Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday, 9 October 2014

Do we need a crisis to reduce the deficit?

The macroeconomic case for not cutting the deficit straight after a major recession is as watertight as these things get, at least outside of the Eurozone. (It is also true for the Eurozone, but just a bit more complicated, so its easier to just focus on the US and UK in this post.) If you want to bring the government deficit and debt down, you do so when interest rates are free to counter the impact on aggregate demand. As the problems of high government debt are long term there is no urgency for debt reduction, so the problem can wait. The costs of fiscal consolidation in a liquidity trap are large and immediate, as we have experienced to our cost.

Sometimes austerity proponents will admit this basic macroeconomic truth, but say that it ignores the politics. Politics means that it is very difficult for governments to reduce debt during booms, they say. Although it would be nice to wait for interest rates to rise before cutting the deficit, it will not happen if we do, so we have to cut now. Like all good myths, this is based on a half truth: in the 30 years before the recession, debt tended to rise as a share of GDP in most OECD countries. And it always sounds wise to say you cannot trust politicians.

However both the UK and US show that this is not some kind of iron law of politics. In the UK debt came down from over 100% of GDP between the wars to less than 50% of GDP by the mid-1970s, and was lower still before the recession. (Debt was lower before the recession than when Labour came to power in 1997.) US debt also fell sharply after WWII, but rose again under Reagan and Bush, fell under Clinton and then rose again under the other Bush. So the empirical evidence on US and UK debt is not that it is inherently difficult to reduce in booms; it is do not elect Republican presidents.

My reason for returning to this issue was thinking about the post 2015 UK election plans of all three main political parties. As I have outlined before, all involve tight fiscal control - in my opinion tighter than would be prudent from a macroeconomic point of view. This is fully six years after the recession. So it looks like politics is capable of promising fiscal consolidation well after a crisis. Are we meant to believe that if instead of austerity we had had additional fiscal stimulus after the recession, within the framework that Jonathan Portes and I suggest, things would have been quite different by 2015?

[1] It is true that no party is - as yet - telling us exactly how these numbers would be achieved, but this does not mean it will not happen: the Conservatives delivered in 2010, and Labour broadly stuck to its fiscal rules until the recession. The only party to go back on their election promises were the LibDems, who campaigned for less austerity than they ended up delivering.


  1. I guess the secret to reducing the debt is not even to delay the cuts until the economy is doing better, it's just to keep spending and taxation stable while the economy grows. That causes the least harm and is the easiest way politically. But most people, including politicians, are probably unable to think in decades. They just see the period until the next election and the boxes they have to check (Do I look tough on deficits? Did I demonstrate that I can shrink the government?). Ordinary people regard the debt as a solid entity, not as just a number that needs to be put into the context of inflation and size of government.

  2. "Do we need a crisis to reduce the deficit"?
    -As you explain, not we don't.
    But they do need a crisis ( and a fabricated one at that) to shrink the size of the state.
    "You never want a serious crisis to go to waste. And what I mean by that is an opportunity to do things you think you could not do before." Rahm Emanuel

  3. I remember the Tories stopped talking about 'austerity' when their poll rating fell in the months leading up to the 2010 election.

    I also remember the Tories saying no top-down reorganisation of the NHS, then Andrew Lansley being presented as having worked on a reorganisation for a decade.

    As a promise-breaker, that was larger than the LibDems' debacle on tuition fees, but I expect the previous LibDem voters, being better educated than Tory voters on average, as less likely to be swayed by media presentation.

    That the LibDems are more likely to be judged on the evidence of austerity than the Tories is bad luck for the former, but I have little sympathy for a Party which more than Labour or the Tories needs to find the cleanest intellectual way through a problem.

    And behaving like they were picking things up from the 1920s with expansionary austerity right back to its dark age prominence, they get the educated opprobrium they deserve.

  4. Unfortunately 'the electorate' don't seem to believe you or JP or many other eminent economists preferring the 'common sense' of the 'macromedia' and as politicians want to be elected they will pander to these prejudices. For some so doing serves the purpose of shrinking the state but for others it means abandoning their formerly held and expressed beliefs; sacrifices on the altar of political necessity?

  5. I hope an Oxford professor of economics (no names mentioned) won’t mind me setting him the following exam question..:-)

    Aiming for any specific size for the debt or deficit is a barmy objective. The objectives should be, 1, minimising unemployment as far as is consistent with acceptable inflation, and 2, keeping interest on the debt down to inflation or below, i.e. aiming for a zero or negative real rate of interest on the debt. As to the size of the debt and deficit, they are just numbers that come out in the wash.


    1. Why would I lend my money to government when I can be sure that there will be a zero or negative real rate of interest? I would only if it was mandatory and in that case it would be easier to tax my money away.

    2. Is it really your money? Mine has pictures of the queen on it.

    3. Anon,

      At a zero or near zero rate of interest, government debt (i.e. a loan to government) is virtually the same as base money. I.e. £10 notes in your wallet are a form of zero interest loan to government. But there’s a demand for base money, so no harm in meeting that demand. In fact we just HAVE TO meet that demand, else the private sector starts saving to as acquire the stock of base money it wants, and that brings paradox of thrift unemployment.

      As to issuing so much base money that the private sector has to be bribed (i.e. paid interest) not to spend it, I fail to see the point of issuing that excess amount. Hence the 2nd objective I mentioned above, namely keeping interest on government debt around zero.

      Note: the above is very much MMT thinking - assuming we MMTers can actually think..:-)

    4. Why would I prefer a government bond? For liquidity I would use cash, for everything else I would invest in other asset classes or abroad.

    5. Anon,

      You’ll “prefer a government bond” if government pays a sufficiently attractive rate of interest. But to repeat what I said above, I’m not saying a rate of interest well above zero is in the interests of the country as a whole.

  6. From B of E and other sources of stats it appears that we haven't made any meaningful reduction in UK total debt for decades, while debt % to GDP has reduced because of a growing economy.
    As yet I haven't noticed any politician advocating growing the economy as a way of reducing the debt % which they are so fond of quoting as if pure poison for our future. Any debt risk must be compared to the assets held and anticipated income. The level of debt we are collectively responsible for should always be monitored but focusing only on the % sign is not a trait I welcome in the leaders and policy maker of this country. The state derives its income from the economy and a growing economy leads to increasing income to the state. Or have I missed something political dogma.

  7. Dear Sir,

    you write:

    "However both the UK and US show that this is not some kind of iron law of politics."

    I have read this argument before on Paul Krugman's blog. Yet it does not convince me entirely. To me, it seems that government CAN bring down debt in times of great technological innovation. I do not doubt that. The question, however, is if it can bring debt down when innovation slows down and we have secular stagnation or least something that is approaching secular stagnation.

    You see, politicians can reduce debt if there is enough additional wealth (compared to previous years) to throw around to reduce debt AND pay off groups of citizens that have supported their campaign. Yet when growth rates are low, there is less additional "cake" to distribute and it will hardly go to the benefit of future generations.

    Or in short: just because it happened before, there is no guarantee it will happen again. Other than that, I am leaning towards your interpretation here.

  8. “Where will the money come from? The Bank of England printing works at Debden. This is not a joke. Under a paper money system the amount of money in existence is a conscious national decision. Don't talk to me about the money printing excesses of countries like Zimbabwe. Just because you cannot draw a line, it does not mean a line cannot be drawn. Ideally monetary policy should be the first line of defence against both slump and inflation. But with official policy interest rates down to ½ pc, there is not much more that can be done by conventional monetary policy; and tax cuts and public works may be necessary to put the money into circulation.(It goes without saying that in opposite conditions of inflationary pressure public sector surpluses would be required.) So far from being socialistic this analysis was developed in the 1930's and 40's by those who wanted to save the capitalist system. But, as always we are in danger of forgetting everything we have ever learned.“

  9. The topic for discussion is how the UK will after all be able to bring down debt when the grass turns green? Really?! Look out the window, and you will see that the US and the UK will be entering a recession in less than a year's time. So the question under discussion should be, after more than doubling the national debt since 2008, and getting so little bang for the buck, is the UK really going to do the same old when the next recession hits?

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