The austerity winds have changed

OK, back to the usual business. When a recent note to Labour's shadow cabinet on fiscal policy was leaked, the biggest negative reaction appeared to come from critics within Labour’s ranks. As a result I posted this, directly attacking what I called the left’s apologists for austerity. [1]

In that post I said the “rational case for imposing yet more austerity on the UK has all but disappeared”. Let me expand on that here. First, let’s look at other countries. The following table is from the IMF’s WEO database [2] and shows the projected deficit (as a percentage of GDP) for each of the G7.

	2014	2015	2016	2017	2018	2019	2020
Canada	-1.640	-1.664	-1.340	-0.960	-0.733	-0.615	-0.285
France	-3.975	-3.776	-3.370	-2.818	-2.129	-1.398	-0.747
Germany	0.306	0.511	0.301	0.354	0.561	1.036	1.036
Italy	-3.035	-2.686	-2.012	-1.249	-0.808	-0.447	-0.204
Japan	-7.295	-5.934	-4.549	-4.050	-3.751	-3.831	-4.143
UK	-5.672	-4.249	-2.830	-1.649	-0.755	-0.021	0.125
US	-4.108	-3.836	-3.590	-3.288	-3.373	-3.889	-4.165

We can see that the amount of projected fiscal tightening (the change in the deficit) is far greater in the UK than elsewhere. Only one country currently in deficit is aiming for a surplus, and that is the UK. If the UK followed a more sensible rule of aiming for current balance (which could avoid the welfare and additional spending cuts Osborne specified after the election), the 2020 figure would be minus the level of public investment, which under Osborne’s plans would be -1.8%.

It is very hard to find any respected institution or economist that will back going for overall surplus and keeping public investment low. The Economist is even talking about helicopter money (and quite right too), which is effectively a fiscal stimulus. It is just a matter of time before political commentators in the UK pick this up.

I suspect those who fear the electoral consequences of an anti-austerity line have in part begun to believe in Osborne’s political invincibility. In truth Osborne was always gambling by taking an austerity stance. He was out of tune with international opinion in 2009. He got lucky when the Greek crisis broke, but is now in great danger of overplaying his hand.

The Conservative response to McDonnell’s proposed plans tell us a lot. The spin is that Labour is planning to borrow forever. That spin is indeed consistent with Osborne aiming for surplus, but it is also incredibly weak and can be knocked down by a feather. Every company knows it makes sense to borrow to invest when interest rates are virtually zero. [3] If Osborne applied the same rule to companies as he proposes for the government, innovation and growth would grind to a halt. The 79-97 Conservative government borrowed on average over 3% of GDP each year. I could go on and on.

The austerity winds are changing once again, and Osborne has become isolated. In truth, any shadow chancellor worth his salt would exploit this by arguing against his new round of austerity. My only fear is that Labour will step back from doing so because the issue of austerity has become caught up in Labour’s civil war. This would be truly ironic, as no Labour MP who challenges Corbyn in an election on the grounds that Corbyn is anti-austerity has any hope of succeeding. Let us hope sense prevails, and Labour can at least unite in opposing Osborne's unnecessary cuts.

[1] Following this post, Hopi Sen noted that I had argued elsewhere that - in hindsight - it might have been better if Labour before the financial crisis had kept government debt close to the 30% of GDP they achieved around the turn of the century (rather than following their fiscal rule number of 40%) and asked if that would have been so different from current (or past) cuts? It is a helpful question, because it illustrates that I do not have a problem with fiscal consolidations per se, but just with the consolidations in 2010/11 and planned over the next five years.

The answer is that the two situations are very different. For a start we have a difference in scale. Keeping debt to GDP at 30% would have required reducing the annual deficit by 1-2%. The planned cuts in the deficit out to 2020 are much larger (see main text). In addition

1. from 2000 to 2007 we were not recovering from a recession, and interest rates were nowhere near their lower bound. So the overall macro risk of a tighter fiscal policy to keep the debt ratio at 30% was zero.
   
   
2. There is currently a strong macro case for additional public investment: very low borrowing costs, poor productivity performance, low real wages etc. Paying for that investment through higher taxes hits a generation ‘enjoying’ these low wages, so fails on intergenerational equity grounds. As the chart in the main text makes clear, the more reasonable aim of achieving current balance would still result in a sizeable consolidation if it was not offset by a large increase in public investment.
   
   
3. Stabilising the debt to GDP ratio at a new lower level after a windfall of unexpectedly high tax receipts in the early 2000s made sense from a tax/expenditure smoothing perspective. Trying to reduce debt rapidly, as current plans would do, does not.

[2] The database was compiled in October 2015, but despite what you may have read in the press, the Autumn statement did not fundamentally change this picture (see chart here).

[3] The UK recently sold a large amount of debt at a fixed nominal interest rate of only 2.5% for 50 years, and the sale was oversubscribed. With a 2% inflation target, that is a real interest rate of 0.5% guaranteed for half a century!