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The impact of austerity in the UK

When they do their forecast evaluation report, the OBR also look at the impact of fiscal policy on GDP. Here is the relevant chart from their reportpublished yesterday.

There is a useful innovation compared to previous years, which comes close to an something I suggesteda few months ago. The orange bar shows the impact of fiscal measures implemented in that year. The total effect of fiscal policy is this plus the impact of previous fiscal policy actions unwinding.

Suppose for example that fiscal policy reduced GDP by 1% in year 1, but its impact on the level of GDP was expected to decay by half in year 2. If no fiscal policy was enacted in year 2, then fiscal policy in year 1 would increase growth in year 2 by 0.5%. Why might the impact of fiscal policy on the level of GDP decay over time? The obvious explanation is that monetary policy ensures that it does by stabilising the level of GDP. This assumption is problematic when interest rates are stuck at their lower bound, which is why it is useful to publish the within year estimates as well as the total estimates,

You can see when this matters from 2012 onwards. We have a run of years where the total impact of austerity on growth is zero or positive, but only because of the unwinding of previous austerity. If monetary policy, or anything else, had not been able to offset earlier fiscal tightening, then instead the impact of austerity would be to reduce growth in all those years. In that (extreme) case the level of GDP in 2016/17 would be over 4% below what it would otherwise have been without any fiscal tightening from 2010/11.

As the OBR’s assessment of fiscal impact is in their publication on forecast errors, they naturally talk about whether there is any relationship between the two. This year they included this chart.

It is important to understand what we are looking at here. It is not whether there is a correlation between fiscal consolidation and GDP. As we have seen the OBR assumes there is, and indeed their calculations were the source of my estimatethat the average household had by 2013 lost a total of £4,000 worth of resources as a result of austerity. The foolishness of austerity in 2010 was not that the OBR underestimated its impact, but that it left us vulnerable to negative shocks because interest rates were at their lower bound. The shock that hit in 2012 was the Euro crisis and the impact of austerity there.

What the chart above might tell us is whether the OBR have in fact underestimated the impact of austerity i.e the numbers in Chart E are too small. Each year there are hundreds of potential reasons for forecast errors, of which underestimating the impact of austerity is just one. So the best we can expect, if the OBR are underestimating the impact of fiscal policy, is a negative relationship going through zero between the two variables in Chart D but with lots of random variation on top. That is what we see in Chart D.


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