The UK now has a surplus on the government’s current budget. George Osborne tweeted “We got there in the end — a remarkable national effort. Thank you.” This has been a remarkable period in UK macroeconomic history, but not in the way Osborne thinks. A majority of economists have always been against trying to reduce the deficit when interest rates are stuck at their lower bound, a majority Osborne chose to ignore. So what has been the cost of this “remarkable national effort”?
The first time I looked at this I did a very simple calculation. The OBR estimate (here, chart E) that fiscal consolidation took just under 1% out of the economy in 2010/11 and over 1% in 2011/12. I wanted to get a simple estimate that no one could suggest was too high. As actual output was pretty flat until 2013, I assumed that output was 2% lower in 2011/12 (1% from the previous year plus the additional 1%) as a result of fiscal consolidation, remained 2% lower in 2012/13, but then fully recovered by 2013/14. That gave a total output loss of 5%, which is almost £4,000 per household.
I think we can now do things a little more scientifically. (If you are not into these sorts of calculations, you can skip to the paragraph starting £10,000.) I originally took the OBR estimates which had embedded in them a declining influence on GDP over time, based on historical experience. I think it is wrong to use these, because the reason that the impact of fiscal consolidation normally declines is that monetary policy counteracts it. This didn’t happen after the Great Recession because interest rates were stuck at their lower bound and QE was pretty ineffective. The OBR have now provided estimates of the ‘direct’ effect of fiscal consolidation, that take out the impact of the decay from past consolidation. See here for a detailed discussion.
The Impact of UK fiscal consolidation on GDP
|Direct impact on growth||-0.8||-1.4||-0.6||-0.7||-0.3||-0.5||-0.2||0.0|
|Impact on level of GDP, no decay||-0.8||-2.2||-2.8||-3.5||-3.8||-4.3||-4.5||-4.5|
The table above starts in row 2 with the direct impact of fiscal consolidation (the orange bars in Chart E). There are reasons for thinking these numbers are too low, because they still embody some within year offset from monetary policy, but lets go with them. Suppose there was no tendency for GDP to rebound from these impacts (like kicking a ball each time it stops). The third row computes the total impact on the level of GDP in each year.
Assuming zero decay from fiscal consolidation is too strong, even when interest rates are at their lower bound. For example the impact of tax or transfer cuts are likely to be greater in the short term than the longer term. QE had some impact. So row 4 assumes a decay of 0.8 i.e. only 80% of the fiscal consolidation remains in aggregate demand the following year. This is very crude and no substitute for a proper model based estimate, but I do not know of any recent model based estimates so it is the best we can do. The final row shows the accumulated loss of output: the total cost of fiscal consolidation over the whole period. The final figure suggests the national effort to reduce the deficit cost over 15% of GDP, which when GDP is around 2 trillion and there are 27 million households, gives over £10,000 per household.
There is a big objection that has been made to this calculation. If GDP had been 2% higher in 2016/17, say, the Bank of England would have raised interest rates because that level of GDP would have been inflationary. In other words I should be using a much higher decay factor as we come closer to 2017. However there is an even stronger counterargument to that. I argued here that austerity was a cause of the productivity slowdown that began in 2012. By delaying the recovery for three years, austerity made firms put productivity enhancing projects on hold, and we have seen no sign as yet of any catch-up. I think it is reasonable to assume that the productivity slowdown caused by austerity led to a reduction of at least 2% of GDP from the supply side by 2015. That nullifies the argument that the bank of England would have had to raise rates if austerity had not happened. 
£10,000 for each household is an average figure, but we know that austerity did not fall evenly, but was concentrated on those at the bottom end of the income distribution. It is certain that cuts to social care and the NHS cost lives: it is just a question of how many thousands of lives we are talking about.
And then there is the political cost of austerity. The Coalition government, and particularly our current Prime Minister, has used immigration as a scapegoat for the impact of austerity. With the help of the right wing press that scapegoating has worked. In particular, as I show here, many people believe that immigration has been bad for public services like the NHS. In reality the opposite is true, but the government and press have succeeded in creating what I call a politicised truth: something that is believed to be true just because politicians and the media keep saying it is.
The government may well have pursued this line even if austerity had not happened, but it gained some of its potency because austerity did lead to pressure on public services like the NHS. That in turn helped create the atmosphere required to gain a majority for leaving the EU. Austerity, for this and other reasons, created the conditions that allowed Brexit to happen. Those who think the UK descended into political madness with Brexit are wrong: the madness started with austerity in 2010.
The final point is that austerity was completely unnecessary. By austerity I mean cutting the deficit when interest rates could not be cut to offset the impact of fiscal consolidation. There is zero evidence that the markets demanded austerity in 2010, and plenty of evidence they did not. Even if the markets had panicked at the size of the deficit, the Bank of England would have bought government debt as part of its QE programme.
The unusual feature of the Great Recession was not just its size, but that for the first time since the 1930s governments started reducing spending in what should have been the recovery period. They have never done that since the 1930s because economic textbooks and state of the art models say it is a stupid and costly thing to do.
Of course the deficit needed to be reduced, but the government could easily have waited for a few years until the recovery was well underway and interest rates were well above their lower bound. The £10,000 per household is not the cost of deficit reduction. If the government had been patient it could have reduced the deficit with no cost at all. Whatever the motive for George Osborne disregarding the lessons of history, his actions have lost the average household £10,000 worth of resources and caused additional ongoing economic and political damage to the economy. Not so much a “remarkable national effort” as a predictable man made disaster.
 There is an argument that without austerity interest rate would have increased in 2011, because they nearly were anyway. But that would have been a huge mistake by the Bank, who were panicked by higher inflation. One of the reasons inflation was high was austerity: the increase in VAT. So I think letting austerity off the hook and passing the hook to the Bank of England because of something they might have done is not a very convincing argument.