LSE blog questions UK budgetary policy

From late March to late May 2010 the LSE’s Election Experts blog provided a forum for LSE experts (and others) to discuss evidence relating to the themes of the general election. Following the success of that temporary initiative, the LSE has now established a permanent facility called British Politics and Policy at LSE.1 The key aim is still to make available serious social science analysis in an accessible and highly relevant way. In a recent blog, John Van Reenen argues that the UK Chancellor of the Exchequer’s recent austerity budget risks causing serious damage to the UK economy. This critical interpretation joins two other recent comments by Joe Stiglitz in The Independent2 and Victoria Chick and Ann Pettifor.3 This article reviews those criticisms. Responses from readers for future publication would be welcome.

Other items related to this theme, published in the Newsletter, include:
Are we suffering from deficit fetishism? (April 2011)
Debating austerity measures (July 2011)
Surely you're joking, Mr Keynes ( October 2011)
Fiscal stimulus imrpoves solvency in a depressed economy (April 2012)
Understanding the crisis: clarity on measurement, clarity on policy (April 2012)
In partial defence of austerity (October 2012)

In his recent blog ‘Extreme austerity is the wrong medicine’, the Director of LSE’s Centre for Economic Performance, John Van Reenen, says that ‘increasing numbers of liberal economists are gravely worried that the UK has made a wrong turn in choosing an austerity budget’. The use of the term ‘increasing’ here is significant, as maybe is the date. The blog was posted on 28 June while the article by Victoria Chick and Ann Pettifor, ‘The Economic Consequences of Mr Osborne’, was published on 6th June. Chick and Pettifor express alarm at the overwhelming political consensus, ‘parroted each day by the BBC’s economic correspondents...’ that ’slashing the deficit’ is a national priority. As this Newsletter went to press (4th July), it was clear that opposition to certain aspects of the budget (the rise in VAT, the overall regressive nature of the package) was growing amongst some political groups, but even so the lack of comment by economists (present company plus David Blanchflower excepted) about its overall macroeconomic impact remains striking.4 Within the last week the UK (and other) stock markets have fallen by roughly ten per cent in response to a succession of gloomy economic news relating to the US and Chinese economies as well as the precarious state of the european banking system. In these circumstance, Van Reenen may well be right and the situation about to change.

The starting point for all three of these critical comments is the effect on aggregate demand of large scale reductions in public spending (and rather smaller increases in taxation) and the danger of pushing the UK economy into the second part of a double dip recession. Part of the argument is about timing. The UK economy is barely staggering out of the recession that the large increase in public spending under Labour was designed to mitigate. Labour itself, as Van Reenen points out, was already committed to bringing down the deficit by £73bn in 2014/15. The Osborne budget adds a further £40bn to that consolidation.At the recent G20 summit this enthusiasm placed the UK government at one extreme with President Obama at the other — arguing for caution on the part of European governments threatening to engage in a competition for the wearing of the hairiest shirt.

All three articles point out that we have been here before. During the 1930s the UK Treasury argued that balanced budgets were the best way to encourage recovery. In fact, although none of the articles actually cites the incident, the parallels with the 1930s are closer than we might imagine. In May 1931, the then Labour Government, faced with a growing budget deficit and warnings of an imminent loss of confidence in sterling (then fixed at £1 to $4.87), set up a committee under Sir George May to make recommendations to stabilise the deteriorating fiscal position. When it was published in July 1931, the May Report recommended increases in taxation and cuts in spending in the proportion of one to four, uncannily close to the ‘Osborne ratio’. Keynes is reported to have decsribed the Report as ‘the most foolish document I ever had the misfortune to read’5 and, when Parliament finally implemented the recommendations in September 1931 he described the steps as ‘the most wrong and foolish things that Parliament has deliberately perpetrated in my lifetime’.6

The arguments

Although the message of all three articles is very similar, there are interesting contrasts in the nature of the argument. Van Reenan, for example, takes it for granted that a sharp reduction in aggregate demand must have real negative effects and that these will not be compensated by any significant ‘crowding in’. Hence the article attacks a set of propositions which, he claims, are used as the basis to justify the policy:

• ‘Mervyn King to the rescue’
In other words a tightening of fiscal policy will enable the Bank of England to loosen monetary policy. This is unlikely according to Van Reenan, given the zero lower bound problem and the modest impact of quantitative easing.

• The markets insist
This is the argument that investors will reject UK government debt forcing up the cost of long-term interest rates but, as Van Reenen (and others) point out, the UK has had higher debt:GDP ratios in the past without a buyers’ strike, the average maturity of UK debt is comparatively long (unlike Greece, for example) and UK governments have a good record on honouring their obligations (though not quite perfect as Van Reenen claims). Furthermore, markets do not seem to have been unduly impressed by the budget. ‘...the argument that we should adopt policies that are objectively bad for the real economy because financial markets might reward us is wrong in both theory and practice’.

• Labour’s consolidation relied too much on tax increases
Under Labour’s proposals, tax increases would have made up 29 per cent of the deficit reduction. Osborne has decreased this to 26 per cent. This is trivial especially when compared with the much larger consolidation. Furthermore, we now know that the additional austerity is likely to fall disproportionately on the poor.

The Chick-Pettifor paper is overwhelmingly an examination of the historical evidence in which periods of fiscal ‘consolidation’ and ‘expansion’ are examined for their effect on the debt ratio and other variables:

Spending figures are shown alongside outcomes for public debt, interest rates, unemployment, GDP and prices. Outcomes are seen as running almost entirely contrary to conventional wisdom, or at least contrary to thinking derived from microeconomic considerations: fiscal consolidation increases rather than reduces the level of public debt as a share of GDP and is in general associated with adverse macroeconomic conditions. The exception was the consolidation after World War II. (p.1)

The following table summarises the findings:


More succinctly, as public expenditure rises, the debt/GDP ratio falls. The paper quotes the following relationship (derived from the full data set):

with an R2 of 0.98.7

Section 3 of the paper provides an analysis of the individual episodes in which the links to other variables can be seen. For, example, the periods 1947-75 and 1976-2009 are brought together as ‘The long expansion’, the break being caused by the IMF loan which the authors claim marked a decisive shift in macroeconomic policy towards a more restrictive stance. The outcomes, pre- and post-IMF are shown in their table 3G.3.

The lower growth rate in public spending and the real economy, as well as the higher real interest rates and growth of the debt ratio are obvious in the post-IMF period.

While the Chick-Pettifor paper draws on the historical record as a warning of Osborne’s folly, Stiglitz is more concerned with cross section evidence. The starting point is essentially the same as that of the other critics. The rapid fiscal consolidation ‘...will make Britain’s recovery from recession longer, slower and harder than it needs to be. The rise in VAT could even tip us into a double dip recession’.8 Describing the scale of retrenchment as ‘Hooverite’ (the US alternative to the ‘Treasury View’), Stiglitz draws his warnings from the recent experiences of Korea, Thailand, Indonesia Argentina and, most relevant of all, Japan, whose recovery in 1997 was thrown off the rails by a rise in VAT.

Of the three critical pieces, Stiglitz is strongest on recommendations, these include a major redirection of spending:

• Major cuts in military expenditure
• Reduce oil and other subsidies
• Increase spending on research and development
• Increase spending on education and on infrastructure

Furthermore, the tax system needs to be restructured with a large increase in capital gains tax.

Unlike the other two papers, Stiglitz explains the current uncritical support for deficit reductions by reference to what is perceived in the USA as the failure of fiscal stimulus to boost the economy after the banking crash. But this, says Stigltz was because the stimulus was not big enough and much of it took the form of beneficial finance for the wrong banks, with the result that additional lending was not forthcoming and the economy has struggled to restart. ‘Instead of producing a consensus that the government should have done more, it has created disillusion that the government can do anything’.

The final suggestion, still focused on banks, is that governments should set up their own banks to restart lending to businesses and households. he notes that some US$700bn was given to US banks. Taking just US$100bn and leveraging that by a factor of 10 from the private sector would create a bank with a trillion-dollar lending capacity: more than enough for a fraction of the bail-out.

Given that the authors are all dismissive of any possible economic logic to support the Osborne package, one might expect them to offer an alternative rationale. In Chick and Pettifor, that is left largely to the reader, but Stiglitz is in no doubt, ‘...politicians like George Osborne are driven by ideology; the national deficit is an excuse to shrink the state because that is what he wanted anyway’.

Van Reenen suspects something similar: ‘...there may be the simple ideology that having a state smaller than it was under Mrs. Thatcher is desirable’ but argues that this is something about which we should have an explicit and open debate. Whether this is the case or not, there are other advantages in taking such draconian steps within weeks of taking office. These include being able to blame any serious contraction in the economy on their Labour predecessors and (as many political commentators have pointed out) getting the pain out of the way as early as possible.

In the January 2009 issue of this Newsletter we talked of the ‘rediscovering of aggregate demand’. This followed an outburst of concern over economists’ (apparent) failure to warn of the crash and a recognition that a major recession was staring the UK in the face and that there was an overwhelming need for a major stimulus to demand. Now, however, we have details of the largest ever planned reduction in demand in the UK (and the prospect of similar, if smaller, reductions throught Europe) and yet with the few exceptions noted here, there is little obvious alarm.. And this cannot be because of the strength of the recovery. On 5th July, under the heading ‘Investors take stock while doubts over recovery grow, the Financial Times listed the following worrying indicators:

• Poor US-household confidence surveys
• Weakening of growth in China and USA
• Disappointing US non-farm payroll figures
• Negative purchasing manager’s surveys
• The S&P 500 down 16 per cent from April
• Rising interbank rates

Of course, events may prove these gloomy predictions wrong and we may laer look back on this extraordinary outburst of austerity as marking a positive turning point in the fortunes of the UK economy. But while we wait, it would be interesting to hear from supporters of this budget why this should be so.

Notes:

1. For further information about the blog go to: http://blogs.lse.ac.uk/politicsandpolicy/?page_id=2

or email the blog administrator, Chris Gilson at: c.h.gilson@lse.ac.uk

2.J Van Reenen, ‘Extreme Austerity is the Wrong Medicine’ http://blogs.lse.ac.uk/politicsandpolicy/?p=3196

3. V Chick and A Pettifor ‘The Economic Consequences of Mr Osborne’, http://www.debtonation.org/

4. This should be interpreted as a refernce to economists commenting on the budget after the details became known. This understates the number of economists opposed to the austerity strategy as a general principle. See for example the letter published in The Guardian on 27th March 2010

5. Quoted in H Dalton, Call Back Yesterday (London: Muller, 1953) p.290

6. D E Moggridge, Maynard Keynes: an economist’s biography (London: Routledge, 1992) p.526

7. This is a regression of contemporaneous variables. It might be interesting to see the effect of introducing lags since fiscal policy presumably takes time to work its effect on GDP

8. Stiglitz’s comments were made in an interview with The Independent newspaper and published on June 27th. The full text can be read at: http://www.independent.co.uk/news/uk/
politics/osbornes-first-budget-its-wrong-wrong-wrong-2011501.html

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