Austerity

Upon realizing that I could easily get the Cyclically Adjusted Primary Balance data from the IMF as well as Real GDP data from the OECD without expending an extreme amount of energy, I decided to add to the empirical findings that already exist about austerity. I also sought to answer some of the concerns that Scott Sumner likes to express about every attempt at drawing a correlation not provided by Mark Sadowski.

I composed one list that included the Euro Area and one that did not (only to make Sumner shut up) and ran a regression taking the change in the CAPB between 2009 and 2014 as the x variable and the growth of real GDP between 2009 and 2014 as the y variable. The first list included Austria, Belgium, Canada, the Czech Republic, Germany, Denmark, Spain, Finland, France, Greece, Ireland, Italy, Japan, the Netherlands, Portugal, the United States, and the United Kingdom while the second list only had the Czech Republic, Japan, the United States, and the United Kingdom. Note that all of the countries were either at the zero lower bound or otherwise in a liquidity trap (defined as a case in which lowering the nominal interest rate to zero could not have resulted in full employment).

The second list was too small to yield any useful data, but the first list suggested that the coefficient on the change in the CAPB is about $-1.27$, with a p value of $9.2274 \cdot 10^{-4}$ (t-stat is $-4.112416418$). The second list did have a negative coefficient of about $-0.35$, but 5 samples is really way too few to actually conclude anything (maybe this is one of the reasons Sumner wants to remove the Euro Area).

One interesting fact that I noticed, that anyone could check in about 5 minutes if they cared to download the publicly available spreadsheet of CAPB from the IMF, is that, at least between 2009 and 2014, contrary to what Sumner claims, the US did less austerity than Europe. How much less? This much: $-0.3359236583554$. That is, the CAPB increased by about a third of a percentage point less in the US than in the Euro Area. If you included the UK, it would be even worse.

Why don't I include countries like Iceland in my calculations? Simple: they did not go to the zero lower bound in 2009 and they were never close to the zero lower bound, thereby making their addition to a regression about the effect of austerity in a liquidity trap a complete waste of time.

I'm still not perfectly happy with this assessment because I wanted to use the real GDP to working age population ratio instead of simply real GDP, as it would have made the intercept for the regression a little bit less uncertain -- while steady state real GDP growth is indeed quite variable, adjusting for demographics seems to solve the problem most of the time. Unfortunately FRED has annoying limitations with graphs and data lists, so this is the best I could do without spending more than a day on this.

The main point here is that, excluding countries obviously not at the zero lower bound, austerity is highly negatively correlated with real GDP growth and this correlation persists, even if it is not significant, when you exclude the Euro Area.

Assessing the Effect of Austerity in the UK

Whether or not austerity has been successful in the UK is perhaps the most natural test of Market Monetarism. The UK, after all, has an independent central bank and there is no question as to whether or not it actually engaged in austerity (the same case can not be made for the United States, in my opinion). 

It has previously been noted that, even though austerity evidently had a negative effect on real GDP in the UK, what really happened is that productivity growth just happened to be zero while Chancellor Osborne was having a fit with the exchequer. I think that the data clearly disagree with the position; as you can see both the employment rate and real GDP lagged during the period of austerity, which I will argue was only pursued fervently in 2010 and 2011, before it was significantly weakened and the economy proceeded to improve.

First, look at employment and real GDP between Q2 2010 (when the first austerity budget was suggested by the new coalition) and 2011 (the last year that the government actually maintained its commitment to austerity). It's clear that both real GDP and employment suffered during this period -- basically disproving the hypothesis that slow productivity growth and austerity were coincidental. 

Of course, the government never vocally backed down on austerity, so why am I limiting my analysis to 2010 and 2011? Well, for that you need to look at the actual and the projected deficits over the course of the Cameron government:

As you can see, the actual deficit was only less than was predicted by the government during 2010 and 2011. After this, the deficit clearly begins exceeding the 2011 vintage projection; that is the government raised the deficit above what they were initially intending. It was only after this point that the economy and employment began to recover, so evidently fiscal policy was loosened in 2012 and this explains the apparent recovery that happened afterward.

The data seem to corroborate the Keynesian view a lot more than the Market Monetarist one; fiscal tightening did cause both output and employment to fall relative to trend, and the economy only began to recover with fiscal easing.

Effect of Austerity on US GDP

I decided I would make a little chart comparing the US output gap [1] to a counterfactual of the output gap without austerity [2]. The graph shows the actual output gap and counterfactual output gaps for government expenditure multipliers of 0.25, 0.5, 0.75, and 1.

[1] The output gap measure I used assumes that potential GDP grows as roughly 2% a year and that the output gap was zero in Q1 2005.

[2] By "without austerity" I mean "if the government spending to potential GDP ratio stayed at 20% from Q1 2005 to Q2 2015."

(The GDP measure I used is the 'GDPC96' series from fred and the government spending measure I used is the 'GCEC96' series)