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.

Hard truths for the IMF

It is to the IMF’s credit that they have an Independent Evaluation Office, and their recent report on the Eurozone crisis is highly critical of the IMF’s actions. The IMF’s own staff told them in 2010 that Greek debt could well not be sustainable, but the IMF gave in to European pressure not to restructure Greek debt. Instead the Troika went down the disastrous route of excessive austerity, and the IMF underestimated (unwittingly or because they had to) the impact that austerity would have. In the last few years we keep hearing about an ultimatum the IMF has given European leaders to agree to restructure this debt, and on each occasion the IMF appears to fold under pressure.

These repeated errors suggest a structural problem. Back in 2015, Poul Thomsen, who runs the IMF’s European department, said “we need to ensure that we treat our member states equally, that we apply our rules uniformly.” But that is exactly what the IMF has failed to do with the Eurozone and Greece. As Barry Eichengreen writes

“When negotiating with a country, the IMF ordinarily demands conditions of its government and central bank. In its programs with Greece, Ireland, and Portugal, however, the IMF and the central bank demanded conditions of the government. This struck more than a few people as bizarre.

It would have been better if, in 2010, the IMF had demanded of the ECB a pledge “to do whatever it takes” and a program of “outright monetary transactions,” like those ECB President Mario Draghi eventually offered two years later. This would have addressed the contagion problem that was one basis for European officials’ resistance to a Greek debt restructuring.”

We could add that, since the Asian crisis of the late 1990s, the fund have understood the dangers of taking actions which just favour creditors, but as part of the Troika it sits down on the same side of the table as the creditors.

As Eichengreen also notes, it is not as if the IMF have had problems demanding commitments from regional bodies such as African or Caribbean monetary unions and central banks in the past. The problem is much more straightforward. He notes that European governments are large shareholders in the Fund, and that “the IMF is a predominantly European institution, with a European managing director, a heavily European staff, and a European culture.”

In other words we have something akin to regulatory capture. The IMF’s job is to be an impartial arbitrator between creditor and debtor, ensuring that the creditor takes appropriate losses for imprudent lending but also that the debtor adjusts its policies so they become sustainable. In the case of the Eurozone it has in effect sided with the creditors, and ruinous austerity has been the result of that.  

How the Eurozone can be reformed

The 50th anniversary issue of Intereconomics is out, and I have a contribution which summarises how I think the Eurozone could succeed without deeply problematic attempts at fiscal and political union. I look at three areas where change is required, and then rerun history to show how the Eurozone crisis could have been transformed into no more than a Greek public debt crisis.

Of the three areas of reform, I have written about the necessity of national countercyclical policy many times. Perhaps the only novelty in the paper is that I make it clear that this could be conceived and run locally or directed centrally: I prefer the former, and I discuss some advantages of subsidiarity, but the issues are separable.  On reform of the ECB I think it's fair to say my discussion is weak: I just think this issue has to be discussed more.

The final area of reform involves OMT and a genuine no bailout rule, the combination of which in 2010 would have prevented the government funding crisis spreading beyond Greece. (This might have creating a banking crisis in some core countries, but problems with banks are best confronted directly.) It is revealing just how many people still think 2010 was all about trying to help those countries with profligate governments. If this is your view, I strongly suggest reading this paper by Orphanides, who slowly unpicks the ‘official’ version of the crisis with the IMF’s help.  

A good paper to write is why the Eurozone has been such a failure at trying to play the role of the IMF (and to some extent corrupted the IMF at the same time). Judging by the number of useful roads built in Spain, Ireland and elsewhere, the EU has had some success at playing the World Bank role, although I’m sure there are also mistakes. However I do not think a political scientist would find the failure to play the IMF’s role any great puzzle. It has taken the IMF many years and errors to learn to at least try to refrain from simply bailing out western creditors. Judging from the failure to even admit the mistakes of 2010, I doubt that the Eurozone would even try. It would be much better if the Eurozone just abandoned trying to play this role, and left the IMF (with reduced European influence) alone to do its job of helping Eurozone governments that get into difficulties.

The ECB as sovereign lender of last resort

Understandably the element of my talk at the Royal Irish Academy which generated most discussion was the role of the ECB. (Here is a media report, but ignore the last two paragraphs which are confused/wrong. Abstract for the talk is here. Paper will follow.) The proposition I put forward was that the ECB’s OMT programme should have been put in place in 2010, and if it had been countries outside Greece could have implemented a more efficient austerity programme (one that produced less unemployment) and might have retained market access (interest rates on government debt would have remained reasonable). [1]

There are two serious and related arguments against this view. The first is that it is unrealistic for the ECB to act as a sovereign lender of last resort because of the transfers between countries that this might lead to. (A sovereign lender of last resort is a central bank that is always willing to buy its government’s debt.) [2] The second is that in practice OMT is bound to be coupled with a requirement for austerity programmes that might have simply duplicated what was actually put into place by national governments. Both arguments speak to a real problem that remains unresolved within the Eurozone, but do not nullify the argument that things should have been done much better.

Government debt in advanced economies is regarded as a safe asset for two reasons. The first is that most governments that borrow in their own currency rarely default. The second is that an individual investor does not need to worry about market beliefs, because if the market panics and refuses to buy the government’s debt the central bank will step in (hence sovereign lender of last resort). If the central bank did not do this, the government might be forced to default because it cannot roll over its existing debt.

It makes sense for the central bank to act as a sovereign lender of last resort, because it avoids self-fulfilling market panics. Doubly so because such panics will be more likely to occur after a large recession when the social value of government borrowing is particularly high. The complication in the case of the ECB is the following. If the market panic is so great that the ECB was forced to actually buy a ‘distressed’ government’s debt (normally the threat to do so is enough), it is possible that this government might choose to default even with ECB support. If it did that, the ECB would make losses which would be born by the Eurozone as a whole (the transfer risk).

Partly for this reason, the ECB has to have the ability not to act as a sovereign lender of last resort, or withdraw support if circumstances change. If that ability exists (a point I will come back to), then the transfer risk associated with the ECB acting as a sovereign lender of last resort are tiny. It represents the kind of minimal risk that should always be offset by the trust and solidarity that comes with the territory of being in a monetary union. I suspect those that suggest otherwise are often trying to hide other motives.

A government that is receiving ECB support of this kind will naturally want to know what it has to do to maintain it, because the threat of its withdrawal is so great. It would be unreasonable to withhold that information. Does that in practice amount to nothing more than the kind of conditions that have in practice been imposed on Ireland and Portugal anyway? Absolutely not. Just as the market does not worry about the build up of debt in a recession in countries like the UK or Japan, a rational ECB would have no reason to impose fiscal consolidation at the time it would do most damage. The time a rational ECB might withdraw its support is once a recovery is complete and the government refuses to embark on fiscal consolidation.

So a sovereign lender of last resort in a monetary union must have the ability not to provide that support. In other words it has to sort Greece from Ireland. That decision is a huge one, because in effect it is a decision about whether the country will be forced to default. It is natural that the ECB wants to share that responsibility with member governments, but as we have seen with Greece member governments are hopeless at making that decision (particularly when their own banks may be compromised by any default). We have also seen that European central bankers are far from rational on issues involving government debt (compared with at least one of their anglo-saxon counterparts), so giving the decision to someone else other than the current ECB would seem like a good idea. However at present there is no institution that seems capable of doing this job.

In this post I suggested contracting out this task to the IMF, although that presumed a reduction in the political influence of European governments on that institution. I have also wondered about whether a body like the newly created network of European fiscal councils could play this role. Another possibility is to reform the ECB so that it is not subject to deficit phobia, and is more accountable. It seems to me that this is where current research and analysis should be going, rather than into schemes involving greater political union.

The existence of various alternatives here means that we should not take what has actually happened in the Eurozone as some kind of immutable political constraint beyond which economics cannot go. There is no intrinsic reason why the OMT that was introduced in September 2012 could not have been introduced in 2010. There is no intrinsic reason why any conditionality that went with that could not have been much more efficient in terms of unemployment costs. Beyond Greece, the Eurozone crisis happened because the ECB thought it could avoid undertaking one of the essential functions of a central bank. This was perhaps the most important of the many errors it has made.

[1] For a country within a monetary union which needs to reduce debt more rapidly than does the union as a whole, a gain in competitiveness relative to the rest of the union is required to offset the deflationary impact of fiscal consolidation. That ‘internal devaluation’ probably requires some increase in unemployment, but it is much more efficient to obtain that increase in competitiveness gradually.

[2] It could be argued that the Fed does not provide lender of last resort services to individual member states. But state debt is typically lower relative to GDP and income than for Eurozone governments. Before 2000, Eurozone governments were able to borrow more because they were backed by their central bank. That means that they are inevitably subject to a greater risk of suffering from a self-fulfilling market panic. The architects of the Eurozone might have initially believed that the SGP might avoid the need for a sovereign lender of last resort, but after the Great Recession they would have known otherwise.

The Great Recession and the Eurozone crisis

Pandemonium erupted in Congress yesterday as senators disagreed on how to deal with the subprime problem. Borrowers are still finding it difficult to repay, despite the government buying these mortgages from the banks seven years ago and imposing strict conditions on the borrowers. Some senators favour continuing the program of compulsory community service and self-improvement lessons, but now others in the senate are openly talking about revoking the US citizenship of these borrowers.

The Great Recession and the Eurozone crisis are normally treated as different. Most accounts of the Great Recession see this as a consequence of a financial crisis caused by profligate lending by - in particular - US and UK banks. The crisis may have originated with US subprime mortgages, but few people blame the poor US citizens who took out those mortgages for causing a global financial crisis.

With the Eurozone crisis that started in 2010, most people tend to focus on the borrowers rather than the lenders. Some ill-informed accounts say it was all the result of profligate periphery governments, but most explanations are more nuanced: in Greece government profligacy for sure, but in Ireland and other countries it was more about excessive private sector borrowing encouraged by low interest rates following adoption of the Euro. Seeing things this way, it is a more complicated story, but still one that focuses on the borrowers.

However if we see the Eurozone crisis from the point of view of the lenders, then it once again becomes a pretty simple story. French, German and other banks simply lent much too much, failing to adequately assess the viability of those they were lending to. Whether the lending was eventually to finance private sector projects that would end in default (via periphery country banks), or a particular government that would end up defaulting, becomes a detail. In this sense the Eurozone crisis was just like the global financial crisis: banks lent far too much in an indiscriminate and irresponsible way.

If borrowers get into difficulty in a way that threatens the solvency of lending banks, there are at least two ways a government or monetary union can react. One is to allow the borrowers to default, and to provide financial support to the banks. Another is to buy the problematic loans from the banks (at a price that keeps the banks solvent), so that the borrowers now borrow from the government. Perhaps the government thinks it is able to make the loans viable by forcing conditions on the borrowers that were not available to the bank.

The global financial crisis was largely dealt with the first way, while at the Eurozone level that crisis was dealt with the second way. Recall that between 2010 and 2012 the Troika lent money to Greece so it could pay off its private sector creditors (including many European banks). In 2012 there was partial private sector default, again financed by loans from the Troika to the Greek government. In this way the Troika in effect bought the problematic asset (Greek government debt) from private sector creditors that included its own banks in such a way as to protect the viability of these banks. The Troika then tried to make these assets viable in various ways, including austerity. Two crises with the same cause but very different outcomes.