Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 10 March 2016

Austerity past and future

It is tempting for journalists in particular to treat arguments against fiscal consolidation (austerity) during the depth of the recession as the same as arguments against fiscal consolidation now. Of course there are connections, but there are also important differences.

Austerity during a recession

Case against

The case against austerity in the depth of the recession is that it makes the recession worse. Because interest rates have hit their lower bound, monetary policy can no longer solve the recession problem on its own, and fiscal policy needs to help. That is what the world agreed in 2009. There are two legitimate economic arguments which, if true, would override this view.

Counterargument 1

The interest rate lower bound is not a problem, because we have unconventional monetary policies like QE. This argument’s flaw is that the reliability of unconventional monetary policy (knowing how much is required to achieve a particular result) is of an order smaller than both interest rate changes and fiscal policy.

Counterargument 2

If governments continued to borrow in order to end the recession, the markets would stop buying government debt. This argument normally appeals to the Eurozone crisis as evidence, but we now know that - before OMT at least - Eurozone governments were uniquely vulnerable because the ECB would not be a sovereign lender of last resort. Other evidence suggests the markets were totally unworried about the size of UK, US or Japanese deficits.

Austerity now

Here I will focus on the UK, because planned fiscal consolidation in the UK over the next five years is greater than in other major countries. During the recession, George Osborne had a target of current balance, which excludes spending on public investment. He now has a much tougher target of a surplus on the total budget balance, which includes investment spending.

Case against

There is a specific problem with Osborne’s current fiscal charter, which is that by targeting a surplus each year from 2020 it fails the basic test of a good fiscal rule, which is that debt and deficits should be shock absorbers. But in terms of the path of fiscal policy until 2020, there are three additional problems:

  1. The policy restricts public investment at just the time that public investment should be high because borrowing and labour are cheap. It is a near universal view among economists that now is the time for higher public investment.

  2. It will bring debt down too fast, penalising the current working generation who have already suffered from the Great Recession

  3. Continuing fiscal austerity is keeping interest rates low, which means central banks are short of reliable ammunition if another recession happens.

I discuss these arguments, and the last in particular, in todays The Independent. The point I want to stress in this post is that of the two arguments in favour of past austerity outlined above, only one - the lower bound is not a problem - is relevant here, and then only for the third criticism above. With debt now falling the argument about a potential funding crisis is not even remotely plausible.

You could say that the market panic argument is still relevant to Osborne’s justification for reducing debt fast, which is to prepare for the next global crisis. I think one way to show the silliness of this argument is to adapt a point I made in The Independent article. Imagine a firm which had lots of promising projects it could invest in, all of which would turn a handsome profit. Banks were knocking on the door of the CEO to offer the firm interest free loans to invest in these projects. But the CEO said no, because someday - maybe in 20 years time - there might be a credit crunch and the firm might get into difficulties if it took on more debt. As a result of the firm’s ‘prudence’, its sales stop growing and its profits fell. I wonder what the firm’s shareholders would think about their CEO’s decision?


  1. None of this seems mutually exclusive to me. I agree with all the 'now' arguments against austerity but I also think much of the 'past' arguments against austerity still apply. E.g do you not think there is (still now) spare capacity in th economy?

  2. Just one problem, the UK doesn't have any austerity. Annual public spending has grown for years.

  3. I think you confuse Osborne' s objective to shrink the state with economic and financial prudence!
    At least New Zealand is showing the way of good governance by outlawing zero hour contracts.

  4. The analogy you draw in your last paragraph sounds uncomfortably like Northern Rock circa 2006.

  5. "As a result of the firm’s ‘prudence’, its sales stop growing and its profits fell."

    You've described the 'enterprise' that is Wolverhampton Wanderers FC...

  6. "I wonder what the firm’s shareholders would think about their CEO’s decision?".

    The CEO will get fired Simon. Only a politician could get away with this kind of stupidity. What makes me so angry is that, the Tory presstitude including the BBC will never call out Osbourne on this.

  7. I think your analogy to the firm facing low interest rates and good investment opportunities is a good tactic to use to argue for increased investment now. And it is probably mostly accurate for countries using the Euro.

    But doesn't using this tactic concede too much, especially with regard to countries like the U.K., U.S., or Japan? As in comparing a national government to a private firm. I mean, this is similar (in nature) to, if opposite in goal, Obama's (not just his) statement that when the private sector is tightening its belt then the government should also. And opponents can justifiably argue using this framework that when a private company invests, shareholders aren't really going to be asked to pay back that investment in taxes.

    But I agree with your goal. And would agree with your tactic if it was successful. So maybe I'm just nitpicking here.

  8. SWL,

    From what I have read, which might be wrong, Britain spends £50 Billion a year on capital expenditure. What would you recommend labour spends seeing as you are advising John McDonnell?

    It is no good saying that labour are formulating a plan over the next couple of years because, as the last election shows, the Tories will dictate the narrative.

  9. Under “Counterargument 2” SW-L says an argument FOR austerity in a recession is that there may be limits to how much government debt markets will buy. Well there’s a simple solution to that: don’t fund stimulus via government debt. Fund it with new base money (aka overt monetary financing). The only slight problem there is that forex markets might take a dim view, thus the pound would fall relative to other currencies. But a fall in the pound is swings and roundabouts: it BENEFITS exporters, which in turn means more jobs in exporting firms, and more jobs is the whole object of the exercise. Moreover, assuming government gets it right and doesn’t let that new money result in excess inflation, those forex traders would ultimately have egg on their faces: they’d end up making a loss. Thus they’d think twice next time they sold the currency of a RESPONSIBLE government just because it’s doing some OMF.

    All in all, the whole idea of austerity during a recession is nonsense.

    1. The entire conclusion you put forward Ralph follows from the premise that the bond markets can decide things.

      However if it is clear to the markets that the government believes it ultimately controls the Bank of England and the understanding is that the Bank of England will prevent yields from rising, then they will not rise.

      The Bank of England can buy the bond for cancellation using QE style techniques. The Bank of England is a subsidiary of HM Treasury. Once it purchases a bond it no longer exists on the government consolidated balance sheet.

      Any bond that drops below par can be purchased by the Bank of England and cancelled. That means that the private sector gets less back than it paid out for the bond.

      And that is a tax. Show me a financial person that will voluntarily queue up to pay a tax (or not take some corporate welfare) and I'll show you a unicorn.

      So it matters not what the bond market thinks. It matters whether the government decides to voluntarily tie its hands.

      "The only slight problem there is that forex markets might take a dim view, thus the pound would fall relative to other currencies."

      There is a lot of myths about that assuming infinite liquidity in the forex market. There is not even now. But especially once private banks cannot create money for currency settlement. There is infinite liquidity in the bond market.

      When the entire financial system melted down in 2008 all that happened is Sterling moved back to its 1997 levels from its over inflated value created by the Brown Bubble. Currency movements are self-limiting due to liquidity constraints and other factors *unless* you have a central bank patsy in the market (as Soros showed.)

      These things are really not that important. Some people will lose money and those on the other side will gain money. Because it's a zero-sum game.

      Every analysis I've ever read from economic types seems to follows a mental model. It is always from the viewpoint of a particular country and the Rest of the World is abstracted to a single lump that is casually mentioned in passing. The lines are hard and rigid and follow the political boundaries of the country in question absolutely and without variation. The RoW is able to take action like a Deus Ex Machina without any effect on anywhere other than the Country in question.

      It is precisely the same sort of mental trap as the 'government borrows' model. It leads to a particular type of behaviour, a particular set of analyses, and a particular set of conclusions - all incorrect.

      But ultimately boils down to this. The end buyer always gets to use the type of money they want and the end supplier always gets the type of money they want. Otherwise there will be no deal. It doesn't matter what the invoice is priced in. It doesn't matter what the currencies are. It doesn't matter where people are physically located in the world. The finance system has to make the finance channel tie up or it all stops and the deal chain collapses.

      Statistics showing excess of imports or excess of exports ("trade deficit") are thus the result of successful end to end deals on both the real and financial sides. They can't be anything else in a floating rate system.

      "Moreover, assuming government gets it right and doesn’t let that new money result in excess inflation"

      Inflation is due to the *flow* of money. And government spends on an unlimited intraday buffer that settles at the end of the day - so it is always funded by base money.

      Too high flows results in hyperinflation and collapse. But that's no reason to pay interest. The interest rate is set by the central bank which is owned and controlled by the government.

      If the government doesn't spend enough, then the central bank has to drop the interest rate to zero to maintain aggregate demand.

      So you don't pay interest. You pay tax instead - since interest is really just taxation by the back door, but into the hands of wealthy people rather than the representatives of the majority of the population.


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