? never heard of it.

  4. cutsandgrazes dotcom

    RT @leftfootfwd George Osborne's policy of "expansionary fiscal contraction" is based on an economic myth http://bit.ly/a8syH4

  5. Liz K

    RT @FalseEcon: RT @leftfootfwd George Osborne's policy of "expansionary fiscal contraction" is based on a myth http://bit.ly/a8syH4

  6. Michael Burke

    This is a very valuable piece.

    EFC is the argument adopted by supporters of the Dublin government’s policies, which have led to the brink of disaster. Crucially, all the examples ignore the stimulative effect of monetary policy easing, both interest and exchange rates. Thus EFC is impossible when interest rates are already close to zero and/or everyone else has adopted the same contractionary policy- as happened in the 1930s.

    Despite this, EFC is what all proponents of cuts are relying on, at whatever pace or severity of those cus.

  7. Sir Marky

    RT @OtherTPA: RT @leftfootfwd George Osborne's policy of "expansionary fiscal contraction" is based on a myth http://bit.ly/a8syH4 (via …

  8. merthyr_bill

    Dublin was brought to the brink by the previous government, not by the government trying to become solvent again. What’s the alternative as they can’t devalue? Spend spend spend until they’re bailed out by the Germans?

  9. Wendy Maddox

    Hint, Osbourne is the emperor: RT @leftfootfwd: Expansionary fiscal contraction and the emperor’s clothes http://bit.ly/alj0AS

  10. John Ruddy

    RT @leftfootfwd: Expansionary fiscal contraction and the emperor’s clothes http://bit.ly/alj0AS

  11. Chris

    “university of london? never heard of it.”

    Fool, have you been living under a rock? You said in a previous thread you’d been to university and you haven’t heard of UL!!! Get back under you rock, you pathetic troll.

    “Dublin was brought to the brink by the previous government, not by the government trying to become solvent again.”

    What previous government? Fianna Fáil have been in power since 97.

    “What’s the alternative as they can’t devalue? Spend spend spend until they’re bailed out by the Germans?”

    They shouldn’t have bailed out Anglo-Irish, let the bankers, property speculators and bond dealers take some pain.

  12. Simon Booth-Lucking

    RT @OtherTPA: RT @leftfootfwd George Osborne's policy of "expansionary fiscal contraction" is based on a myth http://bit.ly/a8syH4 (via …

  13. dan phillips

    An economist declares Osborne has no clothes on @leftfootfwd: http://bit.ly/alj0AS < stick with it, it's a v.good piece

  14. william

    Compound interest on a rising mountain of the previous UK government’s debt,an already depreciated currency,and the impossibility of finding more buyers for UK gilts at the prevailing yields in May,2010 forced the government’s hand,not economic or political theory. The idea that an omniscient central government,not Adam Smith’s invisible hand, can magic up output to fill the output gap,is risible.There is a price to pay for Brown’s disastrous economic policies, namely the4-5 year wait for private sector exports, investment and consumption growth to fill the output gap.Welcome to the real world.Never again elect a Labour leader who wrecks banking supervision, and behaves like a spoilt child with respect to government borrowing to finance transfer payments, which were renamed’investment’.

  15. Jan Bennett

    RT @leftfootfwd: Expansionary fiscal contraction and the emperor’s clothes http://bit.ly/alj0AS

  16. George Irvin

    ‘Compound interest on a rising mountain of the previous UK government’s debt,an already depreciated currency,and the impossibility of finding more buyers for UK gilts at the prevailing yields in May,2010 forced the government’s hand,not economic or political theory. The idea that an omniscient central government,not Adam Smith’s invisible hand, can magic up output to fill the output gap,is risible.’

    I’m afraid it’s your ignorance of economics that’s risible!

  17. william

    Excuse me,Mr. Irvin, but where are your arguments?I am 10 years younger than you,Cantab first in economics,top of class from a major business school,intimate knowledge of financial markets,and your CV,proudly displayed on your website really does not cut any ice.Have you noticed that neither Greece,Ireland or Portugal have access to the sovereign debt market?There is no god given right that enables a UK government to sell gilts,come what may.Go on, tell me,the government can let the exchange rate go to hell, because that is what they taught you at Sussex University!

  18. blogs of the world

    George Osborne's policy of expansionary fiscal contraction is based on an economic myth. B… http://reduce.li/rzzgkh #fiscal

  19. Adam White

    A must read if you want to try and tackle the Tory argument that the cuts will lead to growth http://bit.ly/cJzj04

  20. Mr. Sensible

    Bill, Ireland embarked on this I think late last year and look what has happened; the deficit has got worse, not better, and they are I believe back in recession.

    At the end of May this year, when Spain had its rating cut, I believe 1 of the agencies said specifically that cuts were harming economic growth.

  21. SoapboxLabourUK

    RT @leftfootfwd: Expansionary fiscal contraction and the emperor’s clothes http://bit.ly/alj0AS

  22. Hazico_Jo

    RT @SoapboxLabourUK: RT @leftfootfwd: Expansionary fiscal contraction and the emperor’s clothes http://bit.ly/alj0AS

  23. Chris

    @william

    WTF? Were you stoned when you wrote your post?

    “Excuse me,Mr. Irvin, but where are your arguments?”

    Ermmm, isn’t he the writer of the informative and researched post which you are commenting on?

    “I am 10 years younger than you,Cantab first in economics,top of class from a major business school,intimate knowledge of financial markets,and your CV,proudly displayed on your website really does not cut any ice.”

    I bet his dick is bigger than yours though…

    “Have you noticed that neither Greece,Ireland or Portugal have access to the sovereign debt market?”

    There economies are very different to ours, not least we aren’t controlled by the Hun.

    “There is no god given right that enables a UK government to sell gilts,come what may.”

    But we’re not and weren’t on the brink of bankruptcy, our debt maturity is on average 14 years, Greece’s maturity was about 3 months hence the pressing need for the Greeks to find some wonga.

    “Go on, tell me,the government can let the exchange rate go to hell, because that is what they taught you at Sussex University!”

    Ermmm, who went to Sussex? Unless I’m so stoned I’ve looked up a different George Irvin he says he went to Oxford, LSE and SOAS. And I’d believe his credentials over yours.

  24. Plymouth City UNISON

    ECONOMY: Cutting Public Sector confirmed as not the way to achieve growth (or happiness)! Here's why: http://bit.ly/dy3y5G #cuts #swcuts

  25. Hazico_Jo

    RT @leftfootfwd: Expansionary fiscal contraction and the emperor’s clothes http://bit.ly/alj0AS

  26. william

    Chris, I am sure Mr.Irvin is as proud of his anatomy as his 3 years from 1967 as a research officer in the IDS, Sussex University.Our debt maturity may average 14 years,but there would be no buyers for 3 year UK treasuries at 0.75 percent,the rate that Walmart and Coca Cola command.Debt markets can be unforgiving, as several countries are discovering.

  27. Chris

    @william

    “Chris, I am sure Mr.Irvin is as proud of his anatomy as his 3 years from 1967 as a research officer in the IDS, Sussex University”

    Okay, rather pathetic of you to pick up on Sussex and I don’t understand why your going on about it as its a top UK university.

    “Our debt maturity may average 14 years,but there would be no buyers for 3 year UK treasuries at 0.75 percent”

    So, we’d have to pay more in interest payments. It depends on your political viewpoint, which do you think is the least worst option: paying more in debt interest, mainly to ourselves through our pension funds or mass unemployment and poverty for millions of our fellow citizens. Economies recover but it depends how it will take and at what social cost.

    “Debt markets can be unforgiving, as several countries are discovering.”

    WOW is that your intimate knowledge of financial markets showing through? How come you only got a 1st in economics a man of your obvious abilities should surely of got a double starred first…

  28. william

    As the whole euro project is unravelling tonight,although it will take 6 months to happen,I suggest,Chris, you go to Labour Uncut ,9 NOvember, Nigel Farage, and read the comments.Until our party,Labour,learns the lesson that in a democracy it is the market that is more powerful than any government, we will be returned to the position of Labour under Brown,wholly unelectable.

  29. George Irvin

    @William
    I think the ref to Nigel Farage gives the game away. As for the ad hominem stuff, beneath the economc naivete, you really do sound like a nice ‘fella—we must lunch together some time.
    George

  30. william

    George,the editor of Labour Uncut published a piece ‘Three cheers for Nigel Farage’, so in your terminology I assume that gives the game away:no tory website gives him the time of day.As for economic naivete ,I cannot predict whether this government’ s economic policies will work :my view is that the market would have caused Darling’s timescale to unravel fast.We will never know.If either Greece or Ireland is not in the existing euro before 15 Nov.2011,my belief,lunch is on me,English’s or The Kennels.

  31. Tax Research UK » Expansionary fiscal contraction and the emperor’s clothes

    […] Foot Forward has a blog with the above title by my friend and occasional co-author,George Irvin, who is a research professor at […]

  32. Osborne's intellectual leap of faith | Left Foot Forward

    […] Foot Forward has examined the flaws in the theory of ‘expansionary fiscal contraction‘ before. Today, The Times’ Anatole Kaletsky has a must read piece dismantling the […]

  33. Will Straw

    @mjhsinclair Empirically Ricardian Equivalence doesnt hold up in the current economic circs (if it ever does) http://bit.ly/evKXnS

  34. Osborne’s expansionary fiscal contraction has failed | Left Foot Forward

    […] Expansionary fiscal contraction and the emperor’s clothes 13 Nov […]

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