Tuesday 8 May 2012

How the Chancellor made the right decision about the timing of austerity

[This article originally appeared in the Independent here]. 

Two years ago, the coalition set out its programme for government. Today, the Prime Minister and Deputy Prime Minister reaffirm their commitment to the central element of that programme - cutting the deficit quickly.  This is despite the dismal results this strategy has delivered, despite the fact that even the IMF is arguing that there are more sensible alternatives, and despite the growing realisation in the eurozone that austerity is a dead end.  

But, particularly in the light of the Governor of the Bank of England's comment that the government's approach was a "textbook response to the situation", it is worth looking back and considering what the new government's options were and whether there was, in fact, no alternative.

After the election, it was clear that the recession had left a massive hole in the government's finances.  Ultimately the books needed to be balanced; spending would have to be cut, and taxes increased.  The question was timing: cut the deficit quickly, or wait until growth was reasonably strong again. Both David Cameron and I, from our very different perspectives within government, understood this.  But ultimately the decision was the Chancellor's. 

Fortunately, he made the right call.  And the result was solid, sustained and healthy growth. As he said in his Budget Speech:
"In doing so, I have had to balance two key objectives : first, the essential task of helping recovery; secondly, the need to tackle the deficit so that the recovery will be sustained. I believe that my proposals today strike that right balance. In the year ahead their effect will be broadly neutral, thus allowing the recovery to take hold.  However, for subsequent years, as the economy strengthens, my proposals are designed to build in a wedge of steadily rising revenue."
OK, by now you will have twigged I wasn't talking about 2010.  The quote is from Norman Lamont's Budget Speech in 1993.  David Cameron and I were both 26; I had been Lamont's speechwriter (a civil service position) through and after the election, although I'd left his office by the time of the budget.  Cameron was still his Special Advisor.  
The 1993 Budget famously raised taxes (both National Insurance and VAT) to accompany previously announced tight restrictions on public spending. But neither kicked in immediately. The deficit actually rose in 1993-94, and, according to the Treasury, so did the cyclically adjusted current deficit (the structural deficit that the government currently targets. So there wasn't any fiscal tightening at all.  Only in 1994-95 did the deficits, both structural and headline, begin to come down.    By the time spending cuts and tax increases actually began to kick in, the recovery was firmly established; growth in 1994-95 was close to 4 percent.  As the chart clearly shows, fiscal consolidation followed recovery; it did not cause it.

Fast forward to 2010.  In the Chancellor's "emergency" Budget,  he committed himself to the precise opposite of this approach.  Deficit reduction was a precondition for growth, not something to be achieved after recovery had been secured: 
"Some have suggested that there is a choice between dealing with our debts and going for growth. That is a false choice.  The crisis in the Eurozone shows that unless we deal with our debts there will be no growth.  And these forecasts demonstrate that a credible plan to cut our budget deficit goes hand in hand with a steady and sustained economic recovery, with low inflation and falling unemployment."
So he announced what he described as an "accelerated reduction in the structural deficit." - aiming to reduce it by more than 2 percent of GDP between 2009-10 and 2011-12.  Of course the forecasts turned out not to "demonstrate the credibility" of Mr Osborne's plan, but rather the reverse - unlike Mr Lamont's, which turned out to be very much on the cautious side. 
Two very different approaches. Two very different results.  But hardly surprising, to anyone who remembered even the basics of undergraduate macroeconomics.  There is a simple, absolutely standard prescription for dealing with an unsustainable deficit resulting from a recession.  It is the following. Announce, and commit clearly to, tax and spending measures to deal with the deficit.  But ensure implementation follows recovery, not precedes it. This is the "textbook response" that Mervyn King should have commended to the Chancellor.  

If done right, such an approach will ensure fiscal credibility, maintain confidence, and allow businesses and households to plan, without committing the elementary error of reducing demand when the economy needs it most.  The 1992-97 Conservative government followed this prescription to the letter - and it worked.  Pity about this one. 

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