Was the coalition’s austerity policy a colossal mistake?

Politics is dominated by historical myths, about which the different political camps disagree. Examining these myths critically is one way that societies can find reconciliation. While “austerity”, the favoured shorthand for government cutbacks, is fast sinking as an issue in British politics, long since overtaken by Brexit, its mythology remains a defining issue. This mythology has right and left versions. I want to look at the mythology of the left.

Few in the Labour Party would disagree with Oxford Economist Simon Wren-Lewis in a recent article that austerity “will go down in history as probably the most costly macroeconomic policy mistake since the 1930s, causing a great deal of misery to many people’s lives.” We in the Lib Dems are implicated in this criticism, as part of the coalition government of 2010-2015 that implemented austerity. It is exhibit B in the Labour case that the Lib Dems should cease to exist as a political party, and that all “progressives” should simply join their party (exhibit A being the tuition fees fiasco). So what are we to make of it?

Mr Wren-Lewis sets out this narrative very clearly in his article. He is an open Labour supporter, so his comments come with a political slant – but he is a proper economist and the case he makes is a substantial one.

This narrative runs something like this: in 2008-2009 Britain followed the world into a severe recession, brought about by a global banking crisis. This inevitably created a government deficit, of which he says: “We experienced record deficits in 2010 simply because the recession was unusually severe.” The Labour government used fiscal stimulus to moderate the effects of the recession, but the Conservative-Liberal Democrat coalition that came to power in 2010 rejected this approach and focused obsessively (so the story goes) with reducing the deficit, using austerity policies – cutting government spending severely. He claims that this focus on austerity had no economic merit, and is best understood as a political exercise to reduce the size of government, with misery as its by-product.

Mr Wren-Lewis says that the government defended its policy with three arguments: that innovative monetary policy would provide the necessary stimulus; that improved business and consumer confidence would do the trick; and that financial markets would not finance the national debt unless action was taken. He demolishes each of these arguments, and I would not disagree with him, though there is an element of hindsight and the first two ideas came good in the end. As a result, he says, the British recovery was extremely slow, costing the average household £4,000 a year – coincidentally about the same as the Treasury’s estimate of the costs of Brexit.

But Mr Wren-Lewis is being disingenuous. There was a fourth argument for austerity. And that was that most of the deficit in in 2010 was “structural” – in other words had a deeper cause the recession. If I remember correctly, the Office of Budget Responsibility estimated that about 8% or so of the 11% deficit was structural. In other words a lot of the pre-crash tax revenues were gone for good, and would require more than short term demand management to bring them back.There is plenty of scope for disagreement amongst professional economists here – but it does suggest an alternative narrative, to which I personally subscribe.

This narrative posits that the British economy was not in a stable position when recession struck. It had already been pumped up by excess fiscal stimulus; there was too much private sector debt; and there was an unhealthy dependence on international finance and, to a lesser degree, North Sea oil. The evidence for this is not just the precipitate nature of the crash – bigger in Britain than in other developed nations – but the large current account deficit before, during and after the crash, and the high level of Sterling beforehand, and its abrupt fall. It is true that the public deficit did not look outsized by international standards before the crash, but, as my macroeconomics lecturer pointed out at the time, the overall economic context had classic signs unsustainable fiscal stimulus. The crash was more than an ordinary business-cycle downturn, it was Britain’s financial chickens coming home to roost.

So what does that mean? It means that fiscal stimulus as a response to the recession would have only a limited impact, and would not have restored the economy to its previous health, and in particular it would not have solved the government’s deficit problem. Before long the additional demand generated would have led to inflation (in fact unlikely outside economics textbooks) or (much more likely) a worsening current account deficit, i.e. stimulating other countries’ economies rather than ours. That put the British government in a bind. There was a case for stimulating demand through fiscal policy, and yet government expenditure had to be cut back towards something sustainable in the medium term. The government in fact plotted a middle way and, far from obsessively focusing on deficit reduction, moderated the cuts when the recovery proved slower than they expected. The trajectory of deficit reduction was close to that projected by the outgoing Labour government in 2010.

But many distinguished economists were and remain highly critical of the coalition’s austerity policies. Labour supporters can quote any number of famous names. But you need to read what these distinguished people actually said, rather than the mood music they fed into. In fact they hedged their bets. They focused criticism on the lack of public investment, and not across the board austerity. Investment, in theory anyway, is a magic bullet in this context. It generates future productivity growth, so helps to put the economy on a more sustainable future path, while at the same time providing short-term demand. This is a perfectly valid criticism of the coalition record, shared by many Lib Dems who were part of the government. But it does not suggest that the majority of austerity policies were wrong in principle. Taxes and spending were badly out of line and something had to be done to return them to balance. All I can say in the government’s defence is that public investment is much harder to do in practice than in theory – so often the money ends up in wasteful white elephant projects. But it would have relatively easy to allow the building of more council homes, for example.

Where I agree with Mr Wren-Lewis (though he does not explicitly say it) is that the macro-economic policy presented by Labour at the General Election in 2015, under Ed Balls and Ed Miliband, was much more sensible than the one presented for the Conservatives by George Osborne. Mr Osborne proposed a charge towards fiscal surplus that made little economic sense – and one year on it is being buried by his successor. The Labour strategy would have knocked some of the hard edges off austerity, while promoting a higher level of investment. The left is right to call to call it “austerity-lite”, but wrong to suggest that this was a bad thing.

So criticism of austerity is warranted, but this does not amount to what the left wants it to do: to prove that cuts to government spending and benefits were unnecessary, and still less that they can be reversed. Extra spending will require higher taxes. Economists may feel that austerity policies are self-defeating in many instances, such as in some of the Eurozone adjustment programmes. But there is also growing recognition of a deeper weakness in many advanced economies, including Britain’s, signified by the stagnation of productivity. That is limiting tax revenues and what governments can afford to do. That weakness should be the central topic of political debate.

 

 

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7 thoughts on “Was the coalition’s austerity policy a colossal mistake?”

  1. “Extra spending will require higher taxes.”

    Not necessarily. Extra spending and lower tax rates may stimulate the economy to an extent that total tax revenue increases.

    We firstly do need to understand what the government’s deficit is, how it originates, and why it was so difficult for George Osborne to make good his election pledges of reducing it, let alone turning it into a surplus. We can perhaps expect Philip Hammond to have the same problem. Tories seem very slow learners at times.

    It must be obvious to everyone by now that reducing Government spending, or trying to reduce it, and increasing rates of general taxation, like VAT, has had a deflating effect on the economy which has in turn led to reduced taxation revenues. So the reduction in the deficit has not at all been what it might have been calculated to be in advance. The national macro-economy is quite unlike a household micro-economy in which income and expenditure can be regarded as being largely independent of each other. As the economy has slowed, interest rates have been reduced to absurdly low levels in a attempt to increase the levels of private debt in an already unstable economy which has far too much reliance on personal credit to generate sufficient spending by a reluctant private sector.

    If we look at the problem from a different angle, we can see money flowing into the economy from Government spending and a lesser amount returning to the Government in the form of taxation revenue. The difference is simply what everyone else but Government saves. That ‘everyone else’ includes our overseas trading partners who like, on average, to sell us more goods and services than they buy. They are the big savers and the trade deficit that inevitably results has recently been almost entirely responsible for the Government’s own deficit.

    Many of us, for example Prof Steve Keen at Kingston University in London, who have perhaps a less laissez-faire attitude to the economy than might be typical in Tory circles, argue that the trade deficit needs to be actively reduced. Reduce that and the Government’s deficit will reduce too. Others say we should not interfere with the UK’s trade, or the exchange rate, but neither let’s not worry so much about any deficits that result providing that inflation is kept well under control.

    These are the two sensible choices for any British government to make. Either way we will be able to harness more of the available resources in the country which are needed to run our health and education programs.

    The austerity choice is one that makes no sense at all. It should not be considered to be a left/right issue and so anti-austerity economic policies should fit in neatly with the policies of all political parties – especially the LiB Dems.

    The anti austerity argument holds true both for businesses which have their profitability squeezed, their viability threatened as a result of deflation and low demand for their products, and also their workers who will potentially lose their jobs when there is insufficient demand for their labour.

    1. I appreciate that the arguments can be quite subtle here Peter, and that better economic minds than mine disagree with me, but my belief is still that the usefulness or otherwise of austerity policies depends on context. I’m also not a fan of Steve Keen’s though that may be because I’ve only read a few of his blog posts. I am also extremely wary of using an accounting identity as the basis for policy analysis. But your argument deserves a more thorough critique, that I hope to be able to manage before too long!

  2. Matthew

    From a purely personal view point I have often thought that if people don’t have money they can’t buy things, if they can’t buy things then we don’t make or grow things, if we don’t make or grow things then people don’t have jobs, and if people don’t have jobs then they don’t pay taxes.

    Austerity felt crazy for me. Without understanding the economics of it in depth, taking money from the people who spend all of their money in their communities was self defeating, it not only starved local economies of the opportunity to weather the storm it also robbed people, like myself, of the confidence to spend a little of what we had therefor starving the local community of even more money.

    I also thought that rather than not spend, targeted spending on all the things that are broken in this country would have maybe created some jobs or kept people in jobs who would then have money to spend locally and pay tax rather than claim social security. I felt that we were not being told the truth, that while we had to save the banks we also let the bankers who caused the problem in the first place off the hook, forcing the poorest to pay for the crimes of the wealthiest who possibly saw their income rise. All in it Together was bullshit and the Liberals have paid a very heavy price for their association with it and very weak leadership from Clegg, just my opinion and as noted before I am no expert but I know how I feel.

    We had a real chance to show that the Liberal way was an opportunity for change for the better of everyone. What happened was we allowed the Tories to use a financial crisis to further their ideological attacks on the poorest and most vulnerable, some Liberal MPs did it with a smile on their face like Alexander. They called it austerity but for me it was an assault on my way of life and it worked, I stopped spending what little I have for fear they would take it all away.

    Even now we appear to have no economic policy or if we do I can’t see it or understand it.

    1. I won’t deny that austerity did a lot of damage, and that it depressed demand in the short term. Its justification is that it served to head off an even bigger future crunch, brought on by an unmanageable budget deficit. A bit like Brazil now. We need to ask how we got into the terrible situation where that was the only solution – too many communities reliant on central government controlled handouts and public sector jobs – rather than finding ways that such communities could develop genuine strength.

      You aren’t being quite fair on Mr Alexander. I was never happy that his grasp of macroeconomics was secure, and he may have not been able to answer back his Treasury civil servants as strongly as he should. But he was central to a big push on extracting money from the top 10%, through extra taxes and a clampdown on rich people’s avoidance and evasion (he made sure that he extracted concession for the reduction of the 50% rate – though that was not politically such a good deal). IFS studies showed that the rich got hammered by austerity – though the working age poor also suffered. The globally mobile top 1% probably got away without much damage, admittedly, but that was always going to be the case. And I’m sure the poorest could have been better protected. But I think IDS is as responsible for that as anybody.

  3. ” Its justification is that it served to head off an even bigger future crunch, brought on by an unmanageable budget deficit”

    We often have countries like Argentina, Brazil, Venezuela, Greece and even Zimbabwe cited as example of what will happen if we don’t rein in public spending and act “responsibly” in a fiscal sense . Without going in too much details there are always other reasons why these countries have the problems they do. Argentina borrowed too much in American dollars. Brazil and Venezuela were far too dependent on the high price of commodities in theireconomic planning. Greece hadn’t got control of its own currency. Zimbabwe had kicked out farmers who could farm and replaced them with ones who couldn’t. So the economy collapsed.

    In all these countries the tax system isn’t what it should be. No government can regulate its economy without a well functioning tax system.

    So how big does a budget deficit have to be to be classed as “unmanageable”? There is no set limit. It really depends on what everyone else but Government is doing in the economy. If everyone else (including overseas trading partners) is saving then the Government has to be spending more to keep the economy functioning. If the GDP of a country is $1 trillion then there needs to be $1 trillion dollars of total spending to keep it fully functional. But too much not more than that otherwise we have too much inflation. Just a little more is probably OK if we want 2% inflation and we are trying to get some growth too.

    Individuals like you and can’t adjust our spending to suit the needs of the economy. But Government can, and they should to fine tune the system.

    1. I think this goes to the heart of our disagreement. But you are right that I need to work a bit harder to justify my statement. I think I will need a whole new post to do that. For now I will just say three things. “Unmanageable” means an imbalance that is too big to fix when you need to fix it – when those financial flows turn against you. Second, high imbalances, such as a big budget deficit can affect those financial flows (eg causing capital flight). Third: beware black swans. Using the past to predict the future may be the only way we can do prediction, but it is never entirely secure – and good management means the management of risk – giving yourself more options if things turn out unexpectedly. In other words, perhaps you are right, how can we know that for sure, and what happens if you are not?

  4. @ Bruce,

    ” Without understanding the economics of it in depth, taking money from the people who spend all of their money in their communities was self defeating, it not only starved local economies of the opportunity to weather the storm it also robbed people, like myself, of the confidence to spend a little of what we had therefor starving the local community of even more money.”

    My guess is that you understand a lot more economics than you are giving yourself credit for. What you are describing is what Keynesian economists would call the multiplier effect. So when people like ourselves feel confident in our future prospects , we’ll spend more freely than when we are more concerned about the future. We then may choose to save more of what we have for fear that we’ll have even less in the future.

    This is the main reason why Tory chancellors nearly always fail in their stated goals of reducing budget deficits. They’ll look at taxation revenue in one year and assume that it will be the same the following year even if they reduce spending. Or alternatively they will look at what revenue VAT will bring in at a rate of 17.5% and calculate that if they raise it 20% their tax take will rise proportionally. ie by 14%.

    But of course it doesn’t work like that because of the multiplier effect. As higher taxes and lower spending slow down the economy, tax revenue dwindles. As the economy slows people want to save more. So the deficit doesn’t close. It may even widen as workers lose their jobs, stop paying tax and instead have to get by on unemployment pay.

    So even judging austerity economics by the stated goal of those wishing to pursue it, ie to reduce Government debt, it is an abysmal failure. When, several years ago, Greece was first put on the economic rack, supposedly to reduce its public debt, its debt to GDP ratio was about 110%. It is now nearer to 180%. GDP itself is down by 30%.

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