Thursday, 3 October 2013

The depressed economy is all about austerity

Right now the official unemployment rate is over 7 percent. That’s bad, and many people think it understates the true badness of the situation. On the other hand, there are some people arguing that at this point, possibly thanks to long-run damage from the Great Recession, “full employment” is now a number north of 6 percent. So there is considerable uncertainty about just how depressed we are relative to potential.

But we are clearly still well below potential. And we have also had exactly the wrong fiscal policy given that reality plus the zero lower bound on interest rates, with unprecedented austerity. So, how much of our depressed economy can be explained by the bad fiscal policy?

To have something that would arguably look like full employment, at this point we would not need a continuation of actual stimulus, all we would need is for government spending to have grown normally, instead of shrinking.

Let us compare actual government purchases of goods and services since the Great Recession with what would have happened if those purchases had grown as fast as they did starting in the first quarter of 2001.

The gap is large and has been growing rapidly, it is currently more than 2 1/2 percent of GDP. Given reasonable multipliers, this suggests that real GDP is somewhere between 3 and 3.75 percent lower than it would have been without the austerity. And given the usual Okun’s Law rule of half a point of unemployment per point of GDP, this in turn says that without the austerity we would have an unemployment rate well under 6 percent.

I want to make the point that given what we know and have learned about macro these past five years, and given the modest recovery that has taken place, we are now at a point where, to repeat, to a first approximation the depressed state of the economy is entirely due to destructive fiscal policy.

The austerians have a lot to answer for.

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