Does Austerity Work? Theory and Evidence

A number of factors underpin the Coalition's fiscal strategy, the most important being the use of rules (for the structural current deficit and net debt) and the creation of a new “institution”, the OBR, to monitor it. According to the Chancellor, this combination would ensure the government's “credibility and avoid elevated sovereign default premia and foster sustainable recovery.” It is already clear that the limited degree of independence for the OBR is a major shortcoming but there is another, more serious, problem in the Treasury's belief that the deficit ratio can be reduced by making spending cuts as clear failures by the government to achieve its fiscal targets on the deficit have shown. Such a failure is consistent with the results of research over the last decade which gives strong support to the view that fiscal multipliers are much larger than unity. The length of the downturn, the repeated large failures to hit deficit reduction targets and now the source and nature of the recovery show that his plan is failing. The former was predictable from the evidence just noted. In turn, the recovery relies on the surge in consumer demand following the easing of credit conditions for house purchase and points to a switch to a “Plan B”. It also demonstrates that the Chancellor could have brought about recovery very much earlier had he stimulated demand on taking office not reducing it with his self‐imposed austerity measures. He could even have stimulated demand to a much more constructive long‐term effect by increasing public investment.