By Dr. Jonathan Tiemann, April 20, 2015

Although we don’t hear the word explicitly that often, austerity is very much at the center of economic debate today. In the US, both the Senate and the House of Representatives are working on budget proposals, which would (their sponsors say) balance the Federal budget within a decade. Those proposals would do so largely with budget cuts, including reductions in Medicaid, Obamacare, and food stamps, and (in the case of the House proposal) restructuring how Medicare works. The budget is also a major issue in the run-up to next month’s general election in the UK. Both the Tories and Labour have put forth proposals that would eliminate the current budget deficit, although the Conservative (Tory) proposal is more aggressive. And in Europe, policymakers continue to demand steep reductions in Greek public spending as a condition for the next round of fiscal assistance.

The orthodoxy behind an aggressive approach to fiscal (taxation and spending) consolidation (reducing the deficit) generally holds that fiscal consolidation is advantageous because it improves public confidence, moral because it avoids burdening future generations with the cost of our profligacy, and beneficial because it reduces the share of the public sector in the economy. Even if cuts in government spending bring on a recession in the short-term, the orthodoxy goes, the cleansing effect of the recession clears the way for stronger economic growth in the future. This orthodoxy is exactly the Protestant Ethic, as analyzed by Max Weber.

In Weber’s formulation, the Protestant Ethic thrives on the existence of a class of people he calls “worldly ascetics.” These are people that adopt as their vocation — to the point where they forego the pleasures of life for it — the pursuit of money-making. This may explain why proponents of fiscal consolidation also often advocate deregulation in product markets and labor markets. In the negotiations between Greece and its European creditors, German Finance Minister Wolfgang Schaeuble has been particularly firm that Greece should adopt a program of fiscal consolidation, product market deregulation, and labor market “reform” in exchange for continued support from the rest of Europe.

The International Monetary Fund has historically demanded austerity of its developing-market beneficiaries, and has often adopted a tone both moralistic and paternalistic. But is austerity good economic policy? Recent research from the IMF itself suggests that maybe it isn’t. A 2013 working paper [1] presenting data from the IMF’s October 2012 World Economic Outlook [2] says, “If … forecasters underestimated fiscal multipliers, there should be a negative relation between fiscal consolidation forecasts and subsequent growth forecast errors. In other words, in the latter case, growth disappointments should be larger in economies that planned greater fiscal cutbacks. This is what we found. “ In other words, fiscal consolidation tends to retard growth.

The IMF’s January 2015 WEO [3] includes evidence suggesting that labor market reform isn’t productive either. The illustration at the top of this post is from that report. It shows the effect on productivity of various economic reforms, as implemented in various countries in recent years. The first two lines are the most important. The first line shows that “reform” of product market regulation (that is, deregulation) has a slight positive effect on productivity, although in some sectors the effect can be adverse at first. But the second line shows that labor market “reform” (which usually goes against workers) generally has a modest negative effect in the short term, and no meaningful effect in the medium term.

So if fiscal consolidation retards growth and labor market “reform” reduces productivity, the question becomes, why so many prominent voices in the US, the UK, and the Eurozone call so loudly for both.

[1]  Olivier Blanchard and Daniel Leigh, “Growth Forecast Errors and Fiscal Multipliers,” IMF Working Paper WP/13/1, January 2013.

[2]  International Monetary Fund, World Economic Outlook: Coping with High Debt and Sluggish Growth, Washington, October 2012

[3] International Monetary Fund, “Where are We Headed? Perspectives on Potential Output,” Chapter 3, IMF World Economic Outlook, January 2015