Fiscal tightening in UK recessions: 1981 and 2010 compared

I have decided to abstain from twitter conversations to protect my own wellbeing, but I made an exception for Andrew Sentance recently. The issue was the extent to which the 1981 fiscal tightening was equivalent to 2010 austerity. It was clear this needs a post to clarify things. In the charts below, I compare how various fiscal magnitudes compared to the year before financial year 1981/2 (blue) and financial year 2010/11 (red) in terms of percentages of GDP. (To be precise, the blue line subtracts X in 1980/1 from all subsequent years, where X is the share of some fiscal magnitude in GDP, and the red line subtracts X in 2009/10 from all subsequent years. Source OBR public finances databank) 

First consider public sector receipts.

The 1981 budget was a tax hike, that prompted the famous letter from 364 economists denouncing the budget. However notice that the tax hike was mostly reversed within two years. In contrast the tax hike in 2010 (higher VAT) was smaller as a percentage of GDP but it was not reversed.

With total spending we get a different picture

Under Thatcher the share of total spending in GDP stayed pretty constant. That does not mean there was no tightening, because with a large increase in unemployment we might have expected a rise in spending as a share of GDP (a point Andrew makes). But nevertheless the contrast with 2010 is stark. Public spending was the main component of fiscal tightening under Osborne.

It is worth looking at one component of spending: public investment.

Here we can see some tightening under Thatcher, but once again it was quickly reversed. Under Osborne the cuts grew over time, and by the end were twice as big as anything attempted under Thatcher.

These components can be combined by looking at net borrowing.

The Thatcher fiscal contraction was largely reversed within 2 or 3 years (almost completely reversed if we looked at cyclically adjusted figures). Osborne’s contraction grew steadily over time. It would also be a mistake to conclude that in the first two years Thatcher’s 1981 contraction was as equally severe as Osborne’s. Tax increases have a much lower impact on demand than cuts in public investment or government spending more generally.

So 2010 was not the first time a government had chosen to cut public spending in a recession, which is the reason I added the word ‘sharply’ in my tweet. It was also not the first time a UK government had attempted fiscal tightening in a recession, as 1981 shows, which is why I specifically talked about public spending in my original tweet. But perhaps the most important difference between 1981 and 2010 is longevity. Thatchers fiscal tightening in 1981 was largely reversed by1983: tightening did not just stop but it was followed by fiscal expansion. In 2010 tightening continued year after year. It is no surprise that the recovery was so weak.

Indeed, if you define an economic recovery as growth above past trends, which there is a strong case for doing, there was no recovery from 2010 onwards. Using the same definition there was a recovery after 1981, but it began in calendar year 1983. The temporary fiscal consolidation of the 1981 budget did delay the recovery for nearly two years, but partly because that consolidation was reversed the recovery eventually came. Of course monetary policy played an important role in both periods (the size of the interest rate cut was similar), but the cuts were slower under Thatcher and there was no Quantitative Easing either.

While 1981 was nothing like as bad as the austerity of 2010, it was a serious macroeconomic mistake which undoubtedly caused considerable hardship for many. It also played an important role in creating the conditions, in the mind of many Conservatives, for 2010. Conservative politicians and particularly the Institute of Economic Affairs told a false story, a story where the economists who wrote the 1981 letter were wrong and Thatcher was right. Because they kept on telling their story as if it was true some media commentators began to believe it was true. I’m sure this played some part in sustaining austerity in 2010.

Austerity Confusion, or why the Tories are trapped by austerity

What do we mean by an end to austerity? There seem to be two meanings being used currently. The first, used by Conservative politicians in particular, is equivalent to what economists call fiscal consolidation: cutting spending (or raising taxes) in order to reduce the deficit (as a share of GDP). However when Labour say they will end austerity, I think they mean something even simpler: to stop (and reverse) cuts to government spending as a share of GDP.

The confusion has been compounded by two factors. First, Conservative Chancellors have mainly used cuts to spending rather than tax increases as part of their austerity programme. Second, they have also justified cuts to spending that were needed to finance tax cuts (corporation tax, inheritance tax etc) as austerity, which is a clearly not fiscal consolidation and is simply a reduction in the size of the state.

How do I know Labour do not mainly mean ending fiscal consolidation when they talk about ending austerity. Just look at their GE2017 manifesto. That involved various increases in current spending financed entirely by higher taxes (including corporation and inheritance taxes). This manifesto, which helped gain them such rapid popularity in the GE2017 campaign, was a proposal to increase the size of the state.

I explore in a shortcut piece for the London Review of Books how this ambiguity is a serious problem for the Conservatives. Even if they ended austerity completely (made no further attempts to reduce the deficit), Labour would be able to offer a much more attractive fiscal package to the voters because Labour are prepared to undo the tax cuts the Conservatives have made over the last seven years. 

How do I know such a package would be attractive? Here I reproduce my favourite chart from the latest Social Attitudes survey that I talk about in the LRB piece.

The ‘neoliberal’ line is in yellow at the bottom. In 2010 nearly 90% either wanted to keep the size of the state the same or increase it. It is why the Conservatives were forced to use what I call deficit deceit - pretending cuts to the size of the state were about cutting the deficit - to pursue neoliberal goals (see my last post). By using deficit deceit to reduce the size of the state, when concern about the deficit was bound to wane, the Conservatives have condemned themselves to current unpopularity as voters realise what they are losing.

Why didn't this stop the Conservatives winning the 2015 General Election? Here is a YouGov poll that explains why.

In 2015 more people blamed Labour that the Conservatives for spending cuts. This was translated into views about economic competence because the Conservatives, with the help of mediamacro, made reducing the deficit the key variable in judging economic policy. We are now in a period where this narrative still has an influence but it is no longer enough to win an election. The Conservatives dare not throw it away because many voters still believe it. They have become trapped by their own austerity policy and the reduction in the size of the state that went with it..

Defining austerity

In my recent talk in Dublin, I defined fiscal austerity in a way that is not generally applied, but which I think makes sense. The most common usage is simply an attempt to reduce the budget deficit by cutting spending or raising taxes. The problem with that, as I remember Nick Rowe complaining, is that it becomes identical to the term fiscal consolidation. We could say that austerity is just lots of fiscal consolidation, but that seems weak.

Common usage tends to assume that austerity does some harm: not just to the individuals affected by any cuts or tax increases but for the economy as a whole. Indeed if you look at what google says when you ask for a definition, we get:

“difficult economic conditions created by government measures to reduce public expenditure”

That is different from fiscal consolidation, because consolidation in itself need not lead to ‘difficult economic conditions’. If fiscal consolidation is offset by monetary expansion, there is no reason for the economy as a whole to experience any difficulties.

What I suggest is making this definition a little more precise. I want to define austerity as

“fiscal consolidation that leads to a significant increase in involuntary unemployment, or perhaps more formally but less colloquially as leading to a noticeably more negative output gap.”

If you think this is what most economists mean in practice, I would agree. But they do not always define it this way, even when they should know better. In addition, under my definition the term ‘expansionary austerity’ would make no logical sense, but the term is widely used. Last and probably least, Wikipedia define it as fiscal consolidation rather than the way I suggest.

The advantage of my definition is that I am able to make two clear statements. First, for the global economy or for an economy with its own central bank and floating exchange rate, austerity is generally completely unnecessary, because fiscal consolidation can be delayed until a time when monetary policy is capable of offsetting it. This means that austerity could have been completely avoided over the last five years in the UK, US and the Euro area as a whole. Second, for a member of a monetary union which requires more fiscal consolidation than union members on average, austerity will follow fiscal consolidation, but only to the extent that it enables the internal devaluation necessary to bring about the real depreciation required to offset that consolidation. Austerity will only be limited in this way if the union’s central bank follows appropriate policies. It seems highly likely that excessive austerity occurred in the Eurozone periphery because the ECB delayed introducing these appropriate policies.

To see me give chapter and verse justifying these statements, you will have to wait until I write up the paper!