Mediamacro myth 1: 2010 Britain faced a financial crisis

The idea that the Coalition rescued Britain from a crisis is routinely put forward as fact by both the Conservatives and Nick Clegg. Every time the media let such statements pass (as they invariably do), the language seems to get more florid: Clegg’s latest is that the coalition was born in the “midst of an economic firestorm”. [1]

The facts say this is pure nonsense. The economy had begun to recover from the recession, and this recovery might have continued if it had not been hit on the head by domestic and Eurozone austerity. As Larry Elliott makes clear (see also here), there was no sign of any market panic, either in the markets for Sterling or government debt. 

But the government’s budget deficit was very large, and debt as a proportion of GDP was therefore growing. If, through a separate myth, you have created the idea that the major (perhaps only) goal of aggregate fiscal policy is to reduce deficits, this seems like a serious problem. But the deficit was rising because of the recession. It always does rise in a recession and fall in a boom, as the chart below shows. It was particularly high in 2010 because this recession was particularly deep.

Any economist would cringe at the idea that policy should try and eliminate deficits and surpluses created by the economic cycle, because that would mean destabilising the economy. This is sufficiently well known (cyclical deficits and surplus are called ‘the automatic stabiliser’) that it could undermine the idea that the high deficit was an immediate problem. This is one reason why it is important to push another mediamacro myth - the idea of Labour profligacy, which we debunk tomorrow. [2]

So where is the half-truth that gives the ‘firestorm’ myth some credence? It is of course the Eurozone crisis, and the idea that the UK could suffer a similar fate to the Eurozone periphery. But academic macroeconomists understand that the situation of a country with its own central bank, like the UK, is quite different from a country without, because the central bank can (and in the UK will) act as a lender of last resort, so the government will never ‘run out of money’. That simple fact is sufficient to prevent any crisis happening for an economy like the UK. Greece was profligate, and had to default, but the crisis in the rest of the Eurozone ended the moment the European Central Bank agreed to act as a lender of last resort in 2012.

Why is it so important to keep up the pretence that in 2010 the UK economy was ‘on the brink’ of a financial crisis? Because only then can the pain of the subsequent few years be excused. The truth is that the failure to recover until 2013 was not the inevitable cost of rescuing the economy from crisis, but an avoidable choice by the Coalition government. The delayed recovery, and the damage that did to living standards, was at least in part a direct consequence of attempts to reduce the deficit far too early, and there was no impending crisis that forced the government's hand. [3]

Previous posts in this series

(0) UK mediamacro myths: an introduction

[1] There is something about Clegg that wants me to see him in the best possible light. So I imagine that, when confronted just after the 2010 election by briefings from the Treasury and the Bank about the dire economic situation, he really believed what he was reading. He did not realise that, from the Treasury at least, it is standard practice to say this to any incoming government. (One of the interesting untold stories of austerity is the extent to which it was encouraged by senior Treasury civil servants.) But I suspect my imagine of 'Clegg the naive' is, well, imaginary.

[2] If the financial crisis had permanently lowered UK GDP, or the tax potential of GDP, then that would also imply the need to reduce government spending at some point. But, as most economists agree, you do that when monetary policy can offset the impact of these cuts on demand. You do not choose to undertake austerity when short term interest rates cannot fall any further.

[3] The clear majority of macroeconomists agree that austerity when short term interest rates cannot fall any further will reduce output. The OBR calculate that austerity cut growth in financial years 2010-11 and 2011-12 by 1%, but there are good reasons for thinking this may be an underestimate. 

The power of financial markets

You might imagine that the global financial crisis had reduced the power and influence of finance and those involved in financial markets. After all, the excesses shown by participants in those markets had caused the largest recession since WWII. (Not to mention a constant stream of cases of illegality and mis-selling.) However I wondered yesterday if the opposite might be true.

This was during a debate at the Houses of Parliament, in which Jonathan Portes and I were debating austerity with Roger Bootle and Doug McWilliams. A constant refrain from our opponents was that (a) the stock of government debt was very large, (b) you needed the confidence of markets to be able to maintain this level of debt, (c) markets were fragile beasts, so best take no chances, and (d) therefore we needed austerity to reassure those markets.

I immediately thought of one of my better posts, where I suggest too many people view markets like a vengeful god, and those that are ‘close to the markets’ like high priests. (I couldn’t quite believe it when a member of the audience asked our opponents about whether they thought some proposal would ‘pass muster with the markets’.) Now Roger, who is a sensible guy, did agree that default was not really an issue for the UK, but the danger was rather inflation, if the deficit or debt became ‘too large’ and markets refused to fund it, so it had to be monetised. If it seems odd to you that the markets would start worrying about the monetisation of debt because a large recession increased deficits, but be quite unconcerned today about the central bank creating money to buy huge quantities of government debt as part of Quantitative Easing, then your mistake is to think that the markets are always rational. If they are both fragile and febrile, as our opponents and others close to the markets often suggest, it could happen.

Before the financial crisis, it was in the interests of those involved with financial markets to emphasise how rational they were. No need for regulation - these are clever people who knew what they are doing. The crisis blew that argument apart, but instead it created the idea that the markets could be dangerously irrational: irrationally exuberant at one point, and irrationally risk averse the next. It also showed how dependent on these markets the economy had become. Hence the idea of a vengeful god that could suddenly turn on you for no good reason and who therefore had to be appeased at every turn.

This kind of argument has a strong emotional appeal, particularly when the financial crisis is fresh in peoples’ minds. I suspect that attempts to show that markets are actually pretty rational most of the time will not work. Instead I’m afraid we have to focus on the high priests. A truly irrational market could do anything. The problem comes when the high priests declare that, by being close to the markets, they can discern some logic to its tantrums. And by a divine coincidence, this logic just happens to fit macro view of the world that the high priests hold.

For example, we are told that markets worry about large deficits and require austerity immediately. Never mind that there is no sign of worry, and that interest rates are falling: markets are fragile and febrile and could turn at any moment. The high priests, being close to the markets, understand that. Strangely the high priests never detect any concern that a persistent recession brought about by austerity might - through hysteresis effects - permanently damage productive potential, with potentially greater impacts on the tax base and long term solvency. I guess the high priests markets had not read that paper.

We are told that Osborne needed to give a clear demonstration to the markets that he had the political will to bring the deficit under control, which is why deficit reduction had to be front loaded. It does not seemed to have occurred to the high priests markets that, given his desire to reduce the size of the state and win the next election, front loading austerity is exactly what he wanted to do, even if he had no particular concern about the deficit. To show a clear conviction to give top priority to reducing the deficit required him to do something that was politically costly, like raising inheritance tax.

And do not forget that Ireland and Portugal were constantly told by those close to the markets that they needed to embark on acute austerity to ‘regain the trust of the markets’, when in fact what the markets were looking for all the time was for the ECB to act as a lender of last resort. I could see that from my academic ivory tower, but most of those ‘close to the markets’ did not.

The financial crisis may have told us about the power that financial markets have, and how it is important to understand how they behave. But the way to do that and to make good policy in the meanwhile is through economic science, and not to rely on the wisdom of priests. As I said in my little speech at the debate, the cost of UK austerity in 2010 and 2011 was at least 5% and probably more like 10% of GDP, numbers which neither of our opponents challenged. The gods it seems require big sacrifices nowadays. But if the only reason for making this sacrifice is that the high priests tell us that this is what the gods require, then I think the time for enlightenment is well overdue.