The Time for Austerity: Estimating the Average Treatment Effect of Fiscal Policy

From Oscar Jorda and Alan Taylor:

Elevated government debt levels in advanced economies have risen rapidly as sovereigns absorbed private-sector losses and cyclical deficits blew up in the Global Financial Crisis and subsequent slump. A rush to fiscal austerity followed but its justifications and impacts have been heavily debated.  Research on the effects of austerity on macroeconomic aggregates remains unsettled, mired by the difficulty of identifying multipliers from observational data. This paper reconciles seemingly disparate estimates of multipliers within a unified framework.  We do this by first evaluating the validity of
common identification assumptions used by the literature and find that they are largely violated in the data.  Next, we use new propensity score methods for time-series data with local projections to quantify how contractionary austerity really is, especially in
economies operating below potential.  We find that the adverse effects of austerity may have been understated.

They illustrate their approach by making a forecast of the UK recovery.




The results of this counterfactual exercise are presented in Figure 4, and for reference we also show various actual and forecast paths for U.K. real GDP over the period from 2007 (the business cycle peak) through 2013. As a starting point, absent any knowledge of what was to happen after the 2010 Coalition austerity program, what might have been the expected path of the U.K. economy? This question is answered by the two dashed lines. The double-long-dashed line shows the unconditional forecast path in a financial crisis recession based on the large sample of all advanced-economy recessions since 1870 in the work of Jorda, Schularick, and Taylor (2011), extended to the 6 year horizon. We restrict attention here to their unconditional forecast path for highly leveraged economies after a financial crisis, a category which includes the U.K. case in 2007. Clearly, a seriously painful recession was to be expected anyway: if output is set to 100 in 2007, this path shows a 4% drop over two years, to a level of 96 by 2009, followed by recovery thereafter, with output rising to around 104 in 2013, where the 6 year forecast ends.

What did the authorities expect? According to the June 2010 Pre-Budget report of the OBR they had expected something similar but slightly worse (or slightly lagged) relative to typical historical experience to unfold after 2010, as shown by the short-dashed path in the figure. The bottom in output here is 94.2 and the collapse starts a bit later, reflecting actual data up to 2009, probably because the crisis-recession was only just starting in late 2007, and full blown financial panic did not start until after the Lehman collapse in September 2008. This could explain why actual recovery was predicted to be initially slower, although by 2012 the OBR thought the output level would be 100.6 and by 2013 it would be at 103.4, in the same units. (i.e., the difference between the two displayed forecast paths is only 0.6% by 2013.)

Alas, this did not come to pass, as shown by the solid line in the chart using actual UK (ONS/OBR) data to depict the outturn of events (actual plus latest 2013 forecast, as shown). Everything was going more or less according to the above two forecast paths until 2010. After that, a double-dip recession took hold and the U.K. real economy virtually flatlined for three straight years. (In per capita terms, it actually sank.)

How much of the dismal performance can be attributed to the fiscal policy choice of instigating austerity during a slump? The answer, using our model as described above, is: about three fifths. This is shown by the dotted line in the chart, which cumulates the effects of each of the three years of austerity on contemporaneous and future years’ growth from 2010 to 2013. By 2013, the last year in the window, the cumulative effects of these choices amounted to about 3.0% of GDP (in 2007 units) where the total gap relative to the OBR’s June 2010 forecast was 5.2%, thus leaving an unexplained residual of 2.2% relative to OBR’s forecast. Our model also suggests that additional drag from the 2010–12 policies will also continue to be felt into 2014–16, even not allowing for any further austerity.

The residual relative to the forecasts in Figure 4 could be accounted for by various omitted factors, some as noted: export patterns and the Eurozone, idiosyncratic U.K. sector shocks, or overoptimism in the 2010 forecast. For example, Schularick and Taylor (2012) argue that the banking and shadow banking system in the U.K. (as in the U.S.) created unusually large credit overhang and hence a further drag on the recovery, compared to historical norms. However, one major caveat suggests that we also likely have a biased underestimate of the effects of U.K. fiscal policy. This caveat is the zero lower bound (ZLB) of monetary policy: the U.K. out-of-sample counterfactual corresponds to a liquidity trap environment, but the in-sample data overwhelmingly do not. In that case, the true residuals in 2010–13 could be much smaller than above, and the effects of austerity (i.e., the fiscal multipliers) even bigger, big enough to possibly explain most or all of the growth shortfall after 2010.

About ozidar

I'm an Assistant Professor of Economics at the University of Chicago Booth School of Business and a Faculty Research Fellow at National Bureau of Economic Research. You can follow me on twitter @omzidar.
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