Robert Carling and Stephen Kirchner have a letter in today’s Fin, responding to my piece last week, which restated points I’ve made on the blog (for completeness, it’s over the fold). The letter is notable for not responding to any of my criticisms of Alesina, and for backing away from his previously unimpeachable authority.

John Quiggin’s criticism of us (“Tales of austerity ring hollow”, Opinion, February 16) warrants a response. We referred to Alberto Alesina’s work not because it is the only or last word on this topic, but because it is an example of a much larger literature in support of fiscal austerity (or less pejoratively, “fiscal consolidation”).

It is incorrect to suggest that the case for consolidation “rests largely on the work of Alberto Alesina”. We could also have cited a lot of other empirical as well as theoretical work, as indeed does Alesina himself.

A full examination of the International Monetary Fund and Organisation for Economic Co-operation and Development literature over the years reveals a more nuanced view than Quiggin suggests (not that the IMF or the OECD are the final arbiters anyway). We recognise nuances that we could not canvass in a 600-word article.

One is that the arguments about fiscal consolidation have to be tweaked depending on country circumstances and the credibility of the policymakers. Greece, for example, will suffer from fiscal consolidation, but that is partly the fault of the exchange rate straitjacket they are in.

But, in general, we stand by our basic proposition that fiscal consolidation is essential to the economic rehabilitation of countries with large budget deficits and unsustainable public debt burdens.

The only point worth noting is that the “pejorative” term “fiscal austerity” isn’t mine, it’s from the title of Alesina and Ardagna’s 1998 paper “Tales of fiscal consolidation: can austerity be expansionary”. If austerity is now a pejorative it’s because people know what it means, while “fiscal consolidation” remains a vaguely defined euphemism. Readers with a long memory may recall the US Repubs and Cato dumping “social security privatisation” in favor of “social security choice”

Tales of austerity ring hollow

John Quiggin
PUBLISHED: 16 Feb 2012 00:09:01 | UPDATED: 16 Feb 2012 05:35:23

As philosopher George Santayana observed, those who do not remember history are doomed to repeat it. That’s even more true of those who learn the wrong lessons from history.

European governments appear determined to provide an example.

Faced with a severe economic downturn following the global financial crisis that emerged in 2008 and 2009, these countries have adopted austerity policies, focused primarily on cutting public expenditure. The hope is that by providing room for private investors, austerity will prove to be expansionary.

As Stephen Kirchner and Robert Carling (“Give austerity a chance”, The Australian Financial Review, February 8) have argued, this claim rests largely on the work of Albert Alesina and his colleagues, going back to the 1990s.

The central document in this literature is a 1998 paper by Alesina and Silvia Ardagna, titled Tales of Fiscal Adjustment: Is Austerity Expansionary? – a question to which the authors give a positive answer.

What Carling and Kirchner do not mention is that Alesina’s claims about expansionary austerity have been repeatedly refuted, not just by Keynesian critics but by the International Monetary Fund and even by one of Alesina’s own co-authors, Roberto Perrotti.

In fact, on the very day their piece was published, the Reserve Bank of Australia’s Statement on Monetary Policy joined the critics, noting “there are a number of elements that increase the probability that the large fiscal consolidations now in prospect could be significantly contractionary”.

(Myself and others suggested to Carling and Kirchner that they should have alerted Financial Review? readers to the fact that the research they were citing as authoritative was, at best, highly controversial, but they disagreed).

Fortunately, unlike many economic controversies, this is one case where readers can make their own judgments, since the cases studied by Alesina and Ardagna include Australia in the 1980s. It’s useful to compare the “tale” they tell with historical reality.

Alesina and Ardagna start off badly, with the statement: “In 1985, a single-party left-wing government took office and launched a stabilisation plan.” In fact, of course, the Hawke-Keating Labor government was elected in 1983, at the beginning of the recovery from the deep recession of the early 1980s.

The error here is more serious than just a wrong date. Alesina and Ardagna ignore the fact that the beginning of the expansion phase of the 1980s preceded, and made possible, the fiscal stabilisation represented by the Trilogy commitment of 1984. It is true that the government maintained fairly tight fiscal discipline but, as Keynes observed 75 years ago, “the boom, not the slump, is the time for austerity”.

Alesina and Ardagna miss this point, and get wrong just about everything else about the Australian economy in the 1980s. The real doozy, though, is their conclusion in which they proclaim Australia as a successful example of expansionary austerity because: “A private investment boom was associated with profits and easier access to credit following the financial deregulation process that took place in 1985-86.”

Many readers will remember that boom, led by such heroic entrepreneurs as Alan Bond, John Elliott and Christopher Skase. Even more will remember the crash that followed in “the recession we had to have”, and the years of high unemployment that persisted well into the 1990s. But Alesina and Ardagna, writing in 1998, chose not to mention it.

Of course, it wasn’t the fiscal discipline of the 1980s that caused the crash of 1989. Rather, it was the combination of deregulation and easy access to credit to which Alesina and Ardagna correctly ascribe the boom of the late 1980s. That boom turned out to be a bubble. Throughout that bubble, governments and commentators worried obsessively about the judgments of financial markets and, in particular, the all-powerful ratings agencies. Sadly, those judgments gave no warning of the impending crash.

The history of bubble, bust and financial crisis repeated itself in the US and Europe in the first years of the 21st century. Ignoring the gigantic financial-market failure that caused the present crisis, European governments have convinced themselves that their problems are the result of public profligacy.

Relying on the discredited idea of “expansionary austerity”, they are now seeking to cut their way to prosperity. History tells us they will fail.