Yesterday I spoke at the Resolution Foundation’s launch of their analysis of the UK political parties’ fiscal plans post 2015. I believe this analysis shows two things very clearly. First, there is potentially a large gap between the amount of austerity planned by the two major parties. Second, George Osborne’s plans are scarcely credible. They represent a shrinking of the UK state that is unprecedented and which in my view virtually no one wants.
I would add one other charge - Osborne's plans are illiterate in macroeconomic terms. The UK economy desperately needs more growth. There remains plenty of slack in the labour market, and real wages are continuing to fall. This and the inflation numbers tell us that the problem comes from the demand side. Yet monetary policy can do very little about this lack of demand, because interest rates are at their lower bound and - judging the Bank’s actions - the power of QE is largely spent. This is not a short term problem that is sure to disappear in a year. The risks that world developments will make the problem worse are real - as David Cameron has recently warned.
In this situation a Chancellor should not plan to reduce growth further. I have yet to come across a single macroeconomist who argues that Osborne’s plans for renewed austerity will not in themselves reduce aggregate demand. So doing this when the recovery could go much further but is still fragile is just plain dumb. It is even dumber if you have done this once before, in a very similar situation, and the risks I outlined above have indeed materialised.
So why is the Chancellor proposing to make the same mistake twice? My problem is that I cannot come up with a coherent macroeconomic explanation that fits his words and deeds. So let me list three possible justifications and why each fails.
1) Debt must be reduced because the markets will punish us otherwise
This is a plausible excuse for austerity in 2010, because of what was happening in the Eurozone, but as an IMF evaluation has recently acknowledged, the Eurozone was a false alarm which shifted policy in the wrong direction. There never was a ‘clear and present danger’ that the UK might become like Greece, and there certainly is not that danger now.
The Chancellor must know full well that a more modest pace of debt reduction from 2015 will not lead to any market panic. It might lead to higher long term interest rates, but that will only be because the markets expect additional growth from less fiscal contraction (and therefore an earlier tightening of monetary policy), and that would be a good thing. There is no way markets will react to a more modest pace of debtreduction by starting to think the UK will default! He should know this because he allowed a more modest pace of debt reduction from 2012 (see below), and the markets did not blink an eyelid.
Some say we must reduce debt before the next major crisis. I agree, but the time to reduce debt is when monetary policy can offset the impact of fiscal contraction on demand. It would be a far greater disaster if the next crisis came with interest rates still near their lower bound, and when the recovery was incomplete, so the number one priority is growth, whatever risks you want to avoid.
2) If debt reduction reduces growth, the Bank of England will do whatever is necessary to put things right.
Once again, this argument had some supporters in 2010, partly because the Bank appeared much too optimistic about the extent to which QE could become a substitute for lower interest rates. Today most are a little wiser. In theory, it might (and I stress might) be possible to replace lower rates by QE this way, but QE is now a riskier policy, because we know so little about its impact. So even if the Bank and Fed were still expanding QE, they cannot know what effect it might have compared to cutting interest rates. However neither central bank is expanding QE, even though inflation is well below target and likely to remain so for some time. That suggests they believe the impact of this policy is largely spent, or that additional expansion might do more harm than good. Monetary policy has its limits, and it is a shame that more central bankers do not admit the fiscal policy implications of this. But what is clear is that no Chancellor today would assume that monetary policy is not constrained by interest rates at their lower bound.
3) Fiscal contraction is actually expansionary
Hardly any macroeconomist believes this - the OBR for example think austerity reduced growth by 1% in both 2010 and 2011 - but perhaps the Chancellor thinks otherwise. If this was true, then his plans for more austerity would make perfect sense. However I have two problems with this rationalisation for his actions. First, I cannot find in his speeches a clear articulation of this view. Second, it seems inconsistent with his actions (or rather lack of actions) in 2012/3. Here is the OBR’s assessment of the cyclically adjusted deficit both in the past and expected until 2015, taken from my presentation to the Resolution Foundation meeting. [1]
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| UK Cyclically Adjusted Net Borrowing (OBR estimates) |
The pace of austerity clearly changed in 2012. It does not matter in this context why this happened. If the Chancellor thought getting debt down quickly was all important to promoting growth, he should have changed policy to bring deficit reduction back on track in 2012. To most economists it is obvious why he did not do that - because additional austerity would have hurt growth. But if the Chancellor believed fiscal contraction was expansionary, the opposite logic would apply.
So I cannot think of any way to rationalise what the Chancellor is planning in macroeconomic terms. But perhaps I’m looking for something that does not exist. Perhaps he does not have a coherent economic framework. Instead he has a clear political framework, which has so far been remarkably successful. The goal is to reduce the size of the state, and because (with his encouragement) mediamacro believes reducing the deficit is the number one priority, he is using deficit reduction as a means to that end. However another priority is to get re-elected, so deficit reduction has to take place at the start of any parliament, so its impact on growth has disappeared by the time of the next election. But this explanation would imply we have a Chancellor that quite cynically puts the welfare of the majority of the UK’s citizens at major risk for ideological and political ends, and I do not think I have ever experienced a UK Chancellor (with possibly one exception) who has done that. But as Sherlock Holmes famously said ...
[1] In this chart there are three horizontal lines. ‘Sustainability’ is the level of the deficit that is consistent with maintaining a 80% debt to GDP ratio, assuming nominal GDP growth of 4%. The Labour target line assumes public investment will be 1.5% of GDP. This chart probably underestimates the gap between the austerity implications of Labour and Conservative plans, because the former might be achieved later than the latter, and because the latter also involve substantial tax cuts. For a much more detailed and independent evaluation of the different parties' plans, read the Resolution Foundation's study.
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