Three false claims for austerity in the UK

Despite the IMF’s warnings, the UK Chancellor of the Exchequer, George Osborne, continues to defend his programme of fiscal tightening, worth an estimated 4.3% of GDP between 2010 and 2013. Meanwhile, the economic recovery in the UK remains weak (see chart 1 below); GDP has remained below its pre-crisis for the longest period of time since the 1920s, according to the National Institute for Economic and Social Research; and HM Treasury continues to revise downwards their forecast for UK growth (see chart 2 below).

 

Proponents of austerity often make three arguments. First, they argue that the current level of public debt in the UK is too high and bad for economic growth. Second, they worry that allowing debt to continue to rise would destroy market confidence and credibility, putting upward pressure on UK borrowing costs. And third, they maintain that increasing public spending now will inevitably lead to higher inflation in the future.

All three of these arguments in my view are false, particularly in the current UK context.

1. High levels of public debt are bad for economic growth

Of course, fiscal sustainability in the medium to long term is vital for encouraging investment and promoting economic growth. However, fiscal policy can play two other vitally important roles. First, it can support aggregate demand in the short-run and second, it can boost productivity through infrastructure investments and the provision of other public goods.

In a recently revised paper, Reinhart and Rogoff present evidence suggesting that, on average, countries with high debt-GDP ratios have slower growth than countries with low levels of debt-GDP ratios. The authors go on to state that “debt/GDP levels above 90 percent are associated with an average annual growth rate 1.2 percent lower than in periods with debt below 90 percent debt”, although this appears to be a fairly arbitrary threshold, and one could essentially choose any number and make the same statement – 10, 50, 150! This paper has been used extensively by the pro-austerity camp (Paul Ryan in his proposed “Path to Prosperity Budget” during the 2012 US presidential campaign; Olli Rehn, European Union Economic and Monetary Affairs Commissioner, in support of EU austerity) who have quoted it, completely out of context, as evidence in support of a smaller state.

However as both Brad De Long and Paul Krugman point out, this is simply a correlation and does not suggest that high levels of public debt cause lower growth. It is equally conceivable that weak economic growth reduces the level of government revenues, resulting in a rising level of public debt. In addition, even if one were to assume that the direction of causation ran from high levels of public debt to poor economic growth, the evidence from the paper suggest that the marginal effect is actually very small – De Long estimates that an increase in debt by 1% of GDP would decrease growth by a miniscule 0.06% a decade later.

Of course, what really determines the link between public debt and economic growth is what the government spends the money on. Different types of government expenditure are likely to have different impacts on economic growth both in the short and medium term. As pointed out in a letter by Robert Chote (chairman of the Office for Budget Responsibility) these ‘multipliers’ vary depending on whether the government spends on capital, welfare or public spending but that for the UK economy they are all positive, in the short-run at least. In addition, recent evidence from the IMF suggests that these multipliers may be significantly larger than we first thought – particularly during downturns.

2.    Allowing debt to continue to rise would destroy market confidence and credibility

George Osborne has consistently reminded us that excessive public sector borrowing would result in a loss in market confidence and a sharp rise in the interest rates facing the government. In a speech at Bloomberg in August 2010 he said “the actions we took in the Budget have removed the biggest downside risk to the recovery - a loss of confidence and a sharp rise in market interest rates”. Since then, net UK government debt has increased from 53.5% of GDP in 2009-10 to 75.9% of GDP in 2012-13 and is set to peak at 85.6% in 2016-17. In fact, as Martin Wolf points out, cumulative public sector net borrowing between 2011-12 and 2015-16 was forecast in the June 2010 Budget to be £322bn; in the June 2013 Budget, this had increased to £539bn. So, has this resulted in a loss of confidence and sharp rise in the cost of government borrowing? Quite the opposite in fact. 10-year government bond yields (the cost of long-term borrowing) for the UK, along with other major economies such as Germany and the US, have continued to fall steadily since the middle of 2008 and are currently at an all-time low (see chart 3 below).

Chancellor Osborne would argue that it is thanks to his unwavering resolve in his fiscal ‘plan’ that the UK government is facing record low interest rates. This is wishful thinking. The real reason government bond yields have fallen to record lows is a combination of: continued tension and uncertainty in the euro-area; a substantial programme of asset purchases (quantitative easing) by the Bank of England; extremely low interest rates around the developed world, and; the fact that investors simply know that the UK will not default on its debt.

This final point is important, and one that distinguishes the UK from its European neighbours. With full control over monetary policy and a floating exchange rate the UK has a number of other mechanisms with which to deal with internal and external imbalances, making it easier to deal with debt and to stimulate the economy. This is not the case for members of the Eurozone, for example, who can only rely on fiscal policy.

One indicator of waning market confidence was the downgrading of the UK’s credit rating from AAA to AA+, first by Moody’s in February 2013 and then by Fitch in March. However, it is important to note that both Moody’s and Fitch pointed towards a “weaker economic outlook” in the UK as the primary reason for the downgrade, and, importantly, the challenges this poses for the UK’s fiscal consolidation programme. In other words, it’s economic growth that matters, not the level of debt.

3.    Increasing public spending now will inevitably lead to higher inflation in the future

One way to think about inflation is as a function of the level of aggregate demand in an economy relative to its production capacity. When aggregate demand outstrips supply prices increase; when supply outstrips demand prices fall. In this respect, expansionary fiscal policy could lead to inflation, by increasing aggregate demand. However, given the current anaemic levels of consumer confidence and weak aggregate demand in the UK economy, the risk of runaway inflation anytime soon is almost non-existent.

More importantly perhaps, is the positive impact fiscal expansion can have on the supply side of the economy. In fact, this is the biggest advantage of fiscal policy over monetary policy. In most advanced economies, the central bank’s sole responsibility is price stability, often with some objective relating to financial stability and/or economic output. The various instruments potentially available to a central bank when conducting monetary policy – such as interest rates, the monetary base, asset purchases and forward guidance – are all designed to influence the level of aggregate demand in the short-run; not supply. Yes, supporting a well-functioning financial system does have a positive effect on firms’ output levels, but the primary objective of financial stability is to allow the economy to achieve its natural level of output and hence employment and to seek to avoid the hugely damaging effects of financial crisis.

With base interest rates at 0.5%, and asset purchases already worth £375 billion, the Bank of England has done almost all it can to stimulate the UK economy. There is clearly a potential role for fiscal policy, both in supporting aggregate demand and in boosting the productive capacity of the economy. There is an infinite list of infrastructure investments, for example, that could be made in the UK that would yield a positive real return to the UK economy. This looks even more appealing given long-term interest rates are at an all-time low.