Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 23 July 2019

How the lessons from austerity have not been learned

The UK and the Eurozone are both vulnerable to the next recession, but both politicians and central bankers think each other should deal with it.

I don’t want to talk about the likelihood of a recession in the UK, US or Eurozone. Forecasting is a (necessary) mug’s game, where there are just too many variables to make anything like an accurate prediction. It is worth outlining the risk factors, and Grace Blakeley does an excellent job here. Instead my concern is the vulnerability in both the UK and the Eurozone to the impact of a recession if it happens. This vulnerability was clearly illustrated by the mistakes made after the Global Financial Crisis, yet in many ways the lessons of that failure have not been learnt.

Most people know the story of austerity after the Global Financial Crisis (GFC). In the UK the negative impact of the GFC was so severe that even cutting interest rates from around 5% to 0.5% was not sufficient to counteract its impact. As a result the Labour government in 2009 undertook various fiscal stimulus measures. They, together with lower interest rates, succeeded in stopping the fall in output, but by 2010 the signs of a recovery were still fragile. The new Coalition (Conservative and Liberal Democrat) government decided to focus on the rising budget deficit rather than the recovery, and undertook a large fiscal contraction in what became known as austerity.

The consequence of UK austerity was the slowest recovery from a recession in centuries. Here is a nice chart from a recent report by James Smith of the Resolution Foundation, which clearly illustrates the extent of the weak recovery.

Employment eventually recovered, but at the cost of an unprecedented fall in real wages. James Smith gives some evidence to suggest that the reason employment got off comparatively lightly but wages suffered by much more than we might expect was the 2008 sharp depreciation in sterling. This allowed firms to respond to the recession by keeping wages low, whereas in recessions in which sterling did not fall firms resisted nominal wage cuts and so had to resort to cutting jobs.

The idea that austerity was essential to reduce the deficit is simply wrong. It undoubtedly was a large factor in the weakness of the UK recovery. The tightening of fiscal policy has continued until today, with the consequence that interest rates have had to stay low to offset this fiscal tightening. The net result is that instead of rates being near 5% as they were before the GFC, they are below 1%. As James Smith points out, interest rate cuts in previous recessions have ranged from three to ten percent. This means that conventional monetary policy has almost no room to counteract a new economic downturn if one came.

The Eurozone is in an even worse position. Their history is of two recessions since the GFC, the second of which was largely caused by fiscal tightening as a result of the Eurozone crisis of 2010-12. The last time core inflation in the Eurozone touched 2% was in 2008, and it is currently around 1%. (More details from Frances Coppola here.) Interest rates set by the European Central Bank (ECB) remain at their lower bound. If a new recession happened, caused for example by a disruption in trade due to Donald Trump, conventional monetary policy would be unable to do anything about it.

Of course central banks in the UK and Eurozone still have various unconventional monetary policy tools. But the clue to their reliability at ending a recession is in their name. They are unconventional because they have only been used since the GFC, so we have limited evidence on their impact. It is like having an accelerator on a car where how far you have to push your foot down varies from second to second. You will end up driving slowly, which in economic terms means a prolonged recession.

All this is now largely understood by central bankers. All have said in one place or another that they will be relying on fiscal stimulus to help counteract the next recession. The ECB needs fiscal stimulus right now to get out of the last one. Yet fiscal stimulus is in the hands of politicians and not central bankers, and many of the politicians and political parties that were crucial in implementing the austerity that hit the post-GFC recovery are still in power.

There is therefore a danger that the policy of fighting the next recession will fall between two stools. Central bankers will say, in their own quiet and politically sensitive way, that they are not equipped for the task, but politicians may be deaf to these messages and will once again start worrying about deficits that inevitably rise in an economic downturn. To say more, we need to differentiate between the UK and the Eurozone.

In the UK some may think that with a new Prime Minister the problem of austerity has disappeared. In order to get elected both candidates have promised all kinds of tax cuts or spending increases. But as I have argued recently, what we are seeing here is what economists call deficit bias: the tendency to borrow just for political gain. Worse still, if the borrowing is mainly for tax cuts (including tax cuts for the rich), there is a danger that it is part of a strategy called ‘starve the beast’, which involves increasing the deficit with tax cuts and then demanding spending cuts to bring the deficit under control.

The upshot is that a Tory leader wanting to spend and cut taxes to please party members provides no guarantee that they will undertake effective fiscal expansion in any future recession. Neither of the Coalition partners has apologised for the mistake of austerity, and we have no reason to believe that they wouldn’t do it again in any future recession. The only major party that has a fiscal framework that would automatically move to fiscal expansion when interest rates hit their lower bound is Labour.

In the Eurozone there is also too little recognition among senior politicians that fiscal stimulus is required when ECB interest rates are at the lower bound. This is why Eurozone inflation is still below target. The OECD point to a crying need for more fiscal stimulus. Germany in particular has a great need for additional public investment, but is restrained by a fiscal rule that is worthy of an economic stone age. Efforts to create a Eurozone budget that could act in a countercyclical way have also been blocked by politicians, despite support from the ECB.

We can hope for a change of political attitudes in both the UK and Eurozone, but central bankers should not be content with hope. They have been delegated the task of stabilising the economy, and if they fail to complete this task in economic downturn after downturn many will come to believe that delegating monetary policy to central banks was a huge mistake. In addition, it is not the case that all central banks can do when interest rates hit their floor is unreliable types of unconventional monetary policy.

A fail safe way for a central bank to bring a recession to an end when interest rates are at the lower bound is to create money and give it directly to citizens. It could also create money and give it to borrowers by subsidising borrowing rates. The former is called helicopter money, a term due to Milton Friedman, and would require cooperation from government. The latter has been undertaken by the ECB in the past (see Eric Lonergan here), and so could be done to a greater extent without involving government. In essence it involves cutting interest rates on borrowing to well below the lower bound, but keeping rates for savers at the lower bound, and funding the difference by creating money.

Central banks in most of the major economies have been happy to create money during a recession, but nearly always this money has been used by central banks to buy assets. The impact on the economy is then difficult to predict, because no one's income has increased and the interest rate for borrowing has not fallen significantly. Giving the money directy to people rather than buying assets would have a direct and more predictable impact in stimulating the economy, as Frances Coppola argues in her new book.

So why do central banks not do this? There are two major reasons. First, they worry that increasing people's income is the job of elected governments, although I would argue that it is central bank's job to stabilise the economy if the government does not. (See my article with Mark Blyth and Eric Lonergan for more on helicopter money.) Second, if they create money to buy assets, when the economy recovers they can if necessary take money out of the economy by selling those assets. If they give that money away they wil not have those assets to sell. However this problem could be dealt with by governments guaranteeing the supply of assets a central bank needs.

Besides these arguments, I think there is a third argument why most central banks have not proposed doing these types of measures in a major way, and that is conservatism with a small c. The problem is that, if politicians unprepared to undertake fiscal expansion in a recession remain in power, that conservatism may be very costly both to us and to central banks themselves.


  1. Is this thing about austerity proof by repeated assertion? Many countries that undertook fiscal stimulus also had low growth and high unemployment after 2008. In any case, a lot of investors are wising up about central banks and are rushing to physical assets like gold. See Ray Dalio's post "Paradigm Shifts". Want to see loans denominated in gold? That's what central banks directly distributing money will do.

  2. Conservatives seem to be very slow learning their lessons, not just in the USA. Too bad.

  3. No need for fiscal policy intervention. Just raise inflation to 5% and monetary policy will be sufficient. Or does that come in the way of a bigger govt which seems to be what you want?

    1. This is a common assertion, but how does one raise inflation to 5%? After all,many countries have not managed to raise inflation even to their modest current targets,despite years of trying. E.g. Japan,Eurozone.


  4. The impacts of austerity were well known long before the the latest great financial crash, so to presume the Tories were just being prudent by cutting back on public expenditure in order to reduce the deficit, is really distorting the reality. The Tories are well aware of the total impact their policies are having, and regardless carry on because it allows them to asset strip the state and privatise those public services which they have always condemned.

    So what we are talking about is a deliberate Neo-Liberal policy using financial constraint to transfer power and wealth upwards.

    There is a plethora of evidence proving that the Tories had planned this ever since Thatcher took office, the real great shock though was how New Labour continued with these Neo-Liberal policies which later produced the very crash that repeated the one from 1929. Ever since we have heard interminable declarations by everyone except the Heterodox economists about how essential it is to balance the books.

    These myths persist because although everyone knows its utter nonsense, all serve the same masters. To sum it all up in a nutshell they serve the sole interests of US hegemony wrapped in their Neo-Liberal doctrine which controls people through unnecessary rationing of finance. Globalisation means capital can set one nation against another and reduce living standards to maximise their profits.

    None of which serves anyone except those vulgar people who use their wealth and power to make even more wealth and power.

    What should be obvious to anyone with an iota of common sense is that we don't need to issue money as debt, we can invest directly into the economy, stressing the need to invest because Thatcher dismantled our manufacturing base and if we just spread helicopter money about, it would only be short term as it would suck in too many imports and our Balance of payments would be much worse than it already is.

    In theory that also is not a problem, as it appears not to be now, but it would give a progressive governments enemies an excuse to mount an attack. So investment in new (state) industries that would reverse the damage done by Thatcher and Neo-Liberal governments ever since and reclaim our place in the world as once again an industrial state, rather than the purchaser of other countries finished goods.

    None of this is rocket science, but it does need a totally new paradigm of self sufficiency and spending in favour of people rather than as today on corporate power. Democracy is already dead, we need to revive it and people need to wake up to the fact that sitting around waiting for philanthropic multi billionaires to provide incomes for us just hasn't happened and never will.

    We have the power, we have all the money we need, all it takes is for people to wake up to electing a government that works for us and not Multi National corporations.

  5. Simon, can you do a post on Land Value Tax and Georgism? many thanks.

    A 100% tax on the unimproved value of land (land value tax), does not include buildings or improvements to the site, just "location, location, location" value.

    For future land owners the LVT the freehold title no longer becomes the right to a perpetual free lunch. So it’s exchange value becomes worthless. So now the money that would have gone into buying that title become a sunk and unrecoverable cost.

    I which case the only reason to occupy and carry on occupying a valuable piece of land is to turn its productive potential into income and capital.

    If another person comes along who can do a better job, this will be reflected in the market prices and perhaps a change of ownership.

    That’s how the market works. That cannot happen while freeholders are in receipt of an implicit state subsidy worth hundreds of billions of dollars that allows them to access valuable locations in perpetuity without compensate those they exclude for their loss.

  6. Let me point out some facts in US history that pertain to Keynes' admonition to have "austerity at the Treasury in the Boom."

    What happened everytime we followed Keynes' advice?

    The US federal government has balanced the budget, eliminated deficits for more than three years, and paid down the debt more than 10% in just six periods since 1776, bringing in enough revenue to cover all of its spending during 1817-21, 1823-36, 1852-57, 1867-73, 1880-93, and 1920-30. The debt was paid down 29%. 100%, 59%, 27%, 57%, and 38% respectively. A depression began in 1819, 1837, 1857, 1873, 1893 and 1929.

    Since the US has only had 6 depressions, this shows that everyone of our depressions was preceded by such a period of "fiscal responsibility."

    What happened at least once when we disregarded his advice?

    The largest the the US debt ratio occurred in 1946 when it was 109% public and 121% gross. Rather than austerity, from 1946 to 1973, the debt increased 75%. We had deficits for 21 of the 27 years. GDP growth averaged 3.8% and real median household income surged 74% during this period which has been called The Great Prosperity.

    (If you want to raise the "Europe was Rubble Myth,". look at the chart og pg.60 of Piketty's book which shows that the output of Europe was about the same as the US in the Great Prosperity of 1946 - 1973).

    Finally looking at the 6 depressions, another way of describing the preceding periods of fiscal responsibility is that money flowed out of the private sector since the trade balance was insignificant and the government taxed more than it spent. Except for a brief period in 2003, the same condition happened from 1996 to 2008, this time mainly because the trade deficit was larger than the federal deficit.

    Yet again, we would have had a depression if we hadn't had a Federal Reserve able and willing to pour TRILLIONS into the banking system to save it. But the result was not pretty.

    I think this history shows that austerity is generally a bad idea.

  7. "conservatism with a small c"

    I'd add the caveat that it's more a case of *political* conservatism than economic conservatism. It's not the case that anyone at a central bank has made a principled Miltonian argument against helicopter money; it's that they're all painfully aware that following such an obviously redistributive strategy would expose them to an utterly rabid backlash from well-funded political factions. (Because the people providing said funding would hate that idea.)

    That's not something I've seen anyone state outright, but I'd be amazed if the implicit threat to central banks' political independence from what Krugman would call "professional conservative economists" wasn't distorting their Overton window.

  8. It seems pretty simple.

    1. Stimulate
    2. Stimulate more
    2. Is inflation rising? yes go to 4, no go to 2.
    4. Stop stimulating

    'Big Government' is austerity advocates with convoluted theories of malinvestment and numbers of Debt/GDP ratio.

  9. Is forcing workers to pay workers to build stuff "austerity", or is telling workers they should not pay workers to build stuff "austerity"?

    I grew up when all the parents of my peers were asked to hike taxes on their property to fund debt to pay workers to build schools, roads, water and sewer, etc. As a student in over crowded schools, the voters could vote fast enough to higher taxes on property to fund the debt to pay construction and construction material workers.

    As we drove around, and I looked around the community, I couldn't wait for votes to hike taxes so new stuff got built faster.

    I heard the objections rise which I soon read in Milton Friedman's Newsweek columns about how workers were harmed by eing forced to pay for building stuff like schools, roads, water and sewer, and electric and telephone because it only led to workers earning too much and then spending too much buying too many cars and boats, requiring they pay construction workers to build new houses to get a driveway to park everything, and then buying too many electric appliances to fill these new houses, consuming too much electricity, leading to too much demand which led to government and industry promoting building too much more production of cars, boats, RVs, eldctricity. All of which cost workers, who were paid too much to work, too much.

    I though Keynes and Galbraith were antti-austerity because they wanted government to drive workers to pay more and more workers with higher living costs.

    And I thought Milton Friedman was pushing austerity by arguing workers should pay fewer workers to work.

    Of course, I wanted a job that paid me higher and higher wages, and my depression era parengts and peers were reluctant to volunteer to pay me as much as I wanted to be paid, but they would pay taxes as a duty, and pay the price demanded by capitalists selling cars, boats, RVs, etc, as well as food, housing, etc.

    I can't figure out how any central banks is able to force workers to pay workers to work, and work more. Instead central banks seems to provide the means to work less for pay, but borrow more to buy imported stuff.


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.