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Wednesday 28 March 2012

Austerity doesn't work - in the short or long term

The Dangers of Austerity

The main economic argument behind George's Osborne's policy of austerity is that although it will involve some short-term and medium-term pain, it will restore our fiscal credibility with rating agencies and shrink the size of our public debt in the long-term. He believes that by sticking to his rigid economic plan, it will set our economy on the path to recovery.

In my previous post, I set about to disprove the Chancellor's argument that his policies are the only way for the British economy to recover and that there is in fact a better way to kick-start the economy. A recent presentation by J. Bradford DeLong and Lawrence. H Summers goes even further and suggests that the implementation of austerity in a depressed economy may worsen that country's long-run fiscal position. Furthermore, the crux of the argument made by both DeLong and Summers is that:

...while the conventional wisdom rejecting discretionary fiscal policy is appropriate in normal times, discretionary fiscal policy where there is room to pursue it has a major role to play in the context of severe downturns that take place in the aftermath of financial crises.    
This means that the course of action that the Chancellor has chosen to pursue will have huge ramifications on our economy, more so than if he were residing over a period of sterile economic growth. George Osborne has tried to portray Keynesian fiscal expansion as reckless and lacking in economic credibility.


Stimulus helps short and long term recovery and pays for itself


Yet DeLong and Summers demonstrate how such a policy is in fact self-financing:

A very simple calculation conveys the major message of this paper: A combination of low real U.S. Treasury borrowing rates, positive fiscal multiplier effects, and modest hysteresis effects is sufficient to render fiscal expansion self-financing.   
Although they are applying this to the U.S. economy, its logic could apply equally to the U.K. economy or any other European economy. Through the use of a detailed hypothetical example (which is well worth reading) DeLong and Summers demonstrate how 'a transitory increase in government spending' can eventually be self-financing thanks to, among other things, the outrageously low interest rates that the government would be borrowing money at during depressed economic conditions.

This means that George Osborne has it the wrong way round. A well thought out stimulus package for the British economy would be self-financing as well as providing the economy with both short-term and long-term growth. And although the government's borrowing would increase significantly in the short term (as it has done in the U.S.), it would pay for itself by the end of the economic cycle.

One can only hope that the Labour party has read this compelling study and will finally be brave enough to put together an ambitious stimulus package that shows that they can offer an entirely different (and fiscally credible) vision for the British economy.

Busting the 'private sector will stimulate growth' myth

Another one of George Osborne's often repeated mantras is brought into question by the presentation: the idea that as the public sector contracts because of the need to cut public spending, the private sector will make up for the shortfall in spending:

One channel through which an economic downturn casts a shadow on the future and reduces future potential output is through private investment. The financial crisis that began in 2008 brought a sharp fall in fixed investment in the American economy, especially in residential construction, from its trend average level of 16.5% of potential output to a post-2008 average of 12.5% of potential output, for a cumulative shortfall to date of 14% point-years of GDP less of cumulative investment than pre-2008 trends projected. This shortfall has two origins. The first comes from the financial stringency of the crisis. The second arises because it is hard to see why a firm would ever focus on building out its capacity rapidly if it already possessed substantial slack.

Even if the economy quickly recovers to its productive potential going forward, that productive potential will be lower because of the investment shortfall of the past 3.5 years.
Our Chancellor appears to think that by cutting the top rate of income tax and the basic rate of corporation tax, that these tax cuts will somehow lead to a 'quick fix' for the British economy as it will stimulate spending by the private sector. But given how badly burnt many companies were during the recession, there is an excellent chance that they will choose to save this extra sum of money rather than spending it.

Another problem with cutting corporation tax is that it only helps private companies who are making a profit, whereas there are tens of thousands of British companies who are not making a single penny of profit and would have benefited from a cut in V.A.T. instead - but that is a story for another article.

What is clear though, is that it is incorrect and even unfair to rely on the private sector to engineer an economic recovery, particularly given the appalling economic conditions many companies find themselves in. Those in retail, for example, are calling this February and March the worst trading periods they have seen in decades, as Osborne's cuts, which are starting to kick in, severely affect consumer confidence.

Austerity will bite for decades to come

The presentation goes onto make a connection between long-term unemployment and long cyclical depressions - as DeLong and Summers bring Europe into the discussion:


The case that high European unemployment in the 1980s and 1990s was a result of a long cyclical depression starting in the late 1970s is quite strong.
Which makes Osborne's decision to prioritise the cutting of government spending over tackling unemployment one of the most reckless decisions of this Coalition government. The latest budget did not provide a single measure to tackle unemployment on an ambitious enough scale.

It would be unfair to only level this accusation at this particular government, as the problem is rife across Europe. Europe's reckless austerity measures are in danger in creating a lost generation of youngsters.



Conclusion


As Paul Krugman pointed out a month ago, many anti-Keynesianists are back tracking on their once loud calls for austerity:


Niall Ferguson now says,
I think the issue here got a little confused, because Krugman wanted to portray me as a proponent of instant austerity, which I never was. My argument was that over ten years you have to have some credible plan to get back to fiscal balance because at some point you lose your credibility because on the present path, Congressional Budget Office figures make it clear, with every year the share of Federal tax revenues going to interest payments rises, there is a point after which it’s no longer credible. But I didn’t think that point was going to be this year or next year.
What he said then:
After all, $1.75 trillion is an awful lot of freshly minted treasuries to land on the bond market at a time of recession, and I still don’t quite know who is going to buy them. It’s certainly not going to be the Chinese. That worked fine in the good times, but what I call “Chimerica,” the marriage between China and America, is coming to an end. Maybe it’s going to end in a messy divorce.
No, the problem is that only the Fed can buy these freshly minted treasuries, and there is going to be, I predict, in the weeks and months ahead, a very painful tug-of-war between our monetary policy and our fiscal policy as the markets realize just what a vast quantity of bonds are going to have to be absorbed by the financial system this year. That will tend to drive the price of the bonds down, and drive up interest rates, which will also have an effect on mortgage rates—the precise opposite of what Ben Bernanke is trying to achieve at the Fed.

If only our Chancellor would realise the error of his ways, as other anti-Keynesianists have too.

It is a shame that while the news has been flooded with Cash for Cameron and the latest News International revelations, that this important presentation has been widely ignored as it disproves many of the central principles at the heart of George Osborne's misguided policy of austerity.

1 comment:

  1. According to Keynesian economics one should put money away in the boom times in order to provide a stimulus in a recession. Unfortunately Brown didn't follow Keynes' advice and went on borrowing and spending in the good times in his mad rush to get everyone in the UK dependent on the state. Keynes' theories assume that you are starting the policy at the start of boom or with money in the bank. Unfortunately for Gideon, and thanks to 13 years of Labour mismanagement of the economy, that wasn't the case. He took over during a recession with nigh on £1trillion in IOUs. All in all he is making a slightly better job of it than Labour. The mistake he made was not wresting monetary policy back from the Bank of England.

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