‘The government cannot go on living beyond its means.’ This seems common sense, so when someone puts forward the view that just now austerity is harmful, and should wait until times are better, it appears fanciful and too good to be true. Why would the government be putting us through all this if it didn’t have to?
By insisting on cuts in government spending and higher taxes that could easily have been postponed until the recovery from recession was assured, the government delayed the recovery by two years. And with the election drawing nearer, it allowed the pace of austerity to slow, while pretending that it hadn’t. Now George Osborne is promising, should the Tories win the election in May, to put the country through the same painful and unnecessary process all over again. Why? Why did the government take decisions that were bound to put the recovery at risk, when those decisions weren’t required even according to its own rules? How did a policy that makes so little sense to economists come to be seen by so many people as inevitable?
The place to begin is 2009. By then the full extent of the financial crisis had become apparent. Although the crisis originated in the US, it had spread around the world, leaving no country unscathed. The major UK banks had to be bailed out, not so much as a result of excessive lending to UK borrowers, but because of their unwise overseas investments. The main weapon used to fight recessions is interest rate cuts – lower interest rates encourage consumers to spend rather than save, and business to invest – and by 2009 interest rates had been reduced to nearly zero in all the advanced countries. Yet output continued to decline.
The response of governments and central banks was twofold. First, the Bank of England and the US Federal Reserve embarked on a programme of ‘quantitative easing’, which involves the temporary creation of money, thereby making it possible for central banks to buy long-term financial assets. Second, governments started to spend more or cut taxes, which economists call a fiscal stimulus. The last Labour government’s measures included a cut in VAT in late 2008, albeit for just a year. Barack Obama managed to enact a package of measures which included higher government spending as well as lower taxes, and even Germany undertook a fiscal stimulus package in 2009. The normally austere IMF agreed that fiscal stimulus was the way to go in 2009.
The financial crisis was leading consumers and firms to spend less and save more. That made sense for individuals, but the problem was that because everyone was doing it, the total amount of demand in the economy was falling. As demand fell, firms produced less, so they reduced their workforce. The unemployed had less to spend, leading to further falls in demand, and so on. This process had been dampened by cutting interest rates to the floor, but even with that monetary stimulus there was just too much saving and not enough demand in the economy, leading to falling output and rising unemployment. Unemployment, as well as being harmful to the individuals concerned, is a waste of resources: the unemployed could be producing goods and services that they and others could consume.
The last time interest rates across the globe fell almost to zero, and still the economy continued to decline, was in the Great Depression of the 1930s. Economists call this situation a ‘liquidity trap’. The big problem in a liquidity trap is that interest rates cannot become negative because everyone would just take their money out of the bank and hold cash. Keynes argued following the experience of the Great Depression that in a situation of this kind governments should attempt to replace the missing demand, either by increasing their own spending, or by cutting taxes so consumers have more money. Keynes’s idea, revolutionary when he put it forward in the 1930s, became received wisdom after the Second World War. Although for a number of reasons varying interest rates became the preferred means of managing demand, macroeconomists knew that fiscal stimulus was also available if needed. Economics students have been taught this for more than half a century. In 2009 governments acted on that understanding.
This policy nevertheless had strong opponents. In the US Obama’s stimulus package was opposed by the Republicans, and in the UK the Conservatives objected to Labour’s measures. They focused on the rising budget deficit caused by the recession, which any fiscal stimulus would only increase. A recession always raises the government’s budget deficit for the simple reason that in a recession taxes fall and unemployment benefits rise. The government then has to bridge the gap between its higher spending and lower income by additional borrowing. The bigger the recession, the larger the deficit.
A sharp increase in government borrowing sounds bad. Opponents of fiscal stimulus like to invoke comparisons between individuals and governments. Most individuals are rightly cautious about borrowing, although many do so – for example, to buy a house. A firm may borrow to help fund an investment project. Government borrowing in a recession is neither buying an asset nor funding investment, so isn’t it common sense that it should be brought to an end as soon as possible? The view of nearly all economists is that the analogy between individual and government borrowing breaks down at this point. The name they give the process by which deficits rise in a recession – the ‘automatic stabiliser’ – itself explains why they think this way. If a recession is caused by consumers saving more and spending less, which in 2009 it was, then the fact that consumers are paying less in taxes and the unemployed are getting welfare benefits is a good thing, because it supports consumer incomes. If governments turn off the automatic stabilisers by cutting spending or raising taxes, they will reduce the income of consumers, who will spend even less, making the recession worse. Just as a fiscal stimulus helps in a recession, a fiscal contraction designed to reduce the deficit will make the recession worse.
Shouldn’t we still be concerned that the government is borrowing more? When the government borrows more it sells its own debt (often called ‘gilts’), mainly to financial institutions including banks. To sell more debt, won’t governments be forced to raise the interest rate on this debt to make it more attractive? That was one of the arguments put forward by those who opposed fiscal stimulus in 2009 even though the standard macroeconomic analysis developed since Keynes suggested this would not happen. Think for a moment about the market for government debt as if it were an isolated market. The supply of that debt is rising because of larger budget deficits, but the demand for debt is also increasing because financial institutions have more funds to invest since the private sector is saving more, which is the reason we have a recession in the first place. In reality financial markets are highly interconnected, so the main influence on long-term interest rates such as the interest rate on government debt is expectations about future short-term rates. For example, at the beginning of this year, interest rates on French government debt were about half those on UK debt, because the markets expected short-term interest rates to remain lower in the Eurozone for longer. In 2009, short-term interest rates were near zero as a result of the recession and likely to stay there for some time; many economists argued that large deficits would not, therefore, increase interest rates on government debt.
In 2010, after the fiscal stimulus and rising budget deficits of the year before, everything changed. In the UK, the Conservatives – who had opposed fiscal stimulus – entered government as the majority party in the coalition. George Osborne took charge of the UK economy. The coalition’s minority partner, the Liberal Democrats, had opposed the Conservatives’ harsh austerity plan during the run-up to the election, but signed up to Osborne’s proposals in the coalition negotiations. What I suspect changed their mind was the global macroeconomic event of 2010: the Greek debt crisis.
The trigger here was a report issued by Greece’s newly elected government revealing what the previous government had concealed – namely, the amount of borrowing it had been doing. Now the markets began to doubt that Greece would be able to repay what it had borrowed. Greece was forced to offer higher interest rates to attract lenders, which made its future budgetary position even worse; and the higher interest rates went, the more concerned the markets became – it was a vicious circle. The conventional macroeconomic model, according to which the interest rates on government debt need not rise when borrowing increases, appeared dramatically wrong because it had ignored the possibility of default.
Eurozone leaders tried to avoid a Greek default, but their efforts proved counterproductive, and the markets started to worry about the budgetary position of other peripheral Eurozone countries. For a moment there was no knowing where the panic might strike next and it looked as though those who had argued against fiscal stimulus because of its impact on government borrowing had been vindicated. International opinion changed and the IMF moved from supporting fiscal stimulus to supporting austerity.
In his ‘emergency’ budget of June 2010, Osborne announced a permanent increase in VAT along with additional spending cuts. His aim was to eliminate the government’s current deficit by 2015. Since the current deficit excluded public investment, investment could have been kept high for a few years to help protect any recovery, but this too was cut back sharply. To take just two examples, building programmes at more than seven hundred schools were scrapped that year, and the following year capital expenditure to prevent flooding was cut. UK austerity had begun. Labour continued to argue that Osborne was cutting ‘too far, too fast’, but the argument gained no traction when the headlines were all about Eurozone countries trying to appease the markets by undertaking more and more austerity. The argument that the UK should do the same, to ‘avoid becoming like Greece’, was treated as if it was self-evident.
What about the problem that austerity would make the recession worse? Supporters of austerity put forward two counter-arguments. First, the prospect of a rising government deficit would worry consumers and firms so much that they would spend less as a result; if the government reduced the deficit, the confidence of the private sector would be restored, and it would start spending more. In other words fiscal austerity – cutting government spending or raising taxes – would help stimulate the economy. This flips conventional macroeconomic logic on its head; Paul Krugman dismissed it as believing in the ‘confidence fairy’.
The second argument was that austerity wouldn’t make the recession worse because of the new policy of quantitative easing. The aim there was to put downward pressure on long-term interest rates and upward pressure on prices in the stock market. Lower long-term interest rates and higher stock prices might then encourage additional spending. A key feature of QE is that the policy can be reversed: the central bank can sell back the assets, thereby reducing the money supply. This was important because once the hoped-for recovery was complete there might be too much money in the system, which could lead to inflation. It’s the reason central banks prefer QE to just giving the newly created money to consumers, which is sometimes called ‘helicopter money’. Helicopter money is a more effective way of stimulating demand, but it can’t be undone later.
The effectiveness of QE is still hotly debated among economists. I noted earlier that financial markets are highly interconnected. Although the UK and US central banks bought a large quantity of assets (mainly government debt), the amount was still small compared to the size of the market as a whole. In 2009 the UK and US governments were happy for their central banks to try QE, but because they were unsure what its effect would be, they wanted to use fiscal stimulus along with it. Some opponents of fiscal stimulus were more confident that QE alone would be enough to end the recession.
In 2010, the world switched from fiscal stimulus to austerity; in 2011, doubts about the switch began to emerge. The Eurozone crisis had continued, despite the sharp austerity enacted across the region and the tougher fiscal rules that Eurozone countries were now required to follow. Yet the market panic over levels of government debt remained confined to the Eurozone. In contrast, interest rates on government debt in almost every advanced country outside the Eurozone fell to record lows. Paul De Grauwe of the LSE suggested a very simple explanation for this: Eurozone government debt was uniquely risky.
Imagine you were an investor in 2010, trying to decide whether to buy government debt. If you were sure you’d get your money back, you would have settled for pretty low interest rates, because short-term interest rates were expected to remain low for some time. However, if the government defaulted on its debt you could lose some or all of your investment. There were two reasons a Eurozone government might default. First, it might choose to, because the burden of paying interest on its debt had become too high; second, it might be forced to, because it couldn’t find anyone in the market prepared to buy its debt. So as an investor, you needed to worry not just about the government’s intentions regarding default, but also about what other people in the market thought. Even if you guessed correctly that the government wouldn’t choose to default, it could be forced into default anyway and you’d still lose your money.
In a country like the UK, this second form of risk doesn’t arise. The government would never run out of money, as the Bank of England could always create more by buying the debt itself. This is exactly what the QE programme was doing. However, in 2010 and 2011 the Eurozone’s central bank, the ECB, refused to act as a ‘lender of last resort’ for governments. This is the reason the debt crisis was affecting only Eurozone countries. The conventional macroeconomic view that higher deficits wouldn’t lead to rising interest rates was correct for countries with their own central bank, but incorrect, given ECB policy, for Eurozone economies. The implication was that countries outside the Eurozone had been wrong to panic in 2010, wrong to have replaced fiscal stimulus with austerity.
In 2011 this was only a theory, though a pretty convincing one; in 2012, it was proved correct. As the Eurozone crisis continued, in September 2012 the ECB was forced to change its mind: it offered to become a lender of last resort through its Outright Monetary Transactions programme. This had an immediate impact, and interest rates on Eurozone government debt started falling substantially. Conventional macroeconomics was vindicated too by the experience of the previous two years in the UK, which had shown that austerity would indeed harm an economy caught in a liquidity trap. The recovery that had looked possible in 2010 didn’t materialise, and unemployment stayed high. QE, although it was probably having some effect, was not creating enough additional demand, and the confidence fairy was nowhere to be seen. The Office for Budget Responsibility estimates, somewhat conservatively, that austerity took 1 per cent off economic growth in both 2010-11 and 2011-12. It seriously blunted the recovery.
With no prospect of a UK government funding crisis, and the recovery stalled, 2012 was the moment to dispense with austerity. Did this happen? Not according to Osborne: he was sticking to what had come to be called Plan A. The reality was rather different. The chart shows Osborne’s original plan for the progress of the government’s current balance until 2015, along with what actually happened and is now forecast to happen in the next year. The slowdown in the pace of deficit reduction in 2012 is plain to see.
This slowdown was not caused by the government going back on its plans to reduce its spending. Instead it largely reflected disappointing tax receipts, caused in part by an unexpected decline in real wages. Osborne could have stuck to his original deficit reduction plan by raising taxes or cutting spending further. But he chose not to. An honest chancellor would have said that the funding crisis panic of 2010 had passed so the pace of austerity could be slowed. But to do that would have been to admit that austerity was bad for growth, and therefore that Plan A had delayed the recovery. Instead Osborne chose to bluff it out, and insist that his original plan was on track. To do this he needed a compliant media.
‘Mediamacro’ is the term I use to describe macroeconomics as it is portrayed in the majority of the media. Mediamacro has a number of general features. It puts much more emphasis than conventional macroeconomics does on the financial markets, and on the views of participants in those markets. It prefers simple stories to more complex analysis. As part of this, it is fond of analogies between governments and individuals, even when those analogies are generally seen to be false by macroeconomists. So after the 2010 election (and to some extent before it) mediamacro had bought with barely a murmur the view that reducing the government deficit was the top priority. It even bought a second story, which was that the previous Labour government had played a large part in creating the deficit problem in the first place. Like all good myths this was based on a half-truth: before the recession Gordon Brown had been a little less prudent than he should have been: he had been too optimistic about tax receipts, and followed a fiscal rule that allowed his progress in reducing debt in the early years of the Labour government to be reversed in later years. But as the chart shows, the impact of this on the deficit was dwarfed by the influence of the recession, and the recession was the result of a global financial crisis. Despite this, mediamacro allowed the myth of Labour profligacy to go unchallenged.
This was the climate that allowed Osborne to get away with saying in 2012 that he was sticking to his original austerity plan. And it was the climate that let him get away, in 2013, with an even sillier claim. In the UK, 2013 was the year a moderate but sustained recovery finally began. The chancellor announced that this showed his plan was working, and that his critics were wrong. This would have been an extraordinary enough claim even if he had kept to Plan A. A Keynesian analysis of austerity would have predicted a delayed recovery followed by growth, which is what we saw; if positive growth is good even if it has been preceded by stagnation, why not just close down part of the economy for a few years so you can hype the growth that will occur when it starts up again? It was an even more extraordinary claim because the plan had been changed: austerity had largely halted, which gave more room for a recovery. Once again mediamacro largely allowed these claims to go unchallenged; even the Financial Times chimed in with a leader that said Osborne had won the political argument on austerity.
To my mind, the disconnect between mediamacro and macroeconomics as understood by a clear majority of academics was most clearly visible when, last autumn, Ed Miliband gave a speech to the Labour Party Conference in which he forgot to mention the deficit. The media reported this as a huge gaffe: ‘How could you not mention paying off this appalling deficit?’ Jon Snow, not normally thought to be sympathetic to the coalition, asked in an interview with Miliband the following day. ‘Surely it is the most important issue of all. It is the essence of our economic crisis.’ At about the same time the IMF completed an internal evaluation of its policy advice since the beginning of the recession. As I mentioned, it had advocated fiscal expansion in 2009, but switched to recommending austerity in 2010. Unlike mediamacro, it changed its view again in the following years. Here are some key quotes:
The IMF’s call for fiscal expansion and accommodative monetary policies in 2008-9, particularly for large advanced economies and others that had the fiscal space, was appropriate and timely.
IMF advocacy of fiscal consolidation [in 2010] 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 articulating its concerns [in 2010], the IMF was influenced by the fiscal crises in the euro area periphery economies … although their experiences were of limited relevance given their inability to conduct independent monetary policy or borrow in their own currencies.
In other words, the IMF’s move to advocate austerity in 2010 had been a mistake, and that mistake was caused by a misreading of the Eurozone crisis. Its analysis is particularly pertinent to the UK.
In many senses this echoes Labour’s original line that the coalition’s austerity policy was too far, too fast. Yet such is the influence of mediamacro’s alternative view that the Labour Party has abandoned that stance, and now wants to portray itself as being just as tough on the deficit as the coalition. This has led to a ludicrous situation as the election approaches. Respected economists and think tanks agree that there is a large gap between Labour and Tory plans on future austerity. Even under the most conservative interpretation, Labour’s plans involve fewer spending cuts, amounting to 1.5 per cent of GDP per year less than the Tories are proposing. That’s equivalent to half the UK defence budget, every year. Yet the Labour Party itself seems reluctant to acknowledge this fact, because it doesn’t want to appear weak on the deficit.
We have come to a highly paradoxical situation. The position that many policymakers adopted in 2009 – that in a liquidity trap you need fiscal stimulus to help the recovery – seems to have been vindicated. QE hasn’t proved strong or reliable enough to negate the need for fiscal stimulus. In addition, the view, current in 2009, that we should not worry about increasing government debt in the short term, has also proved correct outside the Eurozone. The key point is that deficit reduction should be left until a time when interest rates are high, so that they can be reduced to counteract the negative impact of austerity on demand. When this view was abandoned in favour of austerity, the recovery in the UK and elsewhere was needlessly delayed or restrained. Yet this is not the media’s perception. Mediamacro still sees reducing debt as the number one priority.
The key question, when it comes to Osborne and the coalition, is about motivation. Was the turn to austerity in 2010 an unfortunate mistake caused by an understandable over-reaction to events overseas and an over-optimistic view of the effectiveness of QE? Has the government subsequently refused to acknowledge the mistake simply because, with the help of mediamacro, it thought it could get away with it? The IMF switched to supporting fiscal austerity in 2010 because of its mistaken interpretation of the Eurozone crisis. There are three problems with interpreting Osborne’s behaviour in the same way. First, unlike the IMF, he didn’t support fiscal stimulus even in 2009. Second, public investment was cut back sharply in 2010 and 2011 even though Osborne’s fiscal rule that the current budget must be balanced excludes public investment. Third, he is proposing to renew austerity after the election, even though we remain in a liquidity trap and there are serious risks to the recovery, and despite the fact that there is no sign today (unlike in 2010) of any government funding crisis. It is as if Osborne’s real priority was and still is to cut all forms of government spending, and as if the deficit was, and he hopes will remain, a convenient pretext to achieve that goal. It will be some time before economists settle on a number for the total cost of the austerity mistake, but a conservative estimate would be that, in total, resources worth around 5 per cent of GDP will have been lost for ever by delaying the recovery. That’s about £100 billion, or £1500 for each adult and child in the country.
If any other government department had wasted that amount, there would be a huge outcry from the media. Yet when it comes to macroeconomics, the media seems to play by different rules. It continues to misrepresent economic ideas even though it has access to academic expertise. Why is this? It’s true that economists will always disagree, and there are some academic economists who will faithfully stick to a party political line. But there can be no doubt that at key points a clear majority of academic macroeconomists would dissent from mediamacro. For example, less than 20 per cent of academic economists surveyed by the Financial Times thought that the recovery of 2013 vindicated austerity, yet the paper’s leader took the line that it had. Part of the explanation, I think, is that we have a particular problem with macroeconomics, which is the influence of economists working in the City. There are some wise and experienced City economists, but there are also many with limited expertise and sometimes fanciful views. Their main job is to keep their firm’s clients happy, and perhaps to help traders improve their predictions of what might happen in the markets in the next few days. Their views tend to reflect the economic arguments of those on the right: regulation is bad, top rates of tax should be low, the state is too large, and budget deficits are a serious and immediate concern. And part of their job is publicity, so they are readily available when the media needs a reaction or a quick interview. There is obvious self-interest here: the more market reaction is thought to be important, the more the media will want to talk to City economists.
Of course it is also the case that large sections of the print media have a political agenda. Unfortunately the remaining part, too, often seeks expertise among City economists who have a set of views and interests that do not reflect the profession as a whole. This can lead to a disconnect between macroeconomics as portrayed in the media and the macroeconomics taught in universities. In the case of UK austerity, it has allowed the media to portray the reduction of the government’s budget deficit as the overriding macroeconomic priority, when in reality that policy has done and may continue to do considerable harm.