Austerity Worked?

At nearly 5% per year, Ireland had the fastest growing economy in the EU or OECD in 2014. 1000 jobs were created every week. Between modest increases in the average wage and falls in the price of consumer goods, people have more money in their back pocket. With house prices rising rapidly, homeowners feel richer. Despite carry a debt bigger than the size of the economy, the government can borrow money cheaper than ever before.

The emerging narrative seems to be: government took the tough decisions, citizens made the necessary sacrifices, and after seven years of brutal tax hikes and spending cuts, we are on the verge of seven years of plenty. And, this time it’s different.

Across the water in the UK, Tory Chancellor George Osborne similarly took great delight in confounding his own critics, from the Labour Party to the IMF, who had said he was slashing the deficit too much and too soon. The UK has bounced back strongly compared to its continental counterparts. Case closed?

We have been here before. Post-1987, Ireland was held up as a dubious poster child for what some economists called ‘expansionary fiscal contraction’; the idea that austerity causes growth. This was to be used as justification for bouts of belt-tightening across the world in the quarter century that followed, including in Ireland itself after the 2008 crash.

So, austerity works?

If one thing happens after another, does that mean that that the second event was caused by the first? Post hoc ergo propter hoc, as they might say in Eton?

No, of course not. Expansionary fiscal contraction is both an oxymoron and a fallacy.

All else being equal, cutting the budget deficit – or increasing the surplus – shrinks the economy. In the case of both Ireland and the UK, aggressive austerity caused the economy to contract by more than had a more patient path been chosen. It is no surprise, therefore, given how steep was the economic decline, and how many jobs were shredded, that we are now seeing a catch-up recovery as the economy makes up for lost ground.

None of this is to say that Ireland could have escaped entirely from the clutches of austerity. Even if we had not been forced by the troika to accelerate fiscal consolidation, it is fantasy to think that we could have continued running massive deficits indefinitely, racking up debt while expecting the private sector or international institutions to keep lending to us on affordable terms.

One may quibble about how and how quickly the budget deficit was brought under control, but there is no doubt that it had to be reined in. If budget cuts were not made when the economy was on its knees, they would have had to be made when recovery was underway. But, that is the very essence of common-sense Keynesian economics.

Some fantasists would have you believe that there were easy solutions, like leaving the euro or running budget deficits that would somehow pay for themselves. The economy had become so out of kilter by 2007, and the subsequent scale of the collapse was so dramatic, that there were no easy options. The pertinent question is whether policy makers made the best of a brutal situation?

While it was heresy to say so in some circles back in 2008, it is now conventional wisdom that the blanket bank guarantee was an unmitigated disaster for the country. Reining in the budget deficit was necessary but, with a free hand, it would have been more prudent to backload the pain until recovery had taken hold.

As for how exactly austerity was executed… much of the same economic literature that heralded Ireland’s ‘expansionary fiscal contraction’ holds as an article of faith that spending cuts trump tax hikes. The evidence is similarly weak, and highly context-specific. What is clear is that the earlier stages of Ireland’s most recent bout of austerity, which relied more heavily on tax increases, made the distribution of income more equal whereas the latter stages, which relied more so on spending cuts, have had the opposite effect.

Much of this may be academic at this point – ancient history to those who prefer to live in the present and look to the future – but it is important that we learn the right lessons from the second economic crisis to hit the country in a generation. Of course, it should never be allowed to happen again. But if it does, whether in Ireland or elsewhere, beware of false prophets preaching fiscal masochism or sound-bite friendly policy solutions as miracle cures.

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