Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 24 April 2015

Mediamacro myth 4: The immediate necessity of belt tightening

In previous posts in this series (0, 1, 2, 3) we have established that the large increase in the deficit in 2010 was a consequence of the recession and not Labour profligacy - the Labour government was clearly not profligate - and that this deficit was not causing any panic in the financial markets. But surely it is a good idea for the government to tighten its belt when it runs a large deficit, just as individuals who spend more than they earn need to take action? Mediamacro is fond of drawing this analogy.

The first point to clear out of the way is that individuals do not always try and ‘balance their books’. People generally spend more around Christmas, and make up any deficit through the rest of the year. You can think about deficits and surpluses that are just the result of the normal economic cycle in a similar way.

As the 2010 deficit was a consequence of the recession, can we therefore assume that it will correct itself as the economy recovers? The answer depends on the extent of the recovery. If we returned to the pre-recession trend level of output then roughly yes [1], but not many economists think that is likely. Instead organisations like the OBR assume that much of the impact of the recession on output will be permanent. We can call the additional deficit that arises from this permanent loss of output ‘structural’. The structural deficit will not go away without some government action.

A good rule for an individual with a ‘structural deficit’ is to take action to correct it sooner rather than later, particularly if there are limits to their ability to borrow. Our mediamacro myth is that the same applies to governments: the 'maxing out the national credit card' idea. This is something that every economics student learns is wrong in the first year of their studies. Cutting the government’s deficit reduces aggregate demand, which reduces output. An individual that cuts their spending does not need to worry about the impact their decision will have on the rest of the economy, but the government because it is so large does have to think about this. When the government is free to borrow more at no extra cost (which we have seen that in the UK it was), then it has an important choice about when to start reducing its deficit.

Is there ever a good time to reduce the deficit, if output will always take a hit? There are two reasons why some times are much better than others. First, there is now quite a lot of evidence that cutting deficits in a recession has a larger impact on output than cutting deficits at other times (see here and here). Second, theory tells us that cutting deficits need not in principle harm the economy at all if monetary policy can offset their deflationary impact. If the Bank of England can cut interest rates at the same time as the government cuts its spending, the net effect on the economy could be zero.

This is a crucial point. Indeed it is the half-truth on which the coalition’s policy of immediate austerity seems to have been based. Modern mainstream macroeconomics says that in normal times governments do not need to worry about the impact their fiscal decisions (like austerity) will have on the economy, because monetary policy will offset that impact. In a speech to the RSA in 2009 this was the idea that the future Chancellor put at the centre of his macro strategy.

There was only one problem, which turned out to be extremely serious. Just before he made that speech, UK short term interest rates hit 0.5%, and the Bank of England decided they could be cut no further. They had reached what economists call the ‘Zero Lower Bound’, sometimes described as a liquidity trap. As a result conventional monetary policy was unable to offset the deflationary impact of austerity, and 2010 austerity killed the recovery that seemed to have just started. We had to wait until 2013 for a period of sustained output growth. The Bank did have some unconventional policies that it tried - most notably Quantitative Easing - but as it had no idea how effective these were, they were hardly an adequate substitute for cuts in interest rates.

Was the problem of nominal interest rates hitting a floor and therefore not being able to offset the impact of fiscal austerity on output something economists had not foreseen? Is that why the Chancellor ignored this possibility in his 2009 speech? Far from it! Keynes had dealt with the problem in the Great Depression in the 1930s. More recently, the same problem had arisen in Japan in the 1990s. By 2009 a large number of articles had been written about this problem, which is why economists like Paul Krugman and myself were such strong critics of fiscal austerity the moment it was proposed.   

Most mediamacro myths in this series just need a look at the data and common sense to bust. In those cases it is natural to look at the media itself for the source of the mediamacro problem. In this particular case busting the myth requires some (entirely conventional) macroeconomics. The fact that this macroeconomics has not found its way into political discussion of fiscal policy may reflect other problems in the knowledge transmission mechanism, including the fact that outside the US central banks seem very reluctant to acknowledge the severity of the Zero Lower Bound/liquidity trap problem.

It is difficult to overstate the consequences of this. As we have seen, the prospective Chancellor in a 2009 speech setting out the theoretical framework behind his policy ignored the problem, even though it was in front of his eyes. Each household in this country lost on average at least £4000 as a result. Yet incredibly, the same person proposes to make exactly the same mistake after 2015, and it is largely left to a few academic bloggers to point this out.
Previous posts in this series

[1] Not a complete yes, because although the deficits caused by this kind of recession would be temporary, they will have raised the level of debt, and the interest on that debt will add to future deficits. We can only ignore that if we soon expect a future boom of equal magnitude, which would be an unwise thing to do. 


  1. I am enjoying this series. I'm one of the general readers you are aiming at, (and I don't always understand every post on your blog), but you are hitting the mark with these. It would be helpful if you could tag all the posts in this series with the same unique identifier. It would help me share them on twitter etc.

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  3. Good reading, many of the waters at present are uncharted, some of those charted need care. I explained all this yesterday, Thursday, in "Budget Planning"

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  6. You should just be Yanis

  7. I would argue that the Fed in the US isn't really taking the zero lower bound issue very seriously either. Janet Yellen, the current chair of the Fed and known as being a dove (in favor of higher inflation), recently put out an article where she explicitly states that she's significantly more worried about inflation getting to high than too low. There is zero discussion about raising the inflation target, which is probably the best tool a central bank has to prevent hitting the zero lower bound in the future.

  8. I learnt this as part of my MBA. Can someone explain to me if cutting is bad in terms of the circular flow of income and its basic stuff. Why are they doing it? Who is this benefitting? Is it just for votes?

  9. "The structural deficit will not go away without some government action."
    You really need to learn sectoral balances - look it up.
    A structural surplus is *impossible* in the UK. Do you hear me Simon?
    When the govt spends, 100% will come back in taxes except the amount saved. It is spent and respect and portions of the money come off as taxes on various transactions. Foreigners like saving in £ assets (we have a large CAD) and UK private sector needs to pay down debt (net save.)

  10. Here:
    May I add, the myth is not "immediate necessary" it was NEVER necessary. Inflation is not excessive in the UK.


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