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The Austerity Delusion? (Or, 'Cuts? What Cuts?')

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The continued dismal performance of the UK economy is entirely consistent with the predictions of those of us who have argued consistently for the last two years that premature fiscal consolidation would be severely contractionary in the short term, and risked doing significant long-term economic and social damage. As has been widely reported, this analysis is now generally shared by most serious economists, including most notably the chief economist of the IMF, Olivier Blanchard, probably the most distinguished empirical macroeconomist working on policy issues at present.

It is obviously impossible to argue that an economy that has grown less than one per cent in the period since the fiscal consolidation was introduced, compared to the approximately six per cent that the government forecast at the time, is performing acceptably. So some commentators who supported the government's programme - or indeed, argued that it did not go far enough - are taking a different approach, arguing that economic weakness cannot be attributed to austerity because, in fact, there is no austerity.

Two notable examples are Fraser Nelson, who argued at the time that the 2010 Budget put us "on the road to recovery", claiming here:

"George Osborne's policy is not working - but for reasons that the Guardian can't quite bring itself to accept. It's not that his evil cuts are retarding the recovery. It's that he's slowly abandoning his deficit plan. The figures show that core government spending is going up, along with the debt and (last month) the deficit."

While John Redwood says:

"Instead of constantly asking questions about the 'cuts', the question that needs to be asked about the UK economy is why hasn't the huge public sector stimulus injected since 2008 succeeded in pushing the economy back into growth?"

Many people will think that they are obviously talking nonsense and can simply be dismissed. But I thought it was worth examining their arguments in detail, for two reasons. First, both are intelligent people; and second, some of the points they make are indeed accurate - although they get the implications wrong - and deserve to be addressed. So, while their overall argument and hence conclusion is wrong, it is useful to go through what they get right and what they get wrong.

First, however, it would be useful to have a definition of 'fiscal stimulus' and hence of its opposite, fiscal consolidation or 'austerity', so we know what we're talking about. It is easy to get hung up on technical issues here, but abstracting from those, the FT has a nice simple one, which makes intuitive (and economic) sense:

"Fiscal stimulus: Government measures, normally involving increased public spending and lower taxation, aimed at giving a positive jolt to economic activity"

With that in mind, let's look at Messrs. Redwood and Nelson's specific points:

1. There has been no austerity, because the deficit remains large and the debt is rising. This is a simple confusion of levels and changes. Indeed, Mr Redwood says:

"Since April 2008 there has been a surge in public spending and borrowing. In 2009-10 the state borrowed 11.1% of our National Income, in 2010-11 another 9.9% and in 2011-12 another 7.9%...The biggest ever fiscal stimulus, Keynesian stimulus, is being tried."

So by Mr Redwood's logic, any deficit is a stimulus. If the government had reduced the deficit from 11 per cent of GDP to one percent, which would have required (say) putting VAT up to 25 per cent, cutting welfare benefits (including pensions) by 10 per cent in cash terms, and abolishing the army (plus a lot more besides), then they would still be trying an (admittedly smaller) "Keynesian stimulus.".This is laughable, of course: a reduction in the deficit, even if the deficit remains positive, is not a 'stimulus' according to the definition above, or indeed any definition used by economists. Any macro model will tell you this, as indeed will common sense.

2. There has been no austerity, because there have been no spending cuts. So Mr Nelson, for example, says that the "figures show core government spending is still going up", while Mr Redwood says "current public spending has been rising in cash and real terms."

This point tends to provoke outrage among people who have been directly affected by public spending cuts. And of course there have been cuts in some specific areas, which have done considerable damage. So, for example, the government cancelled the Educational Maintenance Allowance, despite the strong evaluation evidence that suggested it was cost-effective; and the Future Jobs Fund, before its own analysis showed it to be one of the most effective labour market policies in recent history. These foolish and non-evidence based decisions have rightly been criticised.

But individual spending cuts do not show that spending is falling overall; and on that Messrs Redwood and Nelson have are correct and make an important point. Public sector current spending overall is roughly flat in real terms, with cuts in some areas offset by the operation of the automatic stabilisers. As yet, so far, there has been relatively little (overall) austerity in public services, with health and schools protected, although local authority services have suffered.

But this does not mean there has been no austerity. As we all know, public sector capital spending has been slashed in half, while taxes (VAT on everybody, some taxes on higher earners) have risen significantly. According to the OBR, between 2009-10 and 2011-12 taxes went up by more than 1 per cent of GDP, while public investment fell by 1.7 per cent of GDP. Only in some alternate universe is this not 'austerity', still less Mr Redwood's 'stimulus.' Claiming that, for example, reductions in spending on new social housing and increases in VAT do not represent 'cuts' [in spending and in the deficit] makes no sense.

So what happens if we look at what the government has actually done? Probably the easiest way to see this is to look at this graph from the IMF, which more or less corresponds to the simple FT definition of stimulus (or, in this case, its opposite, fiscal consolidation):

2013-01-27-imffiscaladjustment.jpg

This shows what the Fund rightly describes as a "large and frontloaded" fiscal consolidation. I am not aware of any serious economic analysis that challenges these figures in broad terms (they differ slightly, but not massively, from those of the OBR, for various technical reasons). So on the fundamental point Messrs Redwood and Nelson are simply wrong. The chart does however, show a marked reduction in the pace of consolidation in 2012-13, which leads on to...

3. The government has abandoned its original plan and as a consequence deficit reduction has stalled. The Chancellor is "slowly abandoning his plan" as Mr Nelson puts it, and therefore the "debt and (last month) the deficit are going up."

Actually, I agree with both of these statements; it is the causal conjunction that is incorrect. The government has indeed effectively abandoned its fiscal framework, as I set out here. And the current deficit was indeed higher in calendar 2012 than in 2011, so at the moment deficit reduction is if anything in reverse. But of course the causality goes the other way, as a moment's thought reveals. The government did not adopt policy changes which led to slower deficit reduction. Instead, the front-loaded fiscal consolidation illustrated above (along with other factors, such as the similar, and similarly misguided, policies pursued by our eurozone partners) derailed the recovery, which in turn led to the slowing of deficit reduction, which in turn has forced the government to abandon its fiscal framework. Again, the IMF sets all this out quite clearly.

4. A variant of the error in two is to argue that austerity has failed because it was implemented by tax rises and not spending cuts. Mr Redwood says:

"the high tax rates and the big prices rises put through in the public sector have squeezed people's incomes, cutting confidence and demand. High rail fares, high energy costs, higher VAT, National Insurance, and Income Tax for those pushed into the upper bands have all conspired to cut demand."

Well, these are all indeed contractionary; so by and large this paragraph is accurate. But there is no economic logic in suggesting that austerity measures which take money out of people's pockets and reduce confidence in one way (like VAT or rail fare rises) cut demand, while measures which do so in other ways (cuts to tax credits and benefits, cutting EMA and the Future Jobs Fund) don't. [Note of course that Mr Redwood's first gripe, higher rail fares, is actually a public spending cut!].

So all this paragraph really does is single out some tax rises and spending cuts Mr Redwood doesn't like and points out that they've had a negative effect on demand. As indeed have the other cuts I list, but Mr Redwood doesn't particularly object to those, reflecting his political views, rather than any economic analysis, so he doesn't mention them. Implicitly, he's really making my argument here; contractionary policies are contractionary.

5. Fiscal stimulus cannot work by definition, because "the money must come from the private sector". Mr Redwood argues:

"If the government decides on an extra pound of public spending paid for by a tax increase, that has no overall beneficial impact on the economy. The public sector grows by a pound, but the private sector shrinks by a pound. It is not a stimulus. If the state borrows an extra pound to spend, the private sector cannot spend the pound it lends to the government."

The first assertion is half right, at least as a definitional matter, in that extra spending financed by tax increases is not a (deficit-financed) stimulus. But whether it has an overall beneficial, or expansionary, impact depends on the specifics of the tax and spending. Simon Wren-Lewis has repeatedly pointed out that the theory suggests that in general it will in fact be expansionary, so Redwood is wrong on that, although this is an empirical question.

However, the second assertion is not only wrong, but represents the basic error - the 'Treasury View' from which my blog takes its title - that fiscal policy cannot, as an accounting identity, impact aggregate demand, because the government needs to get the extra money from somewhere, whether through taxes or borrowing. Paul Krugman accurately describes this as "One of the most basic fallacies in economics", while Wren-Lewis merely notes as politely as he can that you'd expect any economics undergraduate to know this. Note that understanding that Redwood is talking nonsense isn't a matter of whether you're a Keynesian or a rational expectations macroeconomist: no model, theoretical or empirical, used or taught anywhere, says this as a general proposition.

I do think it is important not to exaggerate either the magnitude or the impact of austerity in the UK. It explains part, but not all, of our dismal economic performance over the last few years: eurozone austerity, commodity prices, and other factors like the long-term decline in oil production all matter too. Nor are we Greece or Spain, where tax rises and spending cuts have been far sharper and the consequences, predictably, far worse. But any credible analysis suggests that pretending that there has not in fact been a sharp fiscal consolidation in the UK, with predictably adverse consequences, is equally mistaken.