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Why Austerity May Be Worse Than We Thought--And Hard To Predict

Taking an axe to a governmental budget can cut off growth in a most troubling way. Indeed, austerity has proved worse for a country than most economists suspected.

That is, in essence, what a new IMF paper says. The conclusion: Recent austerity measures have been followed by lower-than-expected economic growth, and economists really struggle to predict austerity’s effects at the start. By the end of the campaign, they’re better at it, the paper says—yet, most people become better at their jobs after doing the work for several years.

The paper comes after a noticeable change from the IMF, which only recently became an outspoken critic of austerity. The IMF’s top economist, Olivier Blanchard, and another research economist, Daniel Leigh also concluded in the paper that the the IMF should not have supported quick budgetary cuts in the beginning of the financial crisis. Economists had thought that for each euro cut from a budget, the economy would lose about 50 cents in growth. Turns out, it was about triple that, closer to 1.50 euros in growth.

Economists badly misjudged this because they used fiscal multipliers that worked during normal times. These past few years, of course, have been anything but normal. Here, a graph that shows how initial forecasts fared:

Put another way, cutting a government’s budget, as an economy capsizes, is sort of like if a sailor falls overboard and then his crew members stand safely on deck and expect him to make it back on the ship in about five minutes. He has swam that far, that fast before, and there’s no reason to expect that he can’t do it again. But, oh, there’s also a once-in-a-lifetime storm raging all around.

In a nation, cutting a government’s budget can, in turn, limit consumer spending and confidence—key components of any developed economy. If you’re getting fewer tax breaks and less support, you are likely joining the budget-conscious hoard at Wal-Mart, not perusing the aisles of Kroger or Whole Foods. You’re in the bargain-bin basement, shopping at Sears, not Macy’s. Certainly not at Saks.

What about the latest Apple gadget that will put you back several hundreds dollars? Put off for another year or two.

Or three or four. Or…well, no one seems really sure how long.

Reach Abram Brown at abrown@forbes.com.

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  • JohnnyBee JohnnyBee 2 years ago

    Yeah, austerity is really painful. But the writer fails to discuss its even more painful long term alternative: continued deficit spending, with or without high revenues. As the private sector becomes smaller and smaller, at the expense of ever expanding government sector, then the ability of the economy to grow and create wealth is diminished. We need only look at Europe where unemployment is high, growth non-existent, and governments now consume about 50% of GDP. So, have another drink and tell yourself getting sober is just too, too painful.

    What’s needed is sturctural reform of government programs (read “privatization”) and a gradual withdrawal of the nanny-state. But even small “cuts” like ending public funding for PBS and the NEA are met with howls of protest and threats of recrimination. Sanity, bon voyage!

  • Grant Shaffer Grant Shaffer 2 years ago

    Same thought occurred to me as well.


    Would you prefer that we just get a new credit card or two and keep borrowing away?

  • Abram Brown Abram Brown, Forbes Staff 2 years ago

    Hi all, thanks for your comments. I don’t think that borrowing is what we should do. I think we need to refine the way we raise revenue (and some PRUDENT measures that are not knee-jerk on lowering spending. We’re a country winding down a war…but maintain an impossibly large military complex).

  • Grant Shaffer Grant Shaffer 2 years ago

    Abram, bad argument since cutting the military spending would be the same as an Austerity measure which I believe you are opposed to. The Military employes how many individuals not just with the Government but also the military contractors. Military or Defense programs are just Republican entitlement programs. Replace Military and Defense with Medicaid or Social programs and you get the same argument form the other side.

    There needs to be a sever austerity measure soon, or it’s all pointless. If I’m not mistake our debt to GDP ratio far exceeds that of Greece and Spain added together.

  • Mike Moxcey Mike Moxcey 2 years ago

    The economy is a circulatory system (but not closed). It is based off of basic resources such as food, water, and energy, but the circulation of money itself is what keeps everything lubricated.

    When kings and dictators built infrastructure or monuments to themselves, their nation or city grew because more people and goods were moving around and interacting with each other. During the 1950s when the income tax rate was 90% in America, money rained down thru the economy two different ways. One was the standard income transfer of taking money from the rich and in this case giving it to people who built interstate roads and schools and government buildings, etc.

    The other way was trickle-down but it was not trickle-down Reagan style. The top 1% can only trickle down so much stuff. A middle class making money hand over fist (because the business gets charged excessively on ‘excessive’ profits) trickles a lot of money down to their retired veteran parents and shiftless nephew and various other folks who now need government assistance because this trickle from the middle class dried up when corporations started ‘investing’ profits into their CEOs instead of into their current crop of workers.

    When a recession occurs, what has actually changed? Is there really less food or less water or less oil? No.

    And as far as folks talking about gold standards or devaluations, it is the same issue, just from a broader perspective. What is the total dollar value of everything in the world? Assume it is 25 trillion. What effect does saying it is only worth 5 dollars or is now worth 100 bazillion lira have on the actual economy? None.

    The only thing that has changed is our perception of the future.

    If we reinforce that negative perception of the future with austerity, we should not be surprised at the negative feedback effect.

  • bnen bnen 2 years ago

    Veronique de Rugy has some great charts showing that there have been no “axes.”

  • Abram Brown Abram Brown, Forbes Staff 2 years ago

    Share them!

  • I agree with some of the conclusions but not all. So what is the alternative to austerity—binge spending? That is what brought Dubai, Spain and Greece to its knees. US has already seen the impact of excessive spending–one rating downgrade.

    I think the sane way to handle austerity is thru prudent belt-tightening. Let us start with asking the difficult question–WHAT IS THIS BIT OF PORK GOING TO DO FOR THE ECONOMY? Unfortunately, as most of our legislators are more concerned with keeping their jobs, they never ask this question from their lobbyists–at least not often enough. I have seen this approach applied successfully to companies who are in trouble.

    So maybe the answer is, don’t take a sledge hammer to the budget, but proactively reduce waste first. I bet there is a couple of trillion right there. Congressmen and Senators, Are You Listening?

  • James James 2 years ago

    While I agree with a lot of what you said, Ganesh, I think it’s important to note that the rating downgrade had little to do with our excessive spending–it was almost entirely due to Congress being unable to come to any sort of compromise regarding the debt ceiling, which threatened the ability of the US to pay its debts.

    When looking at and evaluating the effectiveness of austerity measures, though, I think that it would be good to look at what these countries have done with their tax rates at the same time. From a quick look, it seems that all of the Eurozone countries facing austerity measures have also increased taxes–in many cases substantially. Are there any reports of what austerity measures might do to an economy if taxes are left alone (or possibly even lowered slightly)?

  • The rating downgrade occurred because the markets have lost faith in the United States to govern their own affairs. Probably has something to do with 40 or so congressmen who were elected to stop government in its tracks. Sadly they have been very successful.