George Osborne has dodged a bullet, but not by much. Although he barely avoided a triple-dip recession, no one can claim his stewardship of the economy has been a success. He promised us that pain would bring prosperity, but after almost three years of fiscal discipline British real GDP per capita is lower than when the Tories took office. Austerity has been a disaster and at long last, more and more of its acolytes are admitting it. The president of the European Community recognises that the political will for public sector cost-cutting is exhausted, the IMF now suggests the chancellor find a plan B, and an investigation into the data reveals one of the intellectual underpinnings of austerity to be the result of arithmetic and coding errors.
In 2010, Carmen Reinhart and Kenneth Rogoff, the authors of a magisterial study of financial crises going back to 12th-century China, determined that, on average, growth becomes negative whenever government debt levels rise above 90 per cent of GDP. Conservative politicians from the Bundesbank to 11 Downing Street cheered this data point as it justified the policies they advocated. At the time, like now, they were under attack from Keynesian economists who argued that in a downturn, austerity is precisely the wrong medicine. Unfortunately for Osborne et al, a recently published study by academics at the University of Massachusetts shows that Reinhart and Rogoff got their math wrong. The revised average growth rate is a positive 2.2 per cent. The economics blogosphere is agog.
Reinhart and Rogoff admit their mistake but they pooh-pooh its significance. So do most austerians. When asked for his reaction, prominent Republican economist Douglas Holtz-Eakin replied, “There’s nothing about this that will change my view of the universe.” He added, “The sun still rises in the east. It sets in the west. And a lot of debt is still bad.” Even though austerity has failed to promote growth in Britain, Spain, Ireland, Portugal, or Greece, it still has avid supporters.
In part that is because austerity makes intuitive sense. If I owe more than I earn, the last thing I should do is borrow and spend even more. But what is logical for you and me is not logical for the economy as a whole. Elementary economics, at least since 1936, tells us that during a recession, government spending should rise. If households and firms are not consuming or investing enough to keep productive resources working, then the government needs to step in.
Somewhat facetiously Keynes advised governments to hire men to dig ditches and others to fill them. Even that pointless work would give workers salaries, which they would spend, which would stimulate the animal spirits of businessmen who would then hire more workers and invest, creating a virtuous circle and allow the economy to take off. The second world war proved Keynes right by finally ending the Great Depression. It was not the slaughtering of soldiers and civilians that cut unemployment but government deficit spending.
One must assume Osborne and his friends have read Keynes, or at least heard of his theories. Keynes’s response to the austerians of his day was so intellectually devastating that they were a joke for at least 30 years. Why then do austerians feel such certainty in the face of all evidence?
Historically, austerity is the default policy of choice for creditors. During the Latin American debt crisis and the East Asia crisis, bankers demanded governments spend less so the surplus could be earmarked to pay their debts. If you lend money to your brother so he can pay his mortgage, you don’t want to see him spending it on a pony for his daughter. If a German bank lends money to Greece, it doesn’t want to see it wasted on pensions or civil servants’ salaries. This explains the German desire for fiscal probity in the southern periphery. A euro spent on education in Madrid is a euro that can’t be sent back to the bank in Frankfurt. That is why the IMF has always been a fan of austerity in the developing world.
To understand the profound appeal of austerity, imagine you are rich. So rich that unemployment could never be a problem. So rich, in fact that you don’t have a job—you just live off the interest of your capital. That means what you worry about (even rich people have worries) is your investments. You fear the value of your capital will decrease, and today that is not unreasonable. The world is lacking in safe assets. Bond yields are miniscule and shares are overpriced. Fiscal stimulus would restore growth—and if growth returns, inflation could explode.
Inflation is the bugbear of the creditor class, and rightly so. No lender wants to be repaid in depreciated currency. To save the banks, we have vastly increased the monetary base. It has not created inflation yet, but should the economy start growing again, it just might. Government deficit spending will put people to work, utilise idle resources and re-energise the private sector, but all that expansion could be bad for bondholders. Perhaps that explains why all the evidence does not seem to sway George Osborne and his austerian friends. We are naïve if we imagine their passion for spending cuts is out of concern for the general economy. The austerians are looking out for the bankers and the bondholders. The head of Goldman Sachs has just reiterated his support for Osborne’s austerity measures.
Interestingly, though, even in the bondholding community, austerity is beginning to be seen as a lead weight. Bill Gross, manager of Pimco, the world’s largest bond fund, declared on Monday, “The UK and almost all of Europe have erred in terms of believing that austerity, fiscal austerity in the short term, is the way to produce real growth. It is not.” He added that governments have “got to spend money” if we are to emerge from stagnation. This is quite a turnaround. Two years ago, Gross, fearing government debt and its inflationary implications, announced his fund was cutting its investments in US government bonds. He expected yields to rise and prices to fall but his predictions were wrong and he lost a lot of money. Gross learned from his mistakes. Let us hope Osborne can do the same. So far, unfortunately, the gentleman is not for turning.