The Office of Budget Responsibility has given the Prime Minister a public dressing down.   Robert Chote, the OBR’s Chairman, has clearly stated in an open letter that the Government’s austerity policies have harmed economic growth.

The impact of austerity

According to Robert Chote: ‘it is important to point out that every forecast published by the OBR since the June 2010 budget has incorporated the widely held assumption that tax increases and spending cuts reduce economic growth in the short term.’

He goes on to state: ‘To date our forecasts have used ‘multipliers’ that imply that every £100 of fiscal consolidation measures reduce GDP in that year by around £100 for capital spending cuts, £60 for welfare and public services cuts, £35 for increases in the VAT rate and £30 for income tax and National Insurance increases, with the impact diminishing thereafter.’

But the multipliers that the OBR are using are in the lower range (0.3 to 1.0) of the conventional wisdom.  And this means that they may be underestimating the adverse impact of the austerity policies on growth.  According to the IMF, in its World Economic Outlook (October 2012, p.43):  ‘results indicate that multipliers have actually been in the 0.9 to 1.7 range since the Great Recession.’

As Chote states there is huge uncertainty about the size of multipliers.  Jeffrey Sachs seems to think that such uncertainty undermines the case for fiscal expansion. But the lack of empirical regularities is a common feature of economics.  And difficulties in measurement do not undermine the claim that fiscal expansion will boost demand and growth.

Does the OBR agree with the Government?

According to the BBC’s Stephanie Flanders: ‘the OBR is still on the coalition’s side…. in the most important arguments with Labour – over the role of austerity in thwarting recovery, and the scope to boost growth in the short term with higher borrowing ‘.  This is simply wrong as pointed out by Simon Wren-Lewis, as he states: ‘the OBR are not allowed to examine alternative policies to those of the government. So they cannot take sides in the way suggested.’

The momentum for a shift in policy is increasing.  The impact will be greatest with a fiscal expansion which increases public sector investment compared to tax cuts (many of which will be used to repay debts rather than to spend).  Furthermore, an increase in public investment will not only boost demand but will increase the supply potential of the economy – and will do much to ameliorate the long term damage of the Great Recession – much of which has yet to emerge.