Monday, 14 August 2017

How did the UK austerity mistake happen

As the Global Financial Crisis (GFC) and consequent recession were in progress, the Labour government looked at how fiscal stimulus could be used to moderate its impact. This would increase the budget deficit that was already rising as a result of the recession, but they knew that cutting interest rates alone would be insufficient to deal with this crisis, and that you do not worry about the deficit in a recession. That is Econ 101, i.e. basic macroeconomics, and it is 100% correct.

Here Osborne and his advisors saw a political opportunity. Before the recession, fiscal policy had been all about meeting the government’s fiscal rules about debt and deficits, because monetary policy looked after smoothing the business cycle. There had been much discussion about the extent to which Gordon Brown had been fiddling these rules. Osborne could therefore make political capital over the rising deficit, particularly if he could suggest the deficit represented fiscal profligacy rather than the result of the recession.

But what about Econ 101? The advice he was given (I suspect) was reflected in a speech he gave in 2009. This gave a short account of the history of macroeconomic thought, and described how the New Keynesian model underpinned his macroeconomic policy. It said that in today’s world the consensus is that monetary policy not fiscal policy dealt with moderating booms and recessions. Yet it failed to mention that this idea no longer worked when nominal interest rates hit their lower bond. And that unconventional monetary policy was powerless in the New Keynesian model. The speech was given a month after interest rates hit their lower bound.

The speech also said nothing about expansionary austerity, or the need to appease the markets. That would all come later. This also suggests that Osborne's focus on the deficit was a simple but devastating macroeconomic error, a result of just not doing your homework. It was an incredible error to make, as the fact that interest rates had hit their lower bound was all over the financial press. If the media had been in touch with academic economics they would have pounced on this black hole in the speech. (Maybe this is complete coincidence, but his main economic advisor had previously worked at the IFS, where as I have said elsewhere they do not do macro. [1])

As an economic choice his policy was crucially out of date, but as a political choice it was almost brilliant. The line he pushed on the deficit came to dominate the media narrative, which I was later to describe as media macro. It did not win the 2010 election outright, but it went on to win the 2015 election. I say almost brilliant, because it has proved the undoing of his successor. The economic damage done by cutting government spending at the one and only time monetary policy could not offset its impact was immense. I think it is no exaggeration to call it the most damaging UK macroeconomic policy mistake in my lifetime as an economist.

It was damaging in part because politics drove two additional features of his policy after he became chancellor in 2010. First, the austerity policy would have had less economic impact if most measures had been delayed until later into the 5 year term of the coalition government. But that would have meant deep cuts before the next election, and Osborne could see that would do political damage. Second, although the fiscal rule did not require it, public investment was cut back sharply in the first few years, because investment is often easiest to cut. As I say in that 2015 post, those cuts in public investment alone could have reduced GDP by 3%.

By 2010 you need to introduce other actors who played a part in these mistakes. The Treasury did what the Treasury unfortunately often does, and put public spending control above the macroeconomic health of the country. The Governor of the Bank of England pretended that losing his main instrument didn’t matter, even though I’m told the MPC had almost no idea what impact unconventional monetary policy would have. If either institution had acted better perhaps the damage done by the austerity policy could have been moderated, but we will never know.

But the main damage was done when the Conservatives were still in opposition. Did the policy of opposing fiscal stimulus start off as a policy to reduce the size of the state under cover of deficit reduction: what I call deficit deceit? Or was it just something to beat Labour with: the first in what proved to be a long line of bad economic judgements simply designed to wrongfoot his opponents. Without the actors involved telling us, I think it is impossible for us to tell. However there are two things I think we can clearly say.

First, if it started as ignorance rather than deceit, it turned into the latter as Osborne prepared to repeat the policy all over again before the 2015 election, while at the same time cutting taxes. Second, if it started as ignorance it is far too kind to call it a mistake. It is similar to someone who has never learnt to drive taking a car onto the highway and causing mayhem. It reflects a cavalier attitude to economic expertise that has, I have argued, its roots back in the early days of Thatcherism.

[1] This advice served him well in other respects, such as establishing the form of his fiscal rule (which would help limit the impact of austerity after 2011) and creating the OBR.   

9 comments:

  1. Whilst not disputing your conclusions on all this what it does not really address is the issue of fiscal rules and overspending (having said this I know you've looked at this elsewhere).

    You mention the Treasury's concern about spending but imply that the macro rule should take precedence and that, at the ZLB, spending constraints should be relaxed. Whilst this is fair enough it could be seen as yet another postponement of fiscal prudence and, whilst the timing is indeed inappropriate, we do appear to be running secular and significant budget deficits which are never countered by surpluses at any point. In the meantime the public debt gets ratcheted up over the years to the point where it crowds out spending on the NHS; social care et al. This is the ultimate issue which we have failed to address and is what actually counts rather than the motivations and political chicanery that goes on between the various parties that are involved.

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  2. Let me add a bit more.

    I think an execrable act of revenge drawn from the ERM years motivated Cameron, Osborne, and the Tories in opposing the fiscal stimulus of 2009.

    Labour under Kinnock voted in support of the joining the ERM, but when it went wrong John Smith's Labour were successful in the polls by attacking Tory economic incompetence.

    The Tories into the early Blair government years, when New Labour chose to follow Tory spending plans, claimed that the economic growth in the UK was theirs not New Labour’s.

    But this was a Tory Party with 165 seats in 1997, and they gained only one more in 2001. So they could see in 2009 how successful this sort of political strategy could be, only the Tories tried it during the worst fall in world trade on record, not during a UK domestic dispute over ERM membership.

    Then came the 2010 election, with the Lib Dems having been taken over by the Orange Bookers whose economic ideas clearly came from European liberalism and its terrible single currency rather than American economic liberalism which had much more skepticism of the Euro. The Greek debt crisis of February 2010 pushed the Liberal leadership into the arms of the Tories in May 2010, because these Liberals thought the UK was like Greece because they believed so much in the Euro.

    Then, the BoE copied Bernanke at the Fed whose quantitative easing was Bernanke's attempt to use some form of monetary policy in advance of that tried in Japan in the early 2000s.

    And when Osborne changed from Plan A to Plan B in 2012, with Ed Balls repeatedly having made that flat-lining sign with his hand at PMQs to signify no economic growth in the economy, that was when the media should have seen that borrowing more by Osborne made the economy grow more and that he had no long-term economic plan as he claimed leading up to the 2015 election.

    Such a grim list of failures.

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  3. Of course it was deliberate. It was to blame Labour for the Recession, to make the public associate Labour and public spending with recessions, to do spending cuts to finance middle class tax cuts to the electoral advantage of the Tories.

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  4. You are correct. But why has Econ 101 so little traction with politicians and the public? Why were economists like yourself unable to convince the public or even the opposition political parties at the time, or since?

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  5. It was a pity that the blair/brown governments did not set a third rule, forbidding public investment falling below a set optimum volume as determined by a body akin to the newly-established Infrastructure Commission.

    That would prevent it bearing the brunt of cuts during recessions as it invariably does. It is truly sad that that simple lesson is never learnt.

    It would also provided a better springboard for escaping the Great Recession or, rather, Stagnation, as perhaps, it should be known, which seems to be an increasingly forlorn hope.

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    1. That is a really interesting idea

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  6. Prof. Wren-Lewis, do you concur that there may be (rare) situations in which fiscal contractions end up boosting economic activity in the short run?
    Andres Velasco does:

    https://www.project-syndicate.org/commentary/fiscal-contraction-boost-south-america-growth-by-andres-velasco-2017-06

    These cases would be today's Argentina and Brazil.

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  7. We were warned: "Mr Osborne is not a reluctant cutter; he is an enthusiastic cutter; he is a conviction cutter. Normally I applaud conviction politics. It is rare enough for a politician to have convictions. But it is a great shame that the chancellor’s convictions are so little-rooted in theory or in experience. ... Mr Osborne is clearly a man of ability and determination, but I have to say in all seriousness that in his present position he is a menace to the future of the economy." Lord Skidelsky House of Lords speech on the UK’s spending review 1st November 2010.

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  8. The yield on UK government bonds at one stage were higher than that of Spain. The narrative around fiscal discipline, and some of the fiscal discipline itself, helped re-establish UK government bonds as safe haven instruments. That was one of the best achievements of the Conservatives (IMO) but will never be recognized. Once the UK Govt's credibility was established, they could have increased spending (or cut less)- and they did (a bit), which was evidenced by Osbourne failing to meet his own deficit targets.

    I think you are being unfair - around the outcomes, I wont speculate as to the Tories actual intentions - but the real cost to an economy of deficit spending is the cost of future interest payments, and the interest burden which is placed on spending. This must be weighed up against the benefits of current stimulus. Economies sometimes also need to go through bad times, which facilitates creative destruction.

    Lastly, and ill admit to this not being empirically tested (at all) - more UK govt debt issuance - assuming credibility is maintained - will lead to higher (marginally) yields, which has a high correlation with Sterling strength. Too much Sterling strength weighs on demand.

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