Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday 22 February 2016

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.


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!


  1. now I know you don't do predictions, but here is one for you.

    Those deficit projections for the UK are implausible. The UK won't be in surplus by 2020.

    If we look back, as opposed to forward, the case for saying the UK has had *more* austerity than other countries is just untrue.

    1. I cannot see the relevance of your first point, unless it is to introduce the second argument that I have never made!

    2. Your argument is reliant on the IMF's WEO database's projection for the UK being plausible. They obviously are not.

      If however we look at the past, which has in fact happened, it is quite clear that since 2007 (or 2010) it is untrue that the UK has been a land of harsh austerity compared to everywhere else. The opposite is true if anything.

  2. "With a 2% inflation target, that is a real interest rate of 0.5%" - assuming, of course, that the inflation target is achieved, which it hasn't been recently.

    I find it ironic that Osborne welcomed the recent fall in inflation (and associated decline in NGDP growth rate), when it leads to an effective rise in real interest rates, presumably making it harder for him to achieve his debt and deficit reduction targets

  3. I have layman's (stupid?) question about your footnote.

    If we had had lower deficits and debt pre crisis, and interest rates had been lower to compensate, might the crisis have been worse because:

    A. lower rates would have encouraged more bad borrowing/lending pre crisis; and/or

    B. there would have been less room to lower rates post crisis?

    (Assuming the same political constraints on fiscal policy)

  4. I think the footnote about the 50y yields is not really fair. You should compare market yields not with the inflation target but with the market price of inflation. No-one believes that they are going to hit their 2% target for the next few years. The term structure is very important, if you collect 2.5% for free for the next five years you can weather quite a big inflation shock later on.

  5. I am sceptical of the EU as an institution, but pro migration.
    Should I vote 'in' or 'out'?

    1. Me too.
      I'm voting out and making the positive case for immigration wherever possible.

  6. Even if The Economist and all academic economists throw their weight behind helicopter money, do you think this will be enough to convince the public that it is sensible?

    Electoral responses to economic policy seem to mostly be based on gut reactions and simple (ie. often wrong) analogies, and on both cases the idea of printing more money because you don't have enough fails resoundingly.

    What do you think can be done to address this and can you think of a basic idea to explain why helicopter drops aren't as bad as they can very easily be bad to sound?

  7. "The spin is that Labour is planning to borrow forever. "

    But it is really "borrowing"?

    The issue here is one of dynamics and timeframes which overlap. The injections that the government make into the economy from their spending buffer increases the demand for Gilts at the DMO. It's like the economy breaths in before it breaths out.

    The key thing to remember is where the *control point* is. There is *nobody* in this system that can bounce a government cheque and there is nowhere else for anything HM Treasury spend to go other than to other accounts at the Bank of England. So it all just bounces back and forward intra-day and settles up nicely at the end of the day (with DMO borrowing back from the banks like any other bank does if they are short of reserves to hit the arbitrary end of day 'clearing' figure).

    Everything is always 'fully funded' because the money can't go anywhere else. It's like sitting on a water bed. And that's the key point.

    When you look at France, the money there can leak out to Germany - because they are in a fixed exchange system called the Euro. That can't happen here.

    If the bond markets 'won't lend' it is no problem. No issue at all. The Bank of England steps in due to the threat of a collapse in aggregate demand. So we get more 'QE' which then increases the demand for Gilts.

  8. The Treasury spends asynchronously and with no direct relationship with the actions of the debt management office or the bank of england.

    What the debt management office does is maintain the reserve balance in the Treasury accounts at a set value - entirely for the sake of appearance.

    There is no control function here, it is pure politics. Government cheques don't bounce because there is nobody with the capacity to do that. If Treasury decides to spend, then the cheque clears.

    1. Agreed, it is basically neo-liberal smoke and mirrors to fool the 99% and make the government budget look like a regular household (currency "user") budget.

      No Bank, BoE included, has the power to bounce a Treasury cheque. Most entities operate with some form of balance sheet, including the BoE. The Treasury operates with an unbalance sheet, because it is the currency "issuer" and the currency "withdrawer", via taxation, into and from the economy.

      Neo-liberal governments operate with what they call a "Full Funding Rule". This means it issues what it calls "debt" instruments (Gilts and Treasuries), to match its fiscal (budget) deficit. There is no operational requirement to do this. It does it voluntarily, as part of the smoke and mirrors game. It has other voluntary constraints that keep circa 5,000 people employed at Treasury and the BoE. One is a "no overdraft rule", which needs a daily cash management function by the DMO, (CGNCR = central government net cash requirement), another is keeping liquidity pools in commercial banks for big Treasury / HMRC pay days, to prevent destabilising commercial bank clearing functions.

      It is worth understanding the "DMO Remit"

      Look at who is holding all the Gilts that the Treasury does not actually have to issue! Ask yourself why Treasury is giving free money (as interest) to foreign holders. Likewise why is it giving free money to private pension and insurance companies!

  9. There is still an attempt at separation in the proposals between ‘Money Creator’ (aka the central bank) and ‘government’ (aka the Treasury with an account at the central bank under instruction from the government of the day).

    The proposals as they stand denigrate politicians. They are Not To Be Trusted (™). So what you have instead are a bunch of unelected Very Clever People at the central bank who determine how much money will be put into the Treasury’s bank account.

    The implication is that even though the government has had its Finance Bill passed in the House of Commons (the UK’s primary chamber), and even though the constitution of the UK states that the Upper House *will not stand in the way of the elected government’s Finance Bill* (they just wave it through), the bunch of Very Clever People at the central bank can refuse to release the money for it. Essentially they can bounce the government’s cheques.

    That is one of two things: a recipe for a constitutional crisis, if the bouncing of the cheque is a genuine threat, or pointless theatre involving paying some people a rather large amount of money to sit in a room and produce grand sounding reports that have no teeth (much like the ‘Office of Budget Responsibility’, or the US ‘social security’ fund) if ultimately the central bank is going to pay whatever Treasury demands.

  10. There is a straightforward option that nobody seems to be prepared to take. Stop issuing gilts.

    Let’s face it if you’re running a corporate surplus which would you rather do? Invest in the current British economy or take a risk free return courtesy of government spending that would be more effective if directly spent elsewhere? You’re not going to mobilise the corporate surplus with such a subsidy on offer.

    They are a relic of the gold standard and completely unnecessary in our system. If you stop issuing them then people can either leave their money on reserve at 0.5% or do something else with it.

    The money has ALREADY BEEN CREATED. You CAN'T buy gilts with US dollars.

    In our system gilts act like savings certificates. It’s just like you moving money from your cheque account into your deposit account at the bank. You get a better rate of interest.

    In accounting everything has to sum to zero. That includes the entire Sterling zone.

    For the non-government sector to run a surplus (net savings in Sterling) the government sector has to run a deficit (net spending in Sterling).

    All the money the UK government spends appears out of nowhere. All of it. They are the currency issuer – they *must* spend the currency before anybody else gets to use it. In our system it is best to think of the government Spending and then Taxing with the difference being Savings. Taxation simply deletes money from the system entirely.

    Savings are merely a stock of government spending that hasn’t been taxed away entirely yet.

  11. Aiming for a budget balance in an economy that has the second largest BoP Current Account deficit on the planet, will require the non-government sector, to use up its savings and max out its credit cards, to fund its desire for imports. The latter has practical limits for these currency "users".

    Helicopter money IS fiscal stimulus when it is done by the Treasury spending (creating) new "money" (fiscal assets) into the non-government sectors. Tax cuts would have a similar fiscal stimulus affect but smaller and slower.

    "The spin is that Labour is planning to borrow forever." This is the major problem. Until there is an understanding that a sovereign fiat currency "issuing" government, does not have to borrow its own "money" from anybody, nothing will change.

    The government budget deficit is decided by the non-government sectors' spending and saving decisions. This 2015 parliament was going to start with a zero budget deficit from the 2010 parliament; according to Osborne in his 2010 budgets. It didn't happen by a large margin, because the non-government sector didn't let it happen. They saved (includes paying down debts) and spent less from wages that were becoming a lesser share of GNI.

    Government deficits are cancelled by government taxes. Reduced spending yields reduced taxes. More of the government's spending stays in the non-government sectors as "savings", including cash notes under mattresses.

    The size of the government's annual deficit and its accumulated debt, is mirrored in the non-government sectors savings, Pound for Pound. The size of the debt, is a measure of the non-government sectors lack of confidence in its future income from the economy.

    Understand; there is no bill, presented in its own currency, the UK Treasury can't pay. Understand; the UK Treasury can never go broke in its own currency, and that goes for its own Bank, the BoE. Understand; no matter how big the debt to GDP ratio gets, the Treasury will always be able to pay the interest. Ask the Japanese if you don't believe it.


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