Is the Chancellor's medicine marvellous or simply a sugar pill? Our panellists battle it outby Oliver Kamm, Simon Wren-Lewis / January 16, 2015 / Leave a comment
Published in February 2015 issue of Prospect Magazine
The economy may now be growing at a respectable pace but the scars of the banking collapse remain. The remedial measures to deal with the crisis were justified: near-zero interest rates, flooding the financial system with liquidity, taking big public stakes in the banks, and a rise in government borrowing. The recent outperformance of the United Kingdom compared with the eurozone is not due to the economics of austerity but the opposite. Monetary policy has been much more expansionary in the UK and since 2012 the government has eased up on its proclaimed fiscal austerity—indeed fiscal policy was slightly expansionary last year.
There is a large and essential role for government in promoting growth and investment, and in reducing inequality. But there is a big long-term problem with high and rising levels of public debt. That’s where we are. The Conservatives appear to be aiming for a tighter fiscal stance than either the current fiscal mandate or the plans of Labour and the Liberal Democrats, with an overall budget surplus by the end of the next parliament. This shouldn’t be a matter of right versus left but of managing risks. Public sector net debt, excluding public sector banks, amounted to £1,457bn (79.5 per cent of Gross Domestic Product) at the end of November 2014, a rise of just under £90bn from the level of a year earlier.
I would prefer a tighter fiscal stance because I worry about what would happen if interest rates rose to their long-run normal levels—about 2 per cent above inflation and roughly the same as the economic growth rate. Financing public debt will be more difficult, especially in an environment of weak inflationary pressures. It will require tax rises and spending cuts, which will reduce growth and thereby compound the problem: the deficit will be harder to eliminate, and the debt might go on rising. If there is to be a responsible economic debate at the general election, it will have to address the build-up of debt, and the vulnerability of the economy once interest rates do rise.
There are three issues here, which we should keep separate. First, there is the appropriate size of the state. Second, there is how much government debt makes for a healthy economy in the long run. Third, there is how macroeconomic policy should be conducted when nominal interest rates are almost at zero (a liquidity trap). It is this last point I want to focus on. In short, austerity is very dangerous in a liquidity trap. To see why, we need only go back to 2010 and 2011, when we had a sharp fiscal squeeze. At the time the Office for Budget Responsibility (OBR) was expecting a modest recovery, but forecasts often go wrong, which in this case they did. In this situation the only macroeconomic weapon left in the arsenal was quantitative easing, and economists have very little idea how good a weapon it is. So in a liquidity trap austerity leaves the economy effectively defenseless against negative shocks. To ignore this point is taking a big risk, and from 2010 to 2012 that risk materialised. Without austerity we might not have waited until 2013 for a recovery.
The situation in 2015 does not look very different to 2010. Interest rates will still be at or very close to their lower bound. Pretty well everyone agrees that further fiscal tightening, as proposed by George Osborne, will be a significant drag on growth. As the Prime Minister has emphasised, there are real risks to the recovery. If those risks materialise, we will once again have no effective weapon to prevent the recovery coming to a halt. As long as interest rates are low and fiscal stimulus ruled out, this is true. The OBR conservatively estimate that austerity reduced growth by about 1 per cent in both 2010 and 2011. As recovery only occurred in 2013, a reasonable estimate for the cumulative cost of austerity is at least 5 per cent of GDP, which is nearly £100bn, or £1,500 for each adult and child in this country. It was a huge blunder. What is remarkable is that the Chancellor is proposing to make the same mistake again.
Let’s look at that experience of policy earlier in the current parliament. The Lib-Con coalition implemented fiscal austerity in 2011 and 2012 and this did indeed act as a drag on growth. Yet when the government took office in 2010, it was very much a consensus position—and one held to by the OBR, as well as Osborne—that loose monetary policy would be the engine of economic recovery, which would in turn allow a fiscal contraction. Sure, it didn’t turn out that way. Yet it wasn’t so much irresponsible budget-slashing that caused the economy to languish as the initial failure of a radical experiment in monetary policy. That experiment in highly expansionary monetary conditions has since had a stimulative effect. The economy is likely to have grown by around 3 per cent in 2014, and the unemployment rate has come down from 7.9 per cent, when the government took office, to 6 per cent. Meanwhile the structural budget deficit has been halved.
I entirely agree that there are big risks to recovery in 2015 and that fiscal tightening will act as a drag on growth. But not the least of those risks is the distorting effect of the radical monetary policies conducted since the financial crash. In effect, very loose monetary policy has ensured that government bonds are attractive and therefore that tough budgetary choices can be postponed. It’s an economy in which credit is tight for everyone and in which companies have little incentive to take risk. This may go on for a long time, thereby continuing to obscure the economic cost of rising public debt. That’s why I don’t think it’s an option to distinguish quite so rigorously between the three issues that you set out. In the end, the economic fundamentals will come out, and financial markets are unlikely to take a bet that the problem will be solved by a virtuous circle of stimulating growth and achieving budgetary balance.
There was never a majority for 2010 austerity among academic macroeconomists. The OBR does not endorse policy positions. In June 2010 it forecast a modest recovery despite fiscal austerity. Yet as anyone will tell you, forecasts normally do go wrong, so good policy should allow for this possibility. The risks were obvious enough at the time. Relying on quantitative easing to save the day was foolish, as this was a completely untried policy.
In terms of the position from 2015, I think you have got your logic backwards. You clearly do not like very loose monetary policy. Yet further fiscal austerity, which you correctly say will reduce growth, will require loose monetary policy for longer to offset its impact. It would, in my view, be much better to have a more expansionary fiscal policy, producing a strong recovery with rising real wages, so that we can get interest rates back to more normal levels as soon as we can. Then we can worry about the deficit. You mention the financial markets, and I think this is one of the fundamental misunderstandings in how most of the media views the current situation. The world turned from fiscal stimulus to austerity in 2010 as a panic reaction to the eurozone crisis.
Greece aside, we now know that this crisis arose because the European Central Bank failed to act as a lender of last resort. It was forced to change its mind in 2012, and the crisis immediately ended. There was never any chance that the market would start believing the UK would default, because we have our own central bank. The last thing we need to worry about in thinking about fiscal policy from 2015 is market reaction. Of course many City economists pretend otherwise, but then it is in their self interest to do so. This is not just the view of academics like Paul Krugman or myself, but also the conclusion of a recent self-evaluation by the International Monetary Fund. We must not allow Osborne to put the recovery at risk once again by repeating his 2010 mistake.
Far from not liking very loose monetary policy, I believe it was the right course along with other remedial measures, including a rise in government borrowing, to cope with the financial crisis and ensuing recession. My point is rather that such policies, maintained for a long time, have distorting effects.
And that was then. Demand is now stronger, with seven consecutive quarters of growth and a rise in GDP of about 3 per cent last year; the household savings rate has fallen substantially in the last four years; and the collapse in oil prices by around 60 per cent since June, with consequent falling inflation, is reversing the squeeze on living standards.
Yes, there are risks to the outlook, especially from the continued travails of the eurozone, but Britain’s central economic problem is not a deficiency of aggregate demand. Nor can a rising proportion of debt compared to GDP be counted as a benign phenomenon merely because interest rates are currently close to zero. As Jeffrey Sachs has put it, in the context of the United States: “The huge amount of debt that we’ve already taken on (not to mention the added debt that Krugman would like us to take on) makes the future budget very vulnerable to a return of interest rates to normal.” The US, even so, has clear advantages—its size, its energy reserves and the dollar’s status as the closest thing to a global currency. For the UK, the margin for error in judging fiscal sustainability is finer. The next parliament is a time for ensuring that it isn’t tested.
Britain’s central economic problem is that GDP per head is still below the level it was before the financial crisis. Living standards have fallen substantially. Inflation suggests there is still plenty of slack in the economy, which means resources continue to be wasted on a huge scale.
Yet you and this government want to focus on the deficit, not because of any immediate risk, but because of some imagined problem way off into the future. You have not disputed that the renewed austerity proposed by the Conservatives would put the recovery at risk. You have not said why dealing with the deficit cannot be left until when the recovery is complete. Why is the government proposing to deflate the economy through more spending cuts, when interest rates are at their floor and inflation is almost zero?
Why is this government proposing to repeat past mistakes, and embark on a policy that makes so little sense in terms of the macroeconomics taught to students around the world? As an academic I have tried and failed to find a macroeconomic logic to what the government is proposing. Could it be that in reality the deficit is a smokescreen to hide the underlying goal, which is a smaller state? The British people do not want a smaller state, so the only way it can be achieved is by maintaining the myth that reducing the deficit is our top priority. The government can only get away with this myth as long as enough of the media, with the help of City economists, support it.