The question of what role, if any, austerity has played in the performance of the UK economy has come to dominate recent political debate. Simon Wren-Lewis probes the evidence and points out that the theory that fiscal multipliers are (perhaps much) larger than 1 if interest rates are stuck at zero has stood up pretty well. 

There has been some recent debate about whether UK austerity is responsible for the poor performance of the UK economy (which remains poor, despite the Q3 growth numbers). The debate could be summarised thus:

Austerity Critics (e.g. Paul Krugman): “The UK has gone for strong austerity, and since it did so GDP has stagnated – told you so.”

Austerity Apologists (e.g. Tyler Cowen): “But if you ignore tax increases, and public investment, actually there has not been much austerity. The weakness of the UK economy reflects other factors.”

So, for those who are confused, here are some facts. [1]

Austerity can involve tax increases, cuts in transfers and spending cuts, so it is natural to look at the overall deficit. As I have suggested before, the best figure for the direction and impact of policy is the cyclically adjusted primary deficit. Both IMF and OECD estimates show substantial austerity.

UK Cyclically adjusted primary deficit:

However any deficit figure may not be a good guide to the aggregate demand impact of policy, because many tax and transfer changes will have smaller multipliers than changes in spending on goods and services. As I noted here, the IMF suggest that UK austerity over the full 2009-2013 period is relatively focused on government spending rather than taxes. However what about 2011 and 2012 in particular? The table below looks at the government spending on consumption and investment numbers that go into the national accounts.

Growth Rates in UK Government Spending on Goods and Services, and Employment:

The OBR’s forecast is quite old, but the new one will not come out until 5^th December. I’ve included the OECD’s June numbers because their 2012 figure is a clear outlier compared to other forecasts, and because many people (myself included) use these forecasts. If they are right it will make a significant difference, but for the rest of this post I’ll assume they are not, and use the OBR numbers.

Government investment makes up only about a tenth of government spending on goods and services (G for short), so putting the two together the OBR numbers suggest a fall in G of 1% in 2011, about flat in 2012 and a fall of almost 1.5% in 2013. So, the ‘contribution to growth’ of G to GDP is to reduce it by a bit more than a quarter of one percent in 2011 and 2013, with no impact in 2012. (OBR forecast (pdf), Table 3.4.)

However this ‘contribution to growth’ number in effect compares what actually happens to a counterfactual in which there was no growth in G. A better counterfactual is if G had increased by, say, 2% a year in each year, which would be a kind of neutral, average sort of figure.[6] On that basis cuts in G directly reduce total GDP by about three quarters of a percent in 2011 and 2013, and by half of a percent in 2012. If the multiplier was only one, these are still big numbers, but if it was two they become really large. It would mean that the UK economy might have grown by over 2% in 2011 rather than by less than 1%, without allowing anything for the impact of higher VAT.

So whichever way you look at it, it seems that austerity has had a major impact on UK growth. Of course other things have been important too, but I’m not sure anyone has actually claimed that austerity is the only thing holding back the UK economy.

But in one important sense this is all beside the point. Those who criticise austerity only require three things to be true:

(1) Austerity is real, rather than something imaginary. The figures above make that clear.
(2) Multipliers at the Zero Lower Bound are significant.
(3) If we had not had austerity, monetary policy would not have offset stronger growth. [5]

This is why the multiplier debate is so important. There is a lovely non-sequitur in Chris Giles FT piece on this recently, which Jonathan and Richard Portes have already commented on. Chris correctly notes that theory suggests that multipliers are larger if interest rates are stuck at zero, and then says “so theory tells us very little about the likely effect of fiscal policy on economic growth”. As I have argued many times, theory is pretty clear that multipliers on G will be greater than one in current circumstances, and could be a lot greater than one. And as Paul Krugman quite rightly keeps reminding us, it is theory that has stood up pretty well since the crisis.

[1] My thanks to Jonathan Portes for some discussion on this issue, but I alone am responsible for what appears here.
[2] Source: IMF Fiscal Monitor October 2012 Statistical Table 2.
[3] Source: OECD Economic Outlook June 2012.
[4] Final quarter of financial year, so 2011 figure is actually 2012Q1/2011Q1.
[5] Unfortunately we cannot be certain that (3) is true, as I have discussed before. However we cannot be certain the other way either, which is sufficient in my view to continue to criticise UK austerity.
[6] Postscript. We are interested in why the UK economy did not grow by, at the very least, 2% pa. So the natural counterfactual is where G grew in line with GDP at 2%. It is nonsense to say that G did not contribute to zero growth because it also did not grow.

This article was first published on Simon Wren-Lewis’ Mainly Macro blog.

Note: This article gives the views of the author, and not the position of the British Politics and Policy blog, nor of the London School of Economics. Please read our comments policy before posting.

About the author

Simon Wren-Lewis is a professor at Oxford University and a Fellow of Merton College. He began his career as an economist in H.M.Treasury. In 1981 he moved to the National Institute of Economic and Social Research, where as a Senior Research Fellow he constructed the first versions of the world model NIGEM. From 1988-1990, as Head of Macroeconomic Research, he supervised development of this and the Institute’s domestic model. In 1990 he became a professor at Strathclyde University, and built the UK econometric model COMPACT. From 1995 to 2006 he was a professor at Exeter University. He has published papers on macroeconomics in a wide range of academic journals including the Economic Journal, European Economic Review, and American Economic Review. His current research focuses on the analysis of monetary and fiscal policy in small calibrated macromodels, and on equilibrium exchange rates.