Can Austerity be Expansionary?

I discussed in a previous post about the failure of austerity measures in Portugal. Here, I would like to take a few steps back and look better at the theoretical foundations of austerity. Without being a theoretical presentation of austerity, this post rather discusses the empirical evidences regarding the effects of austerity measures.

Quite surprisingly for some, the idea of austerity is not new at all. One of the earlier examples can be found in Northern European countries. The study by Giavazzo and Pagani (1990) found that dramatic fiscal consolidations can trigger output expansions. They studied the fiscal contractions in Denmark, between 1983 and 1986, and Ireland, between 1987 and 1989.

Some newer studies reevaluated the findings in this early paper. First, the study by International Monetary Fund in 2010 showed that the findings of expansionary effects of fiscal austerity measures are rather overvalued. The advantages of this latter study consist in a much larger data set including all OECD economies as well as the examination of a bigger number of austerity episodes. They show that the previous findings are mostly due to the use of cyclically-adjusted primary balance as well as VAR approaches. Their approach is based on the concept of discretionary changes in fiscal policy. Their study clearly indicates a negative impact of contractionary fiscal policy on both domestic demand and GDP.

The study by Perrotti (2011) casts additional doubt on the hypothesis that austerity measures are expansionary. On the one hand, he contradicts some of the assumptions of the IMF paper, although they agree with the basic principle that “all consolidations are contractionary. On the other,he also finds that, at least some of the versions of expansionary contractions are not available to current troubled member of Euro Area.

As the empirical evidence gather against the austerity case, it is probably time for the “austerians” (a terms emerged in 2010) to find some sounder arguments in favor of their case.


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