Why austerity is not Labour’s Legacy

On the relationship between finance and fiscal policy

When Momentum put out this tweet following the latest spat between Corbyn and Blair

“Blair favoured deregulation of the banking industry - leading to one of the worst crashes in modern history. While spending on public services was higher, his legacy will ultimately be the austerity that followed his failure to stand up to big finance.”

I responded with this

“This is parroting the Tory line that austerity was Labour's fault. As wrong coming from the left as it was from the right. Austerity wan't inevitable after the Global Financial Crisis. It was Osborne choosing to shrink the state, because Labour hadn't. Know your true enemy.”

Big mistake. I had criticised momentum and, in some eyes, supported Blair and twitter did its stuff. Among those supporting the momentum tweet was Clive Lewis and (maybe) Grace Blakeley, and among those agreeing with me where Tom Kibasi and Chris Dillow.

A lot of these tweets were totally irrelevant to the original tweet and my response. The original tweet is pretty clear. Blair’s failure to regulate the banking industry led to austerity. So the gradual appeasement of austerity we saw from Labour from 2010 to 2015, which I have strongly criticised elsewhere, is not relevant. Nor are Darling’s plans for cutting the deficit before the 2010 election. As I have said before, it is unfortunate that Darling won his battle against Brown and Balls and allowed reducing the deficit to be part of Labour’s short term objectives. But that has nothing to do with the momentum tweet, which involved the financial sector. [1]

Did Labour’s failure to regulate finance lead to austerity? In a very basic sense the answer is clearly no. Osborne didn’t need to embark on cutting public spending in a recession for the simple reason that no Chancellor since Keynes has done so. It was his choice. Perhaps if Labour had been tougher on banks the UK might have been less vulnerable to the Global Financial Crisis. UK banks collapsed largely because of overseas assets they had on their books (little to do with domestic debt), so the regulation would have had to stop them buying those assets, or forced them to substantially reduced their leverage. But I find it hard to believe that we would have avoided a recession of some kind.

A recession - even a mild one - was all Osborne needed. He was looking for ways to reduce public spending, and he saw a rising deficit as his opportunity. He committed to his policy in 2008, which was well before the extent of the recession was known. So it seems almost certain that the deficit would have risen sufficiently to allow Osborne to undertake austerity.

But why did he undertake austerity. I think it is because he wanted to shrink the state, something he had failed to convince voters to do on its merits [2]. What I call deficit deceit is using the supposed need to reduce the deficit to cut spending. But Grace Blakeley and Clive Lewis suggest something more complex. Here is Grace:

“I suppose it depends on how you view the emergence of neoliberalism - I see it as an ideology that both emerges from and reinforces a change in the balance of class forces under which finance capital becomes hegemonic. ‘Shrinking the state’ is generally political cover for empowering or enriching a particular group and disempowering another - eg PFI used to allow investors to profit from state spending, and austerity used to disempower small l labour at a time when it otherwise might have organised to challenge the status quo.”

Suppose Labour had regulated finance to a much greater degree, and that would include not giving it a central role in Treasury decision making, much as Brown had in 1997 with the Bank and financial sector regulation. If that had reduced the size of the UK recession that would be a good thing. But would it have prevented austerity. I cannot see how. Would it have changed Osborne’s mind about wanting austerity? I cannot see how.

Did finance assist in some ways with the austerity bandwagon. Of course it did, from City folk who said the market for UK bonds was about to collapse to pressure brought through the Treasury. But much of that would have happened even if there had been greater financial regulation. Again there was nothing a Labour government could do to prevent all that, short of nationalising the entire sector. So calling austerity Labour’s legacy makes no sense on these grounds.

Another way to link finance with austerity, pointed out to me by Clive Lewis, was in this paper by Obstfeld. The idea is fairly simple. Too big to fail is all about the state bailing out the banking system. The state has to have the ‘fiscal capacity’ to do that. Ergo we need to moderate government debt levels to preserve that capacity. To look at this argument we need to examine the concept of fiscal capacity and fiscal limit.

Can a government run up a stock of debt relative to GDP that is unbounded? MMTers are quite right to say that, in a country that prints its own currency, a government can never be forced to default. But debt to GDP might get so high that the political burden of paying taxes or curtailing spending to pay the interest on that debt becomes more than the political cost of defaulting. Defaulting can take two forms: a literal default (failure to pay interest) or excess inflation devaluing the value of nominal bonds.

That limit is clearly way above the level of current UK debt. When some say we do not know where that limit is that may be a prelude to saying ‘and it might be near the current level’ which is just designed to scare governments. Governments know their own fiscal limits and the strength of their inflation targets. But Obstfeld’s point is that a financial crisis might push a government beyond its fiscal limit.

I do not think this argument held much weight with Osborne. As I noted above, he chose his policy in 2008, and I think it would have taken him a little longer to work this one out. (Obstfeld’s paper is 2013.) It might have influenced King and some Treasury officials in 2010. But you can see how weak the argument is in a recession by looking at what the Labour government did. In 2008 it bailed out the banks and in 2009 it undertook fiscal stimulus. The reason is straightforward: a recession is as bad for the financial sector as the real economy. The financial sector is hurt by loans going bad in the real economy, something that is made more likely in a recession. The priority in a recession should always be to get out of recession. Indeed I suspect Obstfeld would agree, as his paper is not an argument for austerity.

Even though I do not think there is much credence to the argument that Labour’s failure to regulate the financial sector caused UK austerity, that does not mean that the influence of the financial sector was not crucial elsewhere. Fear about the health of the financial sector in core Eurozone countries lead directly to the imposition of first austerity, and then to a second recession. Greece was hit hardest. In 2010 Eurozone leaders were happy to let Greek leaders pile on extra debt rather than default on debt their banks partly owned. That finance ministers in the Eurogroup were then prepared to tell a subsequent Greek government that they had to pay every penny back or Greece would be out of the Eurozone. (This episode tells you a lot about the Eurozone and those finance ministers and nothing about the EU.)

Banks, and politicians failure to be honest about the need to bail them out, were central to austerity in the Eurozone. Mark Blyth’s phrase “what starts with the banks ends with the banks” remains very apt there. In addition the desire to cut taxes on the rich, many of whom work in finance, is clearly a key motivation behind austerity in the US. But if austerity in the UK is anyone’s legacy, it is George Osborne and not Brown/Blair. He, and he alone, chose to cut spending in the middle of a recession, something no Chancellor has done since Keynes wrote the General Theory in 1936.

[1] For what it is worth, a different economic policy might have changed the 2010 election outcome: Labour might have got more or less seats. But it is absurd to call something a government’s legacy just because the other side were able to do it because they won an election. Under this logic Brexit is Corbyn’s legacy etc etc.

[2] Chris Dillow and others have suggested that his main motive was just to have something to attack Labour with. Some have suggested he just got the macroeconomics wrong (or more accurately it was at least 10 years out of date). It is difficult to bring evidence to bear on this debate, but all three explanations suggest Labour’s financial regulations policy had little to do with it.