Austerity will only end when our leaders start being honest

Austerity was the underlying motivation for starting this blog. Sometimes I think everything that I, Paul Krugman and many others have written over the last six or more years has fallen on deaf ears. Take two recent pieces of evidence: this FT article by Nicholas Macpherson, ex permanent secretary at the Treasury, and this interview of the Chancellor by Andrew Marr.

In talking about Osborne’s fiscal consolidation that began in 2010, Macpherson says: “With hindsight, there was a case for going further faster.” His rationale is that the public like a dose of austerity, but tire after a time. At no point does he mention the economy (a recovery that stalled from 2010 to 2013, and then only started growing at trend thereafter), or monetary policy (interest rates were stuck at their lower bound). His desire for a shorter, sharper fiscal shock would have almost certainly produced a second recession.

I calculated that the fiscal consolidation that did take place cost the average household at least £4,000 in lost resources. This is based on OBR numbers, and assumes (as the OBR does) that the economy recovers quickly from any fiscal consolidation. This latter assumption looks very shaky indeed. Once you stop making it, the costs of austerity become horribly large. Not a word about this from Macpherson, which allows him to make the ridiculous argument that we should have had a shorter sharper consolidation.

One of the other ridiculous things Macpherson says is that, from 2010 to 2016, the UK did not even experience austerity. He justifies this because the debt to GDP ratio over this period rose. I’ve heard similar things in comments on my blog, presumably because of what Conservative politicians or their apologists say in the press. The statement confuses levels with rates of change, whether you are talking about the impact on the economy or on individuals. This is first year undergraduate stuff.

Philip Hammond said in his interview that a deficit of 2.5% is not sustainable. The normal definition of sustainability is a deficit that keeps the debt to GDP ratio constant. The current debt to GDP ratio is 86.5%. To work out roughly what the sustainable deficit is, divide the debt level by 100 and multiply that by the expected growth rate of nominal GDP. That means that today a deficit of 2.5% of GDP would be sustainable as long as nominal GDP grew at about 3%. So his statement that a deficit of 2.5% is not sustainable simply looks wrong.

You could rationalise this by saying that he believes our current debt to GDP level is not sustainable, and that therefore he wants to reduce it, but if that is what he means he should say so. Instead it seems that he wants to pretend that the government is like a household, and so therefore there is some reason why a deficit of zero is desirable. Of course Hammond does not mention interest rates either. And he knows that, in an interview like this, he can get away with anything involving economics or numbers.

Austerity has been supposedly dying since after the Brexit vote, but that just reflects misleading or dishonest reporting. As Torsten Bell says, for most people austerity means cuts to public spending, and for public sector workers and those on low incomes there is more austerity to come. Hammond also said Labour’s proposed fiscal policy would be “catastrophic for the country”. I suspect this kind of nonsense hyperbole, frequently invoked by the right wing press, has now become counter-productive. In reality at the heart of Labour’s fiscal policy is a fiscal rule which takes the government’s role in the economy seriously, rather than reduce it to the budget of a Swabian housewife. I cannot wait for the day that becomes the UK government’s fiscal rule, and we can move discussion of UK fiscal policy away from numbers 'not adding up' and back into the 21st century.

Is pessimism about European debt levels justified?

Barry Eichengreen and Ugo Panizza posted a rather pessimistic account of the sustainability of European debt levels. To quote:

“For the debts of Europe’s problem countries to be sustainable ... their governments will have to run large primary budget surpluses, in many cases in excess of 5% of GDP, for periods as long as ten years. History suggests that such behaviour, while not entirely unknown, is exceptional.”

Is this pessimism warranted? Here are some numbers, updating an earlier post.

	Net debt % GDP 2013	Interest % GDP 2013	Implicit nominal rate 2013	Long term  r-g (high)	Required primary surplus % (high)	Long term  r-g (low)	Required primary surplus % (low)	Underlying Primary surplus 96-07	Underlying Primary surplus 2015
Greece	122.7	3.6	2.9	5	6.1	2.5	3.1	0.0	7.8
Portugal	91.8	3.8	4.1	5	4.6	2.5	2.3	-2.0	4.7
Ireland	90.3	4.0	4.4	5	4.5	2.5	2.3	1.1	3.0
Spain	70.7	2.9	4.1	4	2.8	2	1.4	0.9	0.2
Italy	116.5	4.9	4.2	4	4.7	2	2.3	2.4	4.9
France	73.6	2.1	2.9	2	1.5	1	0.7	-0.8	0.9
Germany	49.1	1.6	3.3	2	1.0	1	0.5	0.6	0.7
Japan	137.5	0.9	0.7	2	2.8	1	1.4	-4.4	-5.4
UK	65.4	2.8	4.3	2	1.3	1	0.7	-0.1	-1.4
US	81.2	2.3	2.8	2	1.6	1	0.8	-0.2	-1.7
Euro area	68.5	2.5	3.6	3	2.1	1.5	1.0	0.8	1.8
OECD	69.1	1.9	2.7	3	2.1	1.5	1.0	-0.1	-0.8

All data comes from the OECD’s Economic Outlook. The first three columns are self explanatory. The fourth column is a complete guess at what a long term growth corrected real interest rate (r-g) might be, and I will discuss these numbers below. If you multiply this by the debt stock, you can compute what the required primary surplus needs to be just to keep the debt to GDP ratio stable. To start getting debt down, surpluses would have to be larger still.

Therein lies Eichengreen and Panizza’s pessimism. They argue that long periods over which primary surpluses have been above 3% are rare. Of the PIIGS, only three of the five are expected to have a primary surplus above the required level by 2015. Are primary surpluses above this required level possible to maintain for a decade or two rather than a year or two?

Yet a quick look at the table shows you that the problem is not so much the starting level of debt, but the assumption about trend r-g. Halve r-g, and you halve the required primary surplus, as columns 6 and 7 show. Numbers above this level, although still a challenge, look much more possible.

The interest rate numbers in the high column assume 2% is the risk free value for r-g, corresponding to a 4% real interest rate and 2% trend real growth. It is applied to the US, UK, Germany, France and Japan because there the chances of default are minimal. We then add percentage points for risk. The argument here would be that, within the Eurozone, OMT prevents numbers getting very large, but equally we will not return to the pre-2008 days when Greek debt was considered only marginally more risky than German debt.

However, I think you could quite plausibly divide all these numbers by two. A number like 4% for the risk free real interest rate would apply to some earlier decades, but at the moment this number looks rather high. [1] Secular stagnation could keep this number even lower. Risk premiums for the high debt Eurozone countries could also be halved, as they are anyone’s guess given institutional uncertainty. With these low numbers, required primary surpluses become more feasible.

The importance of the interest rate assumption also becomes clear if we compare the Euro area to the OECD as a whole. Looking at debt levels and actual primary surpluses, the one country that really looks worrying is not in the Eurozone, but Japan. In terms of primary surpluses, neither the UK nor US is any nearer achieving required levels than the PIIGS. The only reason to single the PIIGS out is because of the interest rates they might have to pay. We saw with OMT that this has as much to do with the institutions of the Eurozone as a whole as it does individual governments. 

[1] The CBO estimates (pdf, page 92) that the real interest rate on 10-year US Treasury notes averaged about 3 percent during the 1960s, about 1 percent during the 1970s, about 5 percent during the 1980s, about 4 percent during the 1990s, about 2 percent between 2000 and 2007, and about 1 percent during the past six years. CBO projects that the average real interest rate the federal government will have to pay on all its debt from 2014 to 2039 will be 1.7%, corresponding to a real rate of 2.5% on 10 year bonds (p104). This implies numbers for r-g perhaps even lower than the ‘low’ column in the table.