The austerity agenda as path to more unemployment...

The Promise of Increased Unemployment

The International Monetary Fund issued a new report on the impact of austerity policies - i.e. cutting government spending during a recession - on increasing unemployment. This "prolonged unemployment through austerity" is the heart of the GOP's economic program.  According to the historical research of IMF economists, it is a recipe for making the existing disaster worse:

Fiscal contractions raise both short-term and long-term unemployment, as shown in Chart 3, but the impact is much greater on the latter. Long-term unemployment refers to spells of unemployment lasting more than six months. Moreover, within three years the rise in short-term unemployment due to fiscal consolidation comes to an end, but long-term unemployment remains higher even after five years.

Fiscal consolidations thus add to the pain of those who are likely to be already suffering the most—the long-term unemployed. This is a particular worry today since the share of long-term unemployed increased in most Organization for Economic Cooperation and Development countries during the Great Recession. And even in countries where it did not increase—such as France, Germany, Italy, and Japan—the share had already been very high even before the recession.

Job loss is associated with persistent earnings loss, adverse impacts on health, and declines in the academic performance and earnings potential of the children of displaced workers (see “The Tragedy of Unemployment,” in F&D, December 2011). These adverse effects are exacerbated the longer a person is unemployed.

Paul Krugman comments at his NYTs blog:

In the first half of last year a strange delusion swept much of the policy elite on both sides of the Atlantic — the belief that cutting spending in the face of high unemployment would actually create jobs. I went after this stuff early and hard...

The latest entry (in a steadily mounting weight of evidence about just how wrong that view was) is a comprehensive review of past episodes of austerity by economists at the IMF, from which the figure above is taken. Yes, contractionary policy is contractionary. And as the authors point out, it’s probably even more contractionary than usual under current conditions:

The reduction in incomes from fiscal consolidations is even larger if central banks do not or cannot blunt some of the pain through a monetary policy stimulus. The fall in interest rates associated with monetary stimulus supports investment and consumption, and the concomitant depreciation of the currency boosts net exports. Ireland in 1987 and Finland and Italy in 1992 are examples of countries that undertook fiscal consolidations, but where large depreciations of the currency helped provide a boost to net exports.

Unfortunately, these pain relievers are not easy to come by in today’s environment. In many economies, central banks can provide only a limited monetary stimulus because policy interest rates are already near zero (see “Unconventional Behavior” in this issue of F&D). Moreover, if many countries carry out fiscal austerity at the same time, the reduction in incomes in each country is likely to be greater, since not all countries can reduce the value of their currency and increase net exports at the same time.

Simulations of the IMF’s large-scale models suggest that the reduction in incomes may be more than twice as large as that shown in Chart 2 when central banks cannot cut interest rates and when many countries are carrying out consolidations at the same time. These simulations thus suggest that fiscal consolidation is now likely to be more contractionary (that is, to reduce short-run income more) than was the case in past episodes.