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
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.
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.
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.
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.
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:
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.
It will bring debt down too fast, penalising the current working generation who have already suffered from the Great Recession
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 today’s 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?