AUSTERITY IS ALWAYS A DRAG ON GROWTH – especially in depressed economies

Keynes was right after all when he said: ''The boom, not the slump, is the right time for austerity at the Treasury.'' That is the conclusion of research by Professors Òscar Jordà and Alan Taylor, published in the February 2016 issue of the Economic Journal.

Their results indicate that only a strong economy can bear a programme of austerity or ''fiscal consolidation'' without significant output losses. According to their analysis, a fiscal consolidation of 1% of GDP translates into a loss of 3.5% of real GDP over five years when implemented in a slump, rather than a loss of just 1.8% in a boom.

The researchers analyse the effects of austerity on macroeconomic aggregates using new propensity-score based methods for time series data. Their results contrast with the ''expansionary austerity'' view of Alberto Alesina and Silvia Ardagna, and amplify the opposing ''contractionary austerity'' view of the International Monetary Fund.

The researchers apply their estimates to make a counterfactual forecast of the post-2007 path of the UK economy without the fiscal austerity policies imposed by the coalition government after the 2010 election.

Two assumptions are needed to make this exercise relevant. First, the study assumes that the UK had ''fiscal space'' and was not forced to do austerity. This view may be defended in that real GDP in 2013 was worse than was expected in 2010 and debt to GDP higher than expected, yet gilt yields remained ultra-low in real terms (and at their lowest nominal level in 280 years of recorded history).

Second, the study assumes that policy-makers care about timing fiscal adjustments so as to mitigate the damage to the real GDP path of the economy. That, at least, is an often-stated goal of most policy-makers.

The results of the analysis are presented in Figure 1, which shows the actual and forecast paths for UK real GDP from 2007 (the business cycle peak) to 2013. How much of the poorer outturn can be attributed to the fiscal policy choice of instigating austerity during a bad slump? The answer is about 60%. Without austerity, UK real output in 2013 would have been steadily climbing above its 2007 peak, rather than being stuck 2% below.

The residual relative to the forecast could be accounted for by various omitted factors, such as export patterns in the Eurozone and idiosyncratic UK sector shocks. There could also have been over-optimism in the 2010 forecast.

But a major caveat suggests that the research produces a biased underestimate of the effects of UK austerity. That caveat is the ''zero lower bound'' for interest rates, when fiscal multipliers are known to be much larger in both theory and evidence. The UK out-of-sample counterfactual does correspond to a ''liquidity trap'' environment, but the researchers'' in-sample data overwhelmingly do not. Thus, the estimate of austerity''s effects in the UK is probably conservative.

''The Time for Austerity: Estimating the Average Treatment Effect of Fiscal Policy'' by Òscar Jordà and Alan Taylor is published in the February 2016 issue of the Economic Journal. Òscar Jordà is at the Federal Reserve Bank of San Francisco and the University of California, Davis. Alan Taylor is at the University of California, Davis.