Economic recovery in the face of austerity
Dick Sargent argues that Chancellor Osborne would have done better to sit on his hands in 2010.
When the coalition government took over in 2010, there was clearly a widening hole in the public purse. Under the Labour government from 1997, there had been surpluses of revenue over expenditure in its earlier years, but in its last two there was a lapse from the fiscal rectitude to which Gordon Brown had proclaimed himself dedicated when he was Chancellor of the Exchequer.
Public Sector Net Borrowing rose to 6.9 per cent of the Gross Domestic Product in the first quarter of 2009 and to 11.2 per cent a year later (excluding the cost of bail-outs for banks).
There were various arguments for an early start on reducing the deficit. One was the risk that the UK might lose its top credit rating. There was a feeling that a demonstration of ‘sound finance’ might encourage economic growth.
The new Chancellor, George Osborne, will have remembered how Mrs Thatcher’s housewifely instincts against living beyond one’s means applied to governments as much as to households. Moreover, the need to cut the deficit would provide an opportunity to cut public spending itself.
At the same time, the idea that doing so might be bad for economic activity was contested by a number of economists. Part of their argument was that empirical evidence to back the idea was lacking, and part of it that there would be an offsetting stimulus to current spending as less borrowing now would mean lower taxes needed in future to pay the interest.
In the event, Osborne decided in October 2010 to aim at virtually eliminating the deficit within 5 years, mainly by cuts in public expenditure, many falling on the cost of the Welfare State. He may have been encouraged by the approval of the President of the European Central Bank, who had declared in June that “the idea that austerity measures could trigger stagnation is incorrect”.
But there were others, including economists at the International Monetary Fund, who were aghast at the proposal to cut government expenditure when, in the wake of the financial crisis of 2008, output was already stagnant and unemployment rising.
Lowering public spending or raising taxes must surely withdraw even more purchasing power from the economy. Even if doubt had been cast on the Keynesian belief that a bigger public sector deficit was a stimulus to demand, would a smaller one really lead people to expect lower taxes in the future, and thus encourage them to spend more now ?
Since demand and output would be inhibited by the austerity measures, revenue from taxes on income, profits and sales would fall and limit the extent to which the public sector’s deficit would itself fall. Indeed, it might even get bigger.
The Keynesian economists supporting these arguments, implying that action to cut the deficit should be muted or delayed, had been unpopular in the Conservative Party since the reign of Mrs Thatcher. So Osborne decided to avert his eyes from the recessionary state of the economy and press ahead with his programme of cuts.
Possibly he was hoping that the hole in aggregate demand created by his cuts would be filled by developments elsewhere in the economy. Investment might have been expected to pick up again as memories of the financial crisis faded. But in 2010 to 2012 it showed almost no sign of reviving, despite low interest rates and ‘quantitative easing’ by the Bank of England. In foreign trade, there were hopes that the 20 per cent fall in sterling’s exchange rate during 2008 would provide a stimulus to exports, but this was substantially offset by a surge in imports.
So the growth rate of GDP began to sag. It had recovered to slightly over 1 per cent per annum in 2009 and for much of 2010, but it lost momentum during 2011, and almost stopped in 2012.
It appeared that the situation had developed as Keynesians had foretold ; austerity had run the economy into the sand. But then something unexpected happened. In the spring of 2013 the growth rate picked up, and during the rest of the year appeared to be accelerating.
What brought about this turn of events ? It soon became evident that the revival was being led by household spending on consumer goods. Yet this seemed at odds with the decline in real wages and the expected impact of cuts to welfare payments. Was it, perhaps, what the press liked to call ‘austerity fatigue’ ?
The chart below points to a development which provided the revival with a more solid basis. During 2008, the year when the recession developed, the percentage of their after-tax income which households saved shot up. It did so again during 2009, and remained for the next two years well above what it had been before the recession began.
While this upward shift in the household savings ratio had the immediate effect of lowering aggregate demand, it also meant that people were stepping up their efforts to improve their financial position, by paying off debt or adding to their assets. So financial liabilities of households declined from 1.7 times after-tax income in 2008 to 1.4 times in 2012, while at the same time financial assets rose from 3.9 to 4.3 times after-tax income.
As a result of these changes, the margin by which households’ financial assets exceeded their financial liabilities rose to 2.8 times after-tax income in 2012 from 2.2 in 2008.
As they improved their financial situation by stepping up their saving, households became more inclined to re-focus on the present rather than the future, and to relax the self-imposed constraints they had lately applied to their current consumption.
It is a behavioural re-adjustment of this kind that explains the revival of consumer demand during 2013. Once they had achieved a better balance between their assets and their liabilities by saving more, it was no longer necessary for households to continue saving as much. A sound basis for an increase in consumption had been established.
Evidently this point had been reached at the beginning of 2013, and so allowed a rise in consumption to trigger the economy’s recovery.
Osborne liked to claim the recovery was part of his ‘long-term plan’ to lower the deficit by public austerity. Yet the resurgence of consumer spending which triggered the recovery was made possible by the austerity which the private sector had previously applied to itself to rebalance its finances. Whatever Osborne may have planned, it was this action by the private sector that enabled the economy to revive.
Earlier, of course, higher private saving had helped to start the recession. But in 2011 cuts in public spending subjected the economy to the severity of a double constraint. What if Osborne in 2010 had decided against an immediate attack on the deficit? Without public spending cuts, incomes and savings would have remained higher than they did, and that would have brought forward the time at which household finances would have improved enough to encourage higher consumption.
Measures to reduce the deficit could then have been launched into a more buoyant economy, reaching their objective without the collateral damage to income and employment which actually occurred.
President Reagan is said to have complained that, when some crisis was threatening, he would hear the cry : ‘Don’t just stand there – do something!’; but often the best policy was ‘Don’t just do something – stand there!’. This advice could well have been heeded by Osborne in 2010. Instead of rushing to cut the public sector deficit, he would have been better advised to stand for a while and wait for a better time to act.
Dick Sargent is an Honorary Professor of Economics at the University of Warwick. This article is an abridged version of an article first published in The Journal of Economic Affairs, October 2014. READ HERE
The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of The Information Daily, its parent company or any associated businesses.
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