It looks as though the new political ascendancy will be reining in the austerity programme, so it struck me as fitting to write about the genesis of austerity – something that I’ve intended to write about for some time. In summary, I feel that the UK population has been sold (and, worse, swallowed) a wrong’un in terms of the economic benefits of austerity measures and fiscal contractions.
For the UK, austerity (the policy of fiscal contraction) has been part of our lives for the best part of a decade now. It has had myriad impacts: from the removal of NHS bursaries for training new nurses, to changes in social policy, to the recently publicised impacts on the UK’s police force. Never was it more relevant than during the recent general election, where each policy (notably from the Labour Party) was costed and the downward trajectory of the UK’s deficit mapped by the Institute for Fiscal Studies.
But what if I told you that the policy of ASAP deficit reduction was based on pretty ropey economics? That’s not to say that a government should run a deficit forever. Rather, my thoughts are that the timing of a reduction in any deficit should be undertaken with consideration of the circumstances.
Let me explain.
Fiscal contractions (i.e. reductions in government spending or increases in taxation) have a negative effect on aggregate demand in an economy. All else being equal, a decrease in government expenditure will generally lead to increased unemployment and falling overall welfare. The key phrase here is ‘all else being equal’.
This is because, generally speaking, a fiscal contraction can take place with a reduced impact on the economy if it is coupled with appropriate monetary policy. In other words, if the government undertakes cuts to government spending, the reduction in employment and wealth that follows can be mitigated by a reduction in interest rates – an expansionary monetary policy.
The issue that we have in the UK, therefore, is obvious: we cannot reduce interest rates any further. This is known as being at the ‘zero lower bound’. Consequently, we have to rely on unconventional monetary policy, such as quantitative easing. These policies have questionable and unreliable effectiveness and, coming out of the global economic downturn, the economic recovery we have experienced has been severely impacted. See the chart from the Institute of Fiscal Studies below – regardless of what you might hear, we have not yet returned to our growth trend after the global financial crisis:
A counter argument for this is that the UK’s employment rate is impressively strong, which some argue puts paid to the argument that fiscal consolidation has had an overall impact on welfare. The UK’s employment rate is, indeed, high. However, one of the features of being at full employment is strong wage growth (full employment implies that demand is at least equal to, if not greater than, supply so prices – or wages – increase). But, putting aside anecdotal evidence of zero hours contracts, the graph below contradicts this as it shows that, apart from Greece, the UK’s wage growth is the lowest of all OECD countries:
So, what am I trying to say?
Not, as I’ve said, that government deficits should continue ad infinitum. Fiscal contractions are sometimes warranted - for example, in cases such as (1) if and when debt is unsustainably large and there is a risk of default or (2) when the economy is at risk of overheating due to previous fiscal stimulus. Needless to say, neither of these circumstances were met when Britain embarked upon its austerity regime.
Therefore, what I am arguing is that austerity and fiscal contraction should have waited until after the recovery was underway and should not have begun until interest rates had lifted away from their zero lower bound. This allows for the fact that tax revenues are higher in a growing economy and allows leeway (through monetary policy) if/when demand is hit by fiscal consolidation. If this means that we are borrowing additional amounts, then so be it – the UK government pays negative real interest rates for its debt, so is effectively being paid to borrow.
And the majority of economists and economic institutions have acknowledged the folly of the actions taken from 2010 onward. With the benefit of hindsight, having promoted fiscal consolidation in Europe following the debt crisis, the IMF wrote the following in 2014:
“IMF advocacy of fiscal consolidation proved to be premature for major advanced economies, as growth projections turned out to be optimistic. Moreover, the policy mix of fiscal consolidation coupled with monetary expansion that the IMF advocated for advanced economies since 2010 appears to be at odds with longstanding assessments of the relative effectiveness of these policies in the conditions prevailing after a financial crisis characterised by private debt overhang.”
Yet, significantly, UK economics and the credibility of parties’ manifestoes are still being assessed based on the extent to which they can be costed. It is often (erroneously) articulated by reference to parallels drawn between government spending and household spending, equating the government deficit with a credit card bill – a concept that chimes with most people’s understanding of finances. When I hear highly educated colleagues and clients questioning how government spending on things such as infrastructure investment, social care and school meals are going to be afforded, it brings home to me the effectiveness of the way in which the story of deficit reduction has been sold.
It might seem odd that an employee of an accountancy firm should be arguing against the country’s obsession with fully costed policies. But this oddness is a function of the fact that the government’s debt reduction fallacy has not been addressed, neither by the opposition political parties nor by the press. I only hope that the fallout from the recent election will result in more economically-responsible policies going forwards.