There is no evidence – and never has been – that austerity works in the fashion promised by those who support it
What do you think about George Osborne's austerity programme? No, I am not trying to be funny. When the chancellor says he is tackling Britain's large budget deficit through a mix of spending cuts and tax increases are you more or less likely to go out and spend money?
The answer to this question appears obvious to most people. Austerity makes consumers and businesses more cautious. It leads to less spending in the economy and throws deficit reduction programmes off track.
That, though is not what Osborne thinks. It is not what the European Central Bank thinks. It is not what the Tea party in the United States thinks. It is not what most mainstream economists think. What they all believe is that any pledge by governments to cut spending imparts a warm glow to those toiling away in the private sector. Confidence blossoms because individuals and businesses expect healthier public finances to result in lower taxes. Businesses will invest and this will lead to higher consumer spending.
Conversely, any attempt by governments to spend their way out of a slump is worse than useless. Perfectly rational economic agents understand that higher public borrowing today means higher taxes tomorrow, and they will prepare for that dread day by reining in investment and spending. The economy will shrink rather than grow.
Let me guess what you are thinking? You are thinking that this sounds like complete mumbo jumbo and bears no relation to the real world. You think that expansionary fiscal contraction – the economic idea used to justify austerity – is a contradiction in terms. You think that there is not one shred of evidence to support the idea that government belt-tightening in a deep slump does anything other than to make that slump deeper and longer.
And you would be absolutely right. There is no evidence – and never has been – that austerity works in the fashion promised by those who support it so vehemently. Britain – used as a laboratory rat in order to prove that expansionary fiscal contraction works – is proof of that, as are the examples of Ireland, Greece and Portugal.
The UK experiment began three years ago when the coalition came to power. The timing could hardly have been better for the new breed of expansionary fiscal contractionists at the Treasury. The deficit was at a peacetime record, the economy appeared to be on the turn and, as an excellent new book by Mark Blyth* shows, it was the time when the brief one-year dalliance with Keynesian economics had just hit the buffers.
What happened was this. In the winter of 2008-09, following the collapse of Lehman Brothers, the world economy contracted at a rate not seen since the early 1930s. Governments decided this was not the time to sit back and do nothing: they got together and co-ordinated the biggest expansion of monetary and fiscal policy on record. The Americans, the Chinese, the British, all cut interest rates and announced stimulus packages. Even the fiscally conservative Germans joined the party.
The unprecedented intervention by central banks and finance ministries prevented a second great depression, but the healing process had only just begun by early 2010. At that point, the narrative changed. As Blyth correctly points out in his book, the crisis began with the banks and it was only when states moved in to re-capitalise institutions that were on the brink of bankruptcy that a private sector debt crisis became a sovereign debt crisis. With the sole exception of Greece, the financial problems faced by western governments did not stem from the profligacy of the state but were the result of taxpayers picking up the tab to bail out the banks.
But this view was quickly challenged. Within months, as Blyth says, it was re-christened a sovereign debt crisis by political and financial elites. Why? In part, it stemmed from the ingrained belief that markets are infallible and governments can never do any good. In part, it stemmed from a genuine – if misguided belief – that government debt levels would explode to unacceptable levels unless austerity was introduced. In part, it was a way to ensure that the people who were actually responsible could shift the burden of clearing up the mess onto those who were quite blameless.
Those determined to push back against the Keynesian experiment came armed with economic evidence. The Italian economist Alberto Alesina made the case for expansionary fiscal contraction when he presented a paper to EU finance ministers in April 2010, citing examples of countries – such as Ireland in the late 1980s – where the approach was supposed to have worked. Jean-Claude Trichet, then president of the European Central Bank, was impressed. So was Osborne, who drew on Alesina's work in his emergency budget of 2010.
Blyth's book traces austerity back to its roots in the works of John Locke, David Hume and Adam Smith, but is particularly impressive in the section that takes apart claims that the last 30 years have provided examples of expansionary fiscal contraction working. Alesina's version of what happened in Ireland in 1987-9 is that an austerity minded government delivered growth by cutting welfare, taxes and the public sector wage bill, with the fiscal tightening offset by a devaluation of the punt. This explanation, however, fails to mention that Ireland's biggest export market is Britain, which at the time was going through the wild excesses of Nigel Lawson's ill-fated boom.
And so it goes on. Blyth has plenty of examples – Britain in the 1920s, for example – where austerity failed. He finds none – not even the recent case of Latvia – where it does what it says on the tin.
IMF economists have done a good job in challenging the claims of the expansionary fiscal contraction brigade. The fund found that the notion that spending cuts are less harmful to growth than tax increases – one of the chancellor's key claims – only holds true if central banks can compensate for the contraction with reductions in interest rates. When official borrowing costs are just above zero that is not possible. The IMF also says spending cuts are more painful when every country is retrenching at the same time, as now.
In short, it believes that austerity isn't working. It believes the US has recovered more quickly than the eurozone because of Washington's belief that growth leads to deficit reduction rather than the other way round. It says Britain's economic recovery is feeble and wants Osborne to boost spending on public infrastructure in order to offset the £10bn of tax increases and spending cuts he has lined up for 2013-14. So ask yourself one final question. If Osborne borrowed £5-6bn to build houses and fix potholes would that be a good or bad idea? Most of us, I would suggest, would take the former view, which is why austerity has failed and why the economic thinking that underpins it is bunk.
*Austerity; The History of a Dangerous Idea by Mark Blyth; Oxford University Press
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