More testing on the economy needed.

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U.K. Election Isn't a Win for Austerity

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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The U.K. is a rather odd country in a number of ways. For example, it has no written constitution. But what’s even odder is that it has elections where macroeconomic stabilization policy is a popular issue, rather than a dry, boring matter for technocrats. The Conservatives, who won a surprise victory last week, had long made fiscal austerity one of their main talking points. Many of the party's critics rallied around American star economist Paul Krugman, who -- as usual --- harshly criticized austerity measures. The Conservative win has been widely interpreted as a victory for austerity. 

Krugman’s case against austerity is based on the overall success of Keynesian fiscal policy. Just looking at the casual evidence, we see that countries that cut deficits in bad times tend to grow more slowly than countries that cut deficits less. When economists dig deeper, the result they find is broadly the same. For example, Columbia University economists Emi Nakamura and Jon Steinsson find that fiscal multipliers -- roughly, the amount that government spending boosts private business -- are relatively high in recessions.  A Berkeley team, Alan Auerbach and Yuriy Gorodnichenko, find the same thing, especially when the spending comes in the form of government investment in things such as infrastructure. Many other studies broadly agree. 

Of course, in macroeconomics, nothing is certain -- some prominent economists, such as the University of Chicago’s John Cochrane, continue to criticize Keynesian policy loudly and vehemently. Nor do economists really understand why stimulus seems to have an effect; the main theories that support it have serious flaws. Additionally, successful fiscal stimulus requires the cooperation of a central bank. And the fickle nature of national legislatures means that governments will always have trouble implementing Keynesian policy. 

But Keynesian policy, despite its mysteries and its shortcomings, remains one of governments’ key weapons for fighting severe recessions. Does this mean that British voters picked the wrong horse by voting for a pro-austerity government? 

Not necessarily. The U.K., as I mentioned before, is a rather odd country. There are peculiarities of Britain’s macroeconomic situation that seem to make Keynesian policy less relevant right now. 

This case was made in a recent blog post by  David Andolfatto, vice president of the Federal Reserve Bank of St. Louis. Basically, the U.K.’s economic troubles don’t look much like the situation that calls for stimulus in Keynesian macroeconomics. 

Yes, the British economy has grown more slowly than that of the U.S. since the 2008 crisis. But slow  growth can happen for many reasons. As Andolfatto points out, British employment levels have actually been very robust. In 2006, before the Great Recession, employment of prime-age workers in the U.K. was about eight percentage points lower than in the U.S. But that gap narrowed in 2009 to less than six percentage points, since the Great Recession hit U.S. employment much harder than British employment. And the gap has been shrinking even more since 2012 and  is now less than five percentage points. Labor force participation fell steadily in the U.S. after the crisis, but rose strongly in Britain. 

So even though the U.S. has grown faster since 2008, Britain has done better in terms of putting people to work. This doesn't look like a classic Keynesian recession. 

The second problem with applying the Keynesian story to Britain is inflation. In a Keynesian world, a deficiency of aggregate demand causes inflation to fall, and may even lead to outright deflation. This is what happened to many countries, including the U.S., during the aftermath of the crisis. But the U.K. saw a burst of inflation in the years of 2010 and 2011 that doesn’t fit this story at all. In those years, what many economists call core inflation -- which excludes food and energy -- stayed faster than 2.5 percent, which is more than the 2 percent target maintained by the Bank of England. It even spiked above 3 percent for a while. 

That’s not a lot of inflation in the absolute sense. The 1970s this is not. But rising inflation definitely throws a wrench into the Keynesian story as applied to the U.K.

 So what is the U.K.’s problem? Mathematically, if you have slow economic growth and robust employment, it means labor productivity is falling. That is true by definition. But what does falling labor productivity mean? It might mean that British companies -- for reasons that would be more in the domain of industrial organization than macroeconomics -- put a lot of low-productivity people to work after the recession. It might mean that British companies are not using the latest technology or management techniques. Or it might mean that Britain has focused too much of its economic energy on finance

Whatever they are, the U.K.’s troubles don’t look very Keynesian. Austerity is unlikely to cure the British economy, but there’s not much reason to think fiscal stimulus would either.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net