Osborne's failure

I've mentioned before the coalition economics website, where the academic economists who analysed the Labour government's economic record for the Oxford Review do the same for the Coalition. My analysis of the Coalition's record on fiscal policy is now up.

It starts by noting three similarities between how Brown and Osborne started their time in office. First, they both made important and progressive institutional changes: Brown established the Monetary Policy Committee and Osborne set up the Office for Budget Responsibility. Second, they both established fiscal rules that improved on past practice. Third, they both started with significant fiscal contractions.

So why will history judge Osborne so much more harshly than Brown? Why did Osborne's policy cost each UK household on average at least £4,000, while Brown's (inherited) contraction had no similar cost in terms of lost resources?

The answer, of course, is that the macro contexts were very different. Brown's fiscal contraction happened when the economy was relatively strong, and interest rates were above 6%. Osborne's austerity happened when the economy was just starting a recovery from a deep recession, and interest rates were at their then Zero Lower Bound (ZLB) of 0.5%. Mainstream macroeconomic theory says that these different contexts make all the difference: when interest rates are at the ZLB, monetary policy cannot counteract the negative impact of fiscal austerity on output.

Why did Osborne ignore this basic piece of macroeconomics? Was his policy based on an alternative macro theory? A remarkable speech he gave at the RSA in April 2009 suggests not. In that speech he said that his macro framework was based on New Keynesian theory, because that theory implied monetary policy should look after macro stabilisation and fiscal policy should focus on debt control. Yet New Keynesian theory also says that monetary policy becomes ineffective at the ZLB, and cutting government spending in that situation reduces output. Incredibly the speech makes no mention of the ZLB problem, even though UK interest rates had just hit 0.5%!  

Could it be that Osborne, or his economic advisers, had simply not done their homework properly? One simple piece of evidence suggests not: his proposals for more austerity after 2015 risks making exactly the same mistake again, with interest rates still at or near their ZLB. A much more plausible explanation for his actions were that the macroeconomic risks were understood, but were put to one side for political and ideological reasons. First the possibility of hitting Labour with a populist concern about the deficit was too great a temptation to resist for a Chancellor for whom political tactics are everything. Second, austerity was a means of implementing an unpopular policy of reducing the size of the state by the back door.

Now you may cynically say that in a contest between economics and politics/ideology, politicians will always choose the latter. However much that is true or false, when that choice costs each household at least £4,000, it would be very strange if that politician survived the judgement of the electorate.  

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Ditulis oleh AndreSurbakti pada tanggal Jumat, 17 April 2015