John Maynard Keynes and Paul Krugman (pictured) are probably right about austerity says new report (Reuters)
Ever since the Great Recession erupted economists have engaged in vicious polemical disputes about the effects of austerity policies on economic growth.
Chancellor George Osborne and Angela Merkel are seen by some as the humourless faces of balanced budgets and savage spending cuts.
Now an original paper by Alan M. Taylor of the University of California Davis and Oscar Jorda of the San Francisco Fed could give anti-austerity campaigners fresh ammunition as the paper looks at the consequences of austerity.
UK Austerity is Disastrous
The paper called The Time for Austerity: Estimating the Average Treatment Effect on Fiscal Policy concludes that the economist John Maynard Keynes was right about when and when not to do austerity.
According to their findings, the UK lost 3% of its GDP between 2010 and 2013 and their model attributes domestic fiscal policy three fifths of the responsibility for the country's worst economic recovery in living memory.
They also added to the growing sense that the side effects of austerity have been wildly underestimated by economists and badly measured by the institutions which have implemented them over the past few years.
For instance, the International Monetary Fund published a devastating report of itself in June 2013 that said it had undervalued the multiplier effect of the savage spending cuts Greece was ordered to make, which then choked off demand.
Both authors seem to take the view that fiscal stimulus is a better emergency measure to combat a slump when low interest rates and quantitative easing tend to be ineffective.
Keynes Was Right
Keynes famously observed that governments should spend money in a slump and cut spending during the boom.
In bad economic weather, when central banks have slashed interest rates, kept them low for a long period of time and there has been no economic recovery, Keynesians point out that the only road to recovery is for governments to spend money.
Jorda and Taylor writes that "it appears Keynes was right after all" and "the vast majority of the difference between the actual UK recovery and the ex-ante forecast (or the typical historical path) could be attributed to the Coalition's austerity policy choices in 2010-2013".
Such a starkly worded analysis of Osborne's austerity policies in a technical academic paper is memorable as it strays away from studies' characteristic politically correct language.
This bias towards Keynes's ideas is expressed towards the end of their work where they mention his contemporary disciple Paul Krugman, who is famous for his scholarship on deflation in Japan since the crash in 1990 and how to beat it.
Krugman applied his own version of a model to explain Japan's 20 year stagnation by John Hicks, a British economist who developed the IS-LM, or Investment Saving-Liquidity Preference Money Supply model, in the 1930s.
Krugman developed the idea of a liquidity trap where some economic crises are so confidence shattering that simply low interest rates and injections of cash into the economy by central banks lose the ability to raise spending and demand.
People simply hoard money afraid that what they spend they will not get back and demand collapses.
Therefore, it is argued by Keynesians that the government must come in and take more interventionist measures.
Complex and Flawed Methodology?
Nevertheless, this new economic research must be treated sceptically.
The authors have introduced a new model into economics and developed something call the local projections/inverse probability-weighted regression adjustment or LP-IPWRA.
It has been used in medical research but has not really been applied to macroeconomics.
To caricature their complex model very simply, they try to remove allocation bias or "insufficient randomisation" in the way they use data to measure austerity.
They attempt to make their model more objective and empirically grounded.
Jorda and Taylor write with force about their model in their paper but they acknowledge that a fundamental problem is that their "UK out of sample counter-factual corresponds to a liquidity trap environment, but the in sample data overwhelmingly does not".
They are right. The UK has not been suffering from falling prices or deflation since 2010 like the United States or European nations but has been experiencing inflation and rising prices.
Such a hard fact undercuts their model and findings of their report to a degree.
The Battle Will Go On
To give Jorda and Taylor credit, they do admit that they do not have enough solid data to "convincingly capture" the zero low bound interest rate effects on the UK's economy since 2010 with "just a handful of observations from Japan".
A fact so large dampens the potency of their conclusions as the level of inflation or deflation in an economy is viewed as having a considerable impact on the behaviour of fiscal policy and monetary policy.
However, they have produced a thought provoking and innovative piece of research that should only sharpen the debates over austerity and whether it has been harmful or helpful since the Great Recession hit Britain.
The emotions that surround austerity that can bring passionate people onto the streets captures even the remote world of academia it seems.
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