Was austerity a horrible mistake? Three challenges to the left’s narrative

The Prime Minister Theresa May recently suggested that "austerity" was coming to an end. That word is one of the political left's most successful abstract nouns; that Mrs May is now using it shows just how successful it is. Alongside the word comes an austerity narrative that is nowadays largely unchallenged. This is that the programme of public expenditure cuts started by the coalition government in 2010 was economically unwarranted, and therefore "ideological", and that this foolish policy is responsible for the UK's weak economic performance in the years since.

Conservatives are unbothered by this austerity narrative. They peddle their own rival one: that the preceding Labour regime was profligate with other people's money and that the cuts were needed to stop public waste. They further, and tendentiously,  suggest that this profligacy is what led to the financial crash in 2007-2009. They feel no need to challenge the left's austerity narrative; they just ignore it. For Liberal Democrats, as part of the coalition, the austerity narrative is much more painful. They neither challenge the left's version, nor come up with one of their own. That war is over and the Lib Dems lost, but for the small number of people who care about what happened and why, should we meekly accept the left's version of events, and acknowledge that it was a horrible mistake?

The economic logic of the left's case is based on the idea of Keynesianism. In 2010 Britain was suffering a recession, with a collapse in output in 2008 to 2009 following the financial crash. A recession is a temporary dip in aggregate demand which can become a doom loop: lower demand cause job losses, which in turn reduces demand further. The quickest way to counter this is to stoke up government spending: this keeps demand going, stopping the job losses until confidence returns, the economy starts growing and the excess government spending is then cut back to restore balance (funnily enough left-wing economic commentators rarely talk about that second phase). This is what Labour did to a modest extent in 2009. But the coalition embarked on a massive programme of cuts in 2010, sucking demand out of the economy when demand was already weak. Instead of bouncing back from recession, as you would expect, the economy stayed at its low level with little or no growth for years, until weak growth eventually returned - the worst performance of any major economy.  America, the argument goes, was not as severe in its cuts, and bounced back much more quickly. Some commentators go as far as to project how much the economy would have grown at the average rate before the crash, to show a massive gap between now and where the economy could have been.

One of the reasons why this narrative is largely unchallenged is that the picture is actually very complicated, so that it is not particularly easy to pursue a considered argument. The winner is goes to the person that shouts the loudest in a dialogue of the deaf. I will sketch out three challenges, however, but I will inevitably oversimplify things to keep this post a manageable size.

Challenge 1: the size of the government debt was becoming unsustainable. The budget deficit in 2010 was in the region of 10% of GDP (with estimates at the time being even higher). This is truly scary, and promised a massive rise in the size of government debt: could the financial markets absorb it? And if they couldn't, there might be a financial crisis that would create an even deeper recession. The Greek crisis, which was emerging at the same time, was used an example. But Greece doesn't have its own currency any more. In Britain we can simply create the extra currency when push comes to shove: the government doesn't run out. This is what Japan has been doing for decades with little ill-effect. But Japan has a current account surplus, meaning that the Japanese spend less than they produce, and do not need foreign money to keep the system going. Britain had (and still has) a large current account deficit, which means the opposite: we are dependent on foreign money. So, the argument runs, if these foreigners lost confidence in the British economy because of an ongoing 10% budget deficit, with the free creation of money (and hence a higher risk of currency depreciation and inflation), then there would be a crunch. At best, the government, or private sector, would be forced to borrow in foreign currency, destabilising the economy. At worst imports would rapidly become unaffordable, leading to severe inflation. This is a very hard argument to get to the bottom of on either side. There was no stress in the market for government borrowing as things turned out. But was that because of austerity? Or  sign that austerity was unnecessary? There is a very good case that the government could easily have borrowed more for investment (in council housing, say), a more difficult case for simply open-ended funding of bureaucrats and benefits.

Challenge 2: the government actually moderated austerity to reflect economic conditions. The government's plans to cut spending announced in 2010 were never adhered to; what actually happened followed the trajectory proposed by the Labour Chancellor in 2010 to tackle the deficit and included in the party's election manifesto. Unemployment never got out of control, and overall employment recovered much more quickly than the overall income figures. A lot of the comments from left-wing writers on the scale of the recession and austerity does not follow the facts. Some even suggest that because austerity was slower than planned "it was a failure in its own terms". This really is disappearing up your own backside. The scale of the cuts to public services simply shows how far public spending had got out of step with tax revenues. The more serious left-wing counter to this is that though employment held up, its quality did not. Pay was squeezed, and a lot of the new employment was insecure. There was scope for more demand in the economy, they say.

Challenge 3: the economy before the crash was unsustainable. To me this is the lynch pin argument, and I'm disappointed that it is so rarely made. This runs in a narrow form and a broader form. The narrow form is that government spending was at unsustainable levels, both because it was running a deficit at the top of the economic cycle, and, more seriously, because so much spending was funded by bubble taxes like capital gains taxes and stamp duty, while more reliable taxes, like income tax, were actually cut. That left a massive gap when the bubble burst, which meant that spending cuts or tax rises were inevitable even taking the Keynesian argument into account. There was never going to be a good moment to make the adjustment.

But the broader argument is more important. There was something fundamentally unsound about the pre-crash economy. It depended too much on the financial sector, drawing in foreign money to invest in British property and other assets. This drove the pound up, strangling export industries and giving us that large current account deficit. Growth in the economy depended on two very dubious sectors: finance and "business services" - the supply to services to other businesses, often in the finance sector. A lot of the reported income turned out to be fictitious, generating huge losses in the banks which the government then had to bail out. This was the culmination of two or three decades of poor economic management, when instead of modernising the economy, Britain went on an orgy of financialisation - not only pumping up a socially useless finance sector and its hangers on, but persuading people to increase consumption by borrowing more. In this light, projecting growth rates from before the crash to after it, to show how far it should have grown, is nonsense. The sustainable growth rate has been near zero for some years. And this puts a severe limit on Keynesian policies: the economy simply couldn't bounce back to where it was before without creating another bubble. In fact with the finance sector flat on its back, such policies would most likely have done little to raise domestic incomes, but simply sucked in more imports and foreign money invested in British property. The rebalancing of the economy, advocated by politicians of the right, left and centre, is a much slower and more painful process. We simply do not have the skills that a rebalanced economy will need.

This is not to say that the coalition government did not make serious mistakes. The more subtle critique made by prominent economists is that the government should have borrowed to invest. In other words the austerity was necessary, but that it should have been balanced by building more infrastructure and (perhaps) developing schools and colleges (the universities did fine). The left-wing commentators who cite these economists (the likes of Joe Stiglitz for example) overlook this.

The problem is that the British economy is in a deep mess, and it will not be easy to break out of it. We cannot do so by trying to go back to the economies of the 2000s, still less the 1970s. We cannot even go back to how the 2000s might have been if we had been wiser (looking more like Germany for example). Trying to work out what this new economy looks like and how to get there is the big challenge facing all politicians. Meanwhile we should regard any arguments about the easy restoration of growth with suspicion.

23 thoughts on “Was austerity a horrible mistake? Three challenges to the left’s narrative”

  1. UK growth was around 3% annually from the end of the recession in the early 90s, so that is under both Tory and Labour administrations. The Tories weren’t running an unsustainable deficit and neither were Labour for the first few years because they had pledged to keep to Tory spending plans.

  2. I agree with much of this, including the point that the Government should have borrowed to invest, particularly in the type of infrastructure investment – such as social housing – that can earn a return in money terms ; and that the ballooning of the public debt (excluding this type of investment) had to be stopped before it went too far. The Government was right to take the opportunity to grasp the nettle of cutting public spending; but in my view failed to take the opportunity to grasp the nettle that it also needed to put up taxation; with the result that the Government’s ‘austerity’ is associated with what looks likely to be an unsustainable – and politically costly – policy of putting all the weight of deficit reduction on public expenditure cuts; as witness that the recent IFS ‘green budget’ has project that £19bn of tax increases seem likely to be needed by 2022/23 to achieve even a minimal level of ending austerity in the priority areas of the NHS, the defence spending commitment to NATO and the commitment on overseas aid, holding expenditure in other areas constant with some further welfare cuts coming in through the transition to Universal Credit.

  3. I’m sure you’ll know what I really think about the use of phrases like ” the size of the government debt was becoming unsustainable”. I’d just ask: Why? The Government’s debt is everyone else’s savings. So you think we are all saving too much?

    So I’ll not go through it all line by line. You already know what I’ll say.

    I notice that economists like the idea of “impossible trinities”. The usual one is about monetary policy, exchange rates, and capital flows. We can’t have all three. We have to choose two. Can I suggest a new one? Based on:

    1) A high exchange rate.
    2) A low debt economy
    3) A healthy economy with growth and low employment.

    Government policy, and public opinion generally, has, of course, always been to have all three. Any fall in the pound is considered bad news. That holiday to Spain, or that imported German car will be more expensive.

    A rise in the deficit/govt debt is bad news too. We hear silly arguments that we are creating debt burdens for our grandchildren and that the IMF will cancel our credit card if we don’t mend our ways.

    And of course it goes without saying that we all want a healthy economy. But what happens when we try to reduce debt levels, by tightening fiscal and monetary policy? We find that the economy tanks.

    The Labour government of 97 -2010 might have appeared to have squared the circle, but all they did was to replace government debt by private sector debt. So they were effectively still choosing options 1 and 3. It becomes politically more difficult to leave out 2 if the debt is Government debt. If we try to do something about that then option 3 is the one we’ll give up on.

    We all like our strong pound!

    1. Thanks Peter. My political allegiances and economic reasoning may different, but I have ended up in much the same place. The high exchange rate for the pound in the years 2000 to 2007 is to me one of the signs that things weren’t right and that Gordon Brown hadn’t pulled off the magic trick that he sometimes claimed. And I also agree that the level of private debt was a bigger issue than government finances.

      Actually I have tried to stay on the fence a bit on the issue of the sustainability of government debt. The issue arises with high government debt combined with a high current account deficit. So my unattainable trinity is high public debt; large current account deficit; sustainable economy. While we might be able to go on for a long time on the first two, the economy is being hollowed out meanwhile, and subject to catastrophic fall when foreign money invested in public or private assets pulls out, or our own citizens suddenly decide to invest in foreign assets because domestic ones are unsafe (capital flight).

      1. I’m slightly torn myself on the question of the trading imbalance and the current account deficit. If Germany wants to sell us twice as much stuff as it buys from us, for example, should we just let them get on with it? If they are sending us more than they are taking from us then isn’t it us who is getting the better deal?

        And even if we don’t like what they, and others like the Danes and Dutch, are doing, should we try to do anything about it? Maybe we hold down our currency to stop it? We’ve seen what happens in the past when currency wars turn into trade wars turn into real wars. So maybe we don’t have any option.

        We can leave it to the Americans maybe? But despite a lot of huffing and puffing they probably won’t do much either.

        So we let the pound float. We run a trade and current account deficit, and that means there will be a capital account surplus. That usually comes in as the form of some sort of debt. So why not just live with it? Especially as there is no easy alternative.

        So your impossible trinity may not be that impossible after all. Unless and until other countries abandon their mercantilism, its simply what has to happen.

        1. Point taken that current account deficits are more sustainable if countries like Germany are determined to export so much, for little long term benefit to themselves. But it still leads to financial imbalances as the Germans become increasingly desperate to find things to do with their surplus money. The bubble will bust, property values dive, negative equity will kill consumer demand, and so on. It won’t be just the Germans that get burnt. A smaller deficit is maybe tolerable, but it all looks too big and persistent to me Of course if the deficit was covering productive investment I think my trinity would not be so impossible.

          1. Yes I agree about financial imbalances. Keynes was keen on the idea that countries should try to closely balance their trade. But he didn’t get his way in the Bretton Wood talks. It should perhaps be allowable for developing countries to run an export surplus to build up a certain level of foreign reserves but there’s no reason for the more developed counties of Europe to do that.

            If property values dive it won’t be due to the German surplus though. That’s the separate issue of too much private debt.

            There’s no reason to be concerned about what Germany, or any other net exporter, will do with its store of accumulated foreign currency. They can save it or they can spend it. If they spend it that will be a good thing as it indicates they are moving away from net exporting. That’s not likely any time soon.

          2. Well I guess if we can channel the Germans into buying gilts that will be OK. The problem comes when Germans (or anybody else, including patriotic Brits) decide to go for the exit and dump Sterling assets.

  4. The Left invariably calls for more public expenditure citing Keynes for justification; there’s no level of public expenditure that’s unsustainable apparently. But has been pointed out the other side of the Keynesian equation is not one the Left embraces. Remember Gordon Brown’s boast that he had conquered boom and bust when Cable challenged the sustainability of the economy?
    Labour didn’t cause the Crash but the scope of the Coalition government, if it was minded, to engage in Keynesian economics to boost demand was limited. No hiding the failure to boost social housing at a time of recession in the construction industry, low interest rates but high demand for such housing though.
    History, they say, is written by the victor – so the Lib Dems are the fall guys. If I remember correctly the economic programme of each party was barely examined at the last election with the Chancellor, his Shadow and economic spokesmen almost invisible.

    1. “……there’s no level of public expenditure that’s unsustainable apparently”

      If the Government overdoes it they’ll be too much inflation.

      Gordon Brown wasn’t a Keynesian at the time of the ‘boom and bust’ comment. He probably was after the GFC.

      1. Or as you know I will say, inflate a financial bubble and create a financial crisis. This clearly happens with loose monetary policy, but I think it is a risk with excess budget deficits too (and in principle if a surplus isn’t big enough, depending on context). One of the disappointments of MMT, for all its supposed iconoclasm, it is has a very old-world narrative on what happens if government spending gets out of balance. The risks must surely be much wider than just inflation. In that way they are no better than the neo-Keynesians before the crisis.
        And it is just about impossible to get somebody on the left to admit that there are ever circumstances when government spending should be cut. Ever. It’s one of the reasons why they are not trusted by so many on the economy – and why Blair/Brown expended so much political capital reversing it the 1990s – for which they are now reviled on the left. MMT needs to be much clearer about when the brakes need to apply; just waiting for inflation isn’t credible.

  5. “The problem comes when Germans (or anybody else, including patriotic Brits) decide to go for the exit and dump Sterling assets.”

    The Germans can either save their assets as they do at the moment or they can spend them on Scotch whisky or Jet engines or whatever else we make these days.

    So what’s the problem? Don’t we want to sell Scotch whisky or jet engines?

    1. Spoken like Nigel Lawson! It would be great to sell them more whisky and jet engines. But if they invest in dodgy derivatives leveraged on the housing market instead, or even if they just pile into British real estate there won’t be a problem straightaway,or pile up sterling bank deposits which then finance dodgy assets it makes the financial system riskier. Of course if they buy gilts, invest in factories or railways, it might be a different matter. It’s blindness to financial risk that has got economists (and people like Lawson) into so much trouble.

      1. Yes. The central problem is, as you describe, that if we allow people to save too much they might well decide to use their savings in ways we don’t approve of.

        So when Germany sells us twice as much as it buys from us it is saving the excess.

        This does mean that we do have to think about rules being imposed which give us some protection. If we don’t want overseas money used to buy up the wrong things, like our housing stock then we have to initiate laws to prevent that.

        America has the same problem. They’d be happy to let use China’s accumulated store of dollars to buy Californian grapes. They’d be happy to sell Boeing passenger jets but they probably wouldn’t want to sell military jets and they certainly wouldn’t want to sell the entire Boeing company.

        1. Fair point. I would go further and suggest that free movement of capital should be challenged as an unalloyed good. That is one piece of the neoliberal architecture that seems to be rarely challenged by leftwing academics. In Bretton Woods days people thought it was mad.

  6. Noted thanks , Peter Your central point seems to me given by opening argument in your first email ‘The Government’s debt is everyone else’s savings – i.e. that the debt simply involves transfer payments which don’t reduce overall welfare. The implication is the proposition P : that Government borrowing on any scale does not matter. Against this I set four arguments for fiscal restraint made in 2011 when austerity was coming in;
    a) Britain is in danger of becoming a basket case like Greece
    b) We should balance the Government’s books in the same thrifty way as a household should
    c) The debt interest is a burden on us and on future generations
    d) Deficit financing, if not constrained, leads to inflation, and then, if still not constrained, to hyperinflation.

    I take it that we would all discount arguments (a) and (b). (c) needs restating in the form (c*) that the debt interest taken in real terms is a burden, given past experience that the real rate of interest is normally positive. However, if proposition P is correct, even this more sophisticated form c* is invalid, since the accrued interest in real terms can simply be added to the sum owed. So the key argument seems to me to be (d), since examples of inflation getting out of control do happen with severe effects (as in Venezuela at present, and arguably in Iran; indeed it was inflation that ushered in Margaret Thatcher in 1979).

    Why should deficit financing lead to inflation? Because, I suppose, deficit financing is liable to lead to an excess of money demand in the national economy over the supply available. But can not this be avoided by consumers purchasing imports instead?. At this point ,we run into Matthews unattainable trinity, of high public debt; large current account deficit; and sustainable economy. And is this trinity really unattainable? This is an argument I must leave to those more versed in the pure economics of the matter!

    1. Yes, of course high inflation is a likely problem if taxes aren’t properly collected and Government overspends. On the other hand deflation and recession are potential and likely problems if Government is too austerity minded.

      I’m sure we can all think of examples of Govts who get it wrong in each direction.

      Countries like Greece don’t have much choice because they don’t have control over their own currency. We do. So we can get it wrong either way, or we can get it right! It depends on how able we are to manage our economy.

  7. PS I wasn’t quite sure if you were serious in your comment that “The debt interest is a burden on us and on future generations”.

    It really doesn’t work like that. The post was generation did OK and weren’t overburdened by war debts. Govt borrowing creates private sector assets. If it overdoes it those assets it can, as previously discussed, create an inflation problem, but only if everyone decides to spend too much. If they decided to not do anything with them they are economically inert and remain as Govt debt.

    Interest payments work in the same way. They too create non government assets. They aren’t huge and have to be compared with the rate of inflation. I’ve got a few premium bonds and do win a few small prizes in lieu of interest payments every month. So when that happens my assets increase. It’s really not a problem for Govt to pay out 1% interest when inflation is higher than that.

    And how are future generations going to be any more burdened? Aren’t the payments just going to be made to others of the same generation? If they think there’s any unfairness about that they’ll be the ones who’ll decide to do something about it via the taxation and social payments systems at the time.

  8. “MMT needs to be much clearer about when the brakes need to apply; just waiting for inflation isn’t credible.”

    Why not? The brakes (higher taxes and or reduced Govt spending according to political choice) only need to be applied when the economy is moving too fast and is in danger of overheating. That’s it. There’s no other reason. We can’t be any clearer.

    The Govt deficit is exactly the extent to which everyone else creates new net savings in the Govt’s currency. The Govt debt is the sum total of all previous savings. So if we’re worried about deficts and debts being too high we have to be worried that everyone else is saving too much.

    Of course, ironically, one way to discourage net savings is to deliberately stoke up inflation. So, we arrive at the counter intuitive result that way to reduce the deficit is to spend more and tax less.

    1. Quite so. But how do you know when the economy is overheating? Using inflation is not just driving by looking at the rear view mirror, but with that mirror skewed to one side of the road! How do you stop the car going off a precipice?

      1. We’ve got the same problem now. Moving to a more MMT way of thinking doesn’t really change anything. We have to look at a range of indicators in the economy to determine the level of inflation and the level of utilisation of available resources.

        I’d say there needs to be more regional emphasis. The economy can be overheating in London and the SE of England and still be lukewarm in Northern Ireland and the N.E. of England. So Govt spending needs to be targetted to these cooler areas to equalise the level of activity in the economy.

        I said above that the way to reduce the Govt’s deficit was encourage people to save less (and borrow more). That’s exactly what’s been happening for the last 30 years as interest rates have been reduced. The mainstream wouldn’t actually put it that way but that’s in effect what they’ve done.

  9. I agree , Peter, that efforts to get a country’s budget into balance can be, and is overdone – as is the case at present in that Hammond wants to achieve break even in the sense of zero public borrowing in money terms; this ignores (a) the effect of inflation in reducing the national debt in real terms and (b) the distinction that some public expenditure is on investment which creates corresponding assets, other expenditure on current services consumed in the current year. My previous comments were directed at the situation in 2010 when the budget deficit topped 10% of GDP; and the view I developed was that the main reason against allowing this to continue was the danger of it creating inflation (the causality in part going via a depreciation of the currency – the Bank of England, rightly or wrongly, was warning of a threatened ‘run on the pound’). The view that interest payments are a burden on us (as taxpayers) was expressed by, for example, one George Osbourne. This seems to me an understandable point of view , if one assumes that there are some limits to borrowing as you may be, but not the fundamental point. .

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