Why did Osborne not try to protect the recovery in 2010?

I see that George Osborne is giving the RES lecture this year. This post might be useful background, just in case what he says goes beyond simplistic electioneering of the '0.5% inflation is welcome news' kind. 

In an earlier post I outlined how a credible austerity plan could have been enacted in such a way as to protect the recovery. This is not what I would have done. We needed fiscal stimulus not austerity in 2010, and the threat from the financial markets was non-existent. However some have difficulty accepting this last point, so what I tried to show in that post was that a worry about the financial markets did not excuse the coalition’s actions.

In particular I noted that public investment could have stayed high, but instead was immediately cut back, even though there was no necessity to do so because it was not part of the coalition’s primary fiscal mandate. According to the OBR net public investment was 3.3% of GDP in 2009, but only 1.9% by 2011. A total multiplier of 1.5 for public investment is quite plausible, so that alone could account for around 3% less GDP. Good projects, like flood defences or school renovation, that were ready to go were instead cut back

Was this just a random (but very costly) mistake, or was there some logic behind it? Osborne has repeatedly talked about monetary activism. In September 2009 he said:

“Monetary activism to keep interest rates low and stimulate the economy. Fiscal responsibility to restore confidence and rebuild our battered public finances.”

It is of course true that this assignment does indeed reflect the academic consensus, as long as interest rates are not at or close to the Zero Lower Bound (ZLB). At the ZLB you have Quantitative Easing (QE), but QE is just not reliable in its impact on demand, so it does not make the ZLB problem go away.  

Osborne or his advisors knew this. UK interest rates hit their ZLB in March 2009. Here is a key excerpt from Osborne’s 2009 RSA speech, made shortly afterwards:

“[New Keynesian] Models of this kind underpin our whole macroeconomic policy framework – in particular the idea that by using monetary policy to manage demand and control inflation you can keep unemployment low and stable. And they underpinned the argument David Cameron and I advanced last autumn – that monetary policy should bear the strain of stimulating demand….”

Now if it is true that New Keynesian models underpinned their macroeconomic framework, they should have also known that the Zero Lower Bound (ZLB) problem is a big deal in those models. Furthermore in basic New Keynesian models QE does nothing. In these models there are ways of mitigating the ZLB problem, but they involve departures from the inflation target, and Osborne has never shown any interest in doing that.

In his Mais lecture of February 2010 he acknowledges the arguments of those that said fiscal consolidation should wait until the recovery was assured. Here is a key passage:

“To be fair, a more sophisticated version of the argument for delay also takes into account the complex interaction between fiscal policy and monetary conditions. It says that at the moment, and for as long as policy and market interest rates remain low, fiscal tightening should be as gradual as possible because there is little scope for more accommodating monetary conditions to accompany it, either through lower market interest rates or through the reaction function of the Bank of England. And only as and when monetary conditions begin to tighten can the pace of fiscal consolidation be accelerated.

But even this, more nuanced, version of the case for delay is too complacent. For it brings me to the second consideration: the realities of financial markets.”

So there is no attempt to dispute the validity of the ZLB problem. No attempt to argue that with QE the ZLB problem was not real. Instead the argument is that there is a still greater danger, which is that the markets might suddenly lose confidence in UK government debt.  

This suggests to me that Osborne, and the coalition more generally, never really believed in the position that QE alone could deal with the ZLB problem. Taking that position would rationalise what they did – in particular cutting public investment was fine in macro terms because the hit to GDP would be compensated for by more QE. However if that was the case, you might have expected to see that position explicitly stated, and as far as I am aware it has not been.

Instead I think we are being too sophisticated in trying to find a macroeconomic rationale for coalition actions. For what it is worth, I think policy was based on two political, not economic, imperatives. The first was to reduce the size of the state, and the deficit was always a pretext for that. Here he was just copying his US cousins. As a result public investment as well as consumption had to be cut even though this was not part of his main fiscal rule. Second, austerity could not be back loaded, even though that would have made macroeconomic sense, because that would mean doing unpopular things just before an election. As a result public investment had to be cut quickly rather than kept high to protect the recovery.

Under this interpretation, Osborne did what he did for essentially political or ideological motives, and just ignored the risk of potential costs that then came to pass. This is not to suggest that he intended to waste almost £100 billion, but just that he did not give sufficient regard to that possibility. As he lost every adult and child in this country something in the order of £1500 each, he deserves full censure. He certainly does not deserve a reputation for economic competence, unless you are mediamacro and equate competence with deficit cutting. 

What does not seem plausible is that his actions were designed to prevent the financial markets believing the UK would default. If you are still not convinced of this, consider one final, almost bizarre, piece of evidence. He plans if re-elected to pursue almost the same policy again (austerity in the early years of the government) while UK interest rates are at (or at best close to) the ZLB, and when there is not even the hint of any funding crisis for UK government debt. Here is Tony Yates on the folly of this strategy.

Thus those who suggest that the coalition had to undertake 2010 austerity to appease the markets are thrice wrong. First, the UK was never going to default and the markets knew it. Second, if that had been Osborne’s concern he could have designed a much more recovery friendly plan. Third, it now seems clear that he never undertook 2010 austerity for that reason. In the UK, as elsewhere, fiscal austerity justified by an imperative need to reduce the deficit was and remains a massive confidence trick.