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.

How UK deficit hysteria began

Laura Basu has a good book just out on UK media coverage of events from the Global Financial Crisis (GFC) until 2015, which I have reviewed for Open Democracy. Among other things, it tells the story of how what Mark Blyth calls the ‘biggest bait and switch in history’ happened in the UK. Laura argues that it can be dated almost exactly to the Budget of April 2009.

That the right wing press would start talking about the horrors of the rising UK deficit is no surprise. Osborne had decided in the previous year to oppose the Labour government’s stimulus measures because he saw in the rising deficit a way to beat Labour. The puzzle is why a broadcast media, ever conscious of balance, pushed the same line, even though it was clearly advantageous to one side politically.

The following story is mine, not Laura’s. Before the GFC, the way that the broadcast media covered budgets had become quite formulaic. Each budget would present estimates of the deficit over the next five years, and with the help of the IFS commentators broadcasters would discuss not only what tax changes had been announced, but also what might be implicit in the projections. No doubt this framework suited journalists well, because it allowed easy analogies with households. If the IFS felt that the projections were over optimistic and therefore fiscal rules might be broken, they said so and that became one of the budget talking points. The state of the economy was hardly ever discussed, because the Bank of England seemed to be doing a pretty good job of keeping things stable.

That all changed with the GFC, when monetary policy ran out of reliable levers to manage the economy. However journalists wouldn’t know that from the Bank of England, who tended to talk as if Quantitative Easing was a close substitute to interest rates as a monetary policy instrument. They would know it from academic macroeconomists, but journalists were generally too busy to make the effort to talk to them. For whatever reason, they did not fully appreciate how much the world had changed as a result of the GFC.

So when in the budget of April 2009 the Treasury showed the full extent of the deficits that the recession (and to a smaller extent the government’s stimulus measures) had created, journalists behaved exactly as they would have done before the GFC. Compared to deficits seen before the financial crisis, the numbers were indeed large. But crucially, because the Treasury estimated that the GFC had reduced the trend level of GDP, fiscal savings were necessary as a result. When these took the form of efficiency savings, the IFS were rightly skeptical.

So the coverage was all about higher taxes and lower spending, and whether they would be enough to close the record deficit. At no point in the subsequent discussion does anyone ask whether the current deficits are large enough to create a strong recovery. The growth forecasts are taken as given, and only their fiscal consequences are discussed, as if the former had nothing to do with the latter: an assumption that is only appropriate if monetary policy is in complete control of the economy. The government’s line that these deficits were necessary to ‘support’ the economy was almost entirely ignored.

Furthermore, the issue of whether the markets would purchase all this extra debt was already being raised. This is City speak, seeing a recession as involving more government debt and therefore perhaps higher rates, rather than understanding that the recession was caused by more saving and less borrowing so there would be plenty of new savings to buy the additional debt.

In other words the broadcasters had a framework for commenting on the budget which was appropriate before the financial crisis, but totally inappropriate after it. What they should have been asking is whether the Chancellor had done enough to ensure the recovery that was forecast, or whether perhaps larger deficits might be needed. In retrospect, that was exactly the right question to ask.

At the time, the reason for these deficits was clearly spelt out by the IFS as well as the Treasury. "The Treasury's assessment of the fiscal damage wrought by the current economic and financial crisis is breathtaking," said IFS director Robert Chote. "It will require two full parliaments of mounting austerity to repair." But in a telling indicator of things to come, the headline paragraph loses the bit about the GFC. As Laura’s book shows, it became so easy for a media prone to amnesia to forget about the financial crisis and blame everything on Labour profligacy, as after a time most voters began to believe. But the fundamental mistake was focusing on the deficit as a problem rather than as an instrument designed to produce a strong economy. The mistake came from the media’s inability to see how the GFC had changed the macroeconomic rules of the game.

Is austerity to blame for Brexit?

Mark Blyth writes

“Strip away all the electoral politics at the moment in the U.S., the U.K., Italy, Spain and elsewhere, and that's the underlying political economy. It's a creditor/debtor stand-off where the creditors have the whip hand. And yet, the more they crack the whip, the more the backlash against austerity, in all its forms, gains strength.”

Or in other words, it is all about austerity. That is a big claim, particularly when applied to the current US elections, but I want to examine it in the specific case of the EU referendum. In short, did austerity cause Brexit? Given how opposition to austerity has been such an important part of this blog, in some ways it is an attractive line for me to take, but I do try and base what I say on evidence rather than on what is convenient.

In the past I’ve argued that there is a massive problem with this idea, and the related idea that Brexit was a more general protest vote against elites. The obvious time to protest against austerity was the 2015 General Election. Yet rather than protest against the party that introduced austerity and promised much more of it, the British people gave the Conservatives a surprise victory.

It is nevertheless possible to argue that austerity caused Brexit in more subtle ways. I’ve also argued in the past that some of the concern over immigration is actually the result over concern about reduced public services and low wages, and a belief that the issues are linked. To the extent that reduced access to public services and to some extent low wages is actually the result of austerity, and if much of the public believe that austerity is nevertheless necessary, then what should be a protest over austerity could get displaced as a protest about immigration.

If your response to this idea is to say that concern over immigration is also a result of racism and xenophobia, I would agree, but argue that this is beside the point. When talking about the Brexit vote, we should be concerned about what you might call the swing voters, a point that Chris Dillow also makes. Remember that a large number of those voting Leave would not have been prepared to pay anything to reduce immigration: they do not sound like voters whose overriding concern is to see less foreigners on their streets. It is the Brexit voters who thought Brexit would make them better off that we should be concerned about.

So there is a possible mechanism by which austerity could have caused Brexit. That mechanism is part of a more general phenomenon: when things get tough, people become much more receptive to potential unfairness. It is what helps drive a belief that welfare goes to scroungers, a belief that some Conservative ministers seem happy to encourage.

Is there any evidence to support the idea that the mechanism I’ve outlined was important? Here is polling on the EU referendum over a long time period (source).

If there is a general recession effect here (i.e. applying to every UK recession) it is masked by other factors. However after the global financial crisis and austerity we did see a big shift against the EU, although that could also be explained by the Eurozone crisis. The drop in support for leaving before the 2015 election seems to go against the austerity caused Brexit hypothesis, but that was also a time the government and much of the media was claiming that the UK economy was recovering strongly. The true state of the NHS only became apparent to most people after the election, when support for Leaving revived. So I do not think this historical evidence is conclusive either way.

There is some econometric evidence for a link between the extent of public service cutbacks and the proportion of people voting Leave (for a summary, see this VoxEU article). But as the article itself notes, the measure of austerity used could simply be acting as a proxy for more long term deprivation, which is a widely acknowledged influence on Brexit.

In my view more compelling evidence for an impact of austerity on the Leave vote comes from the little polling evidence we have on why people think high levels of EU immigration is a problem. Here is the result of a poll on this that I have reproduced before, which speaks for itself.

As I have argued here, the current squeeze on the NHS is unprecedented. The share of NHS spending in GDP has a natural tendency to rise over time, for reasons that are well understood. Yet not only did few in the media contest the ‘common sense’ idea that austerity was necessary, but also voters hear time and again that NHS spending is being protected. As they see services deteriorate, it is not surprising that they conclude that there is just too much demand. I doubt very much that it is coincidence that the Leave campaign’s bus had the £350 million a week going to the NHS.

So there is evidence that links austerity to the Brexit vote, particularly if we remember we are not talking about a core vote that would have voted Leave anyway (because of xenophobia, for example), but the swing voters who at other times and circumstances might have voted the other way. But what about arguments that the Leave vote reflected a reaction to deprivation caused by globalisation, or that it was the result of the malign influence of the tabloid press? (I’ve made both arguments in the past.)

There is some complementarity here. As I noted at the beginning, the media is important in transforming concern about austerity from the politicians that impose it into concern about immigration. More importantly, there is no need to find the cause of Brexit. It seems quite possible to believe that the vote would have gone the other way if we had not had austerity, or if we had a tabloid press that was not just a cheerleader for Leave and a broadcast media indifferent to expertise, or if the impact of globalisation had been offset in various ways. With the vote so close, it is legitimate to argue that all three on their own might have been responsible for Brexit, or equivalently that the Brexit result was a consequence of a perfect storm of bad policies and institutions.