Expansionary Contraction Theory Takes Another Hit

November 8th, 2011 at 12:56 pm

When it comes to cutting our way to prosperity, you can’t get there from here.  Whether it’s here in the US, where stimulus is fading too soon, in the UK, where austerity measures have led to slower growth, or evidence from research by the IMF and others evaluating the early work on this idea: it doesn’t work.

Most of this analysis, including an influential early paper by Perroti himself (w/Alesina), has been done through statistical modeling or taking averages over lots of economies over many time periods.  But in an interesting new paper, Perotti takes a case study approach, which makes a lot of sense given the nuances in the historical record.   The statistical work, for example, can mess up on causality grounds, like when an expansion is underway and fiscal tightening occurs—the models can misinterpret that as growth caused by fiscal tightening.

In this paper, Perotti undertakes four case studies, focusing on consolidations through fiscal and exchange rate policies.  The results:

…cast doubt on some versions of the “expansionary fiscal consolidations” hypothesis, and on its applicability to many countries in the present circumstances.  A depreciation is not available to EMU [Eurozone] members, except possibly vis à vis non‐Euro members.  An expansion based on net exports is not available to the world as a whole. A further decline in interest rates is unlikely in the current situation. And incomes policies [reducing wage/income growth] are not popular nowadays, and in any case probably ineffective for more than a few years.

There’s an important and obvious, though underappreciated, point in there.  Often such consolidations are targeted at lowering interest rates and inflation (including wage inflation), a mechanism which can, in fact, make a difference when high values of those variables are choking growth.  That’s not our problem.  Policymakers both here and in the UK who are arguing for lower deficits to reduce interest rates are tilting at windmills, fighting non-existent dragons at the behest of non-existent confidence fairies.


Print Friendly, PDF & Email

One comment in reply to "Expansionary Contraction Theory Takes Another Hit"

  1. the buckaroo says:

    …seems symmetrical reasoning applies to differences in degree of altruistic interdependence.

    Getting the Genie back in the bottle will mean abandoning the euro..good luck with that.