Friday, 8 March 2013

Why Austerity Doesn't Work as Expected

Proponents of austerity appear to have the impression that the whole supply and demand issue (as discussed here) holds and prices adjust automatically to any fall in demand. Truth is, this does not appear to be the norm in real life. Inflation data from Greece indicate the following:

The three vertical lines indicate the three austerity packages passed by the country's parliament. The most shocking observation is that prices did not fall not even after the third austerity package. Data show that the first reduction in prices occurred in January 2013, i.e. 2 years and 8 months after the first austerity package (in May 2010). In comparison, data from the other countries which have been struggling with austerity show similar patterns:

(Vertical lines again indicate austerity packages. Gaps indicate lack in data.)

As the graphs show, Ireland has been luckier than Portugal in the sense that prices were falling before the austerity package came along. However, we cannot infer that the austerity package has indeed caused the reduction in the inflation rate. It is more likely that the reduction had been caused by something completely different and the packages may have helped to prolong this phenomenon. As the above graphs indicate, all sample countries had an inflation reduction in 2008, which is probably the outcome of the sub-prime crisis in the US.

Increased inflation indicates that people can afford less with a given amount of money. Then, as unemployment increases, the amount of money circulating in the economy is reduced. Thus, reduced money in addition to increased prices means that consumption is much less than expected. Then, as consumption falls, GDP falls and the vicious cycle continues. This self-perpetuation of contraction is a notion very similar to the Debt-Deflation Theory of Irving Fisher, which appeared in 1933(!) in the aftermath of the Great Depression; it is more recently presented the other way around (i.e. borrowing and boosting growth can result in less debt) by DeLong and Summers about a year ago. According to Edward Hugh a version of this has appeared in Spain and we can almost be sure that this has happened (or will happen) in probably every other Southern country.

The big question here would be why are not prices lowered as soon as producers witness a drop in consumption? Well, the world does not really work that fast. First of all, a producer cannot fully distinguish a permanent drop in sales from a non-permanent one unless some time passes. The reason for that is that sales fluctuate significantly over time (e.g. seasonally or over business cycles). Then, even though sales drop, the cost of producing (i.e. raw materials, etc) does not; the producer's supplier is further back the chain and will need an even larger amount of time to realize a drop in consumer demand. Only when the producer reduced order sizes over a long period does the supplier note the change. In addition, a drop in producer prices (as can be seen below) does not necessarily mean that consumer prices will also be reduced since the transfer mechanism takes a significant amount of time to understand that this reflects a permanent reduction. As it appeared, oil prices started an upwards trend in early 2009 so the producers were right in not reducing their prices significantly (the reduction can be largely attributed to an oil price reduction of more than 50% in the fourth quarter of 2008).

The above arguments have been one of the reasons that Moody's (and every other ratings agency for that matter) has been unwilling to increase the ratings of any country in which harsh austerity measures have been implemented. It appears that the agencies have a clearer view on the subject than politicians and policymakers. Lately, it has been suggested that the UK downgrade by Moody's is more of an opportunity than a calamity. The rationale behind this suggestion is that it provides policymakers the incentive to realize that austerity measures are not helpful to the economy. In Moody's words the UK's "most significant policy challenge is balancing the need for fiscal consolidation against the need for economic stimulus". The same would hold for the rest of Europe as well.

Although the debate on Fiscal Multipliers has been raging over the past months Simon Wren-Lewis is correct to note that their sign (i.e. that it's positive) has never been argued. Yet, for some politicians (like David Cameron who still believes that "(...) we are making the right choices. If there was another way I would take it. But there is no alternative." ) nothing of the above holds as it is too "complicated" to see that austerity measures bring more trouble to the economy than increased public debt.

If each nation has the politicians it deserves then people surely deserve the outcome of their (irrational) decisions...

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