Sunday, 27 January 2013

The Austerity Delusion?

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 1 percent in the period since the fiscal consolidation was introduced, compared to the approximately 6 percent 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% of GDP to 1%, which would have required (say) putting VAT up to 25%, cutting welfare benefits (including pensions) by 10% 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.

2There 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 percent of GDP, while public investment fell by 1.7 percent 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):


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 2 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.

[Updated 30/01/2012] The second assertion, as written, is not only wrong, but represents the basic error - the "Treasury View" from which this 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."  However, Mr Redwood's subsequent blog, which refers (correctly) to second-round effects, makes clear that this was not in fact what he meant. 

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. 

26 comments:

  1. I think most of these problems relate to the lack of everyone using the same clear definitions. When that happens we get people making stuff up to fit their prejudices. Of course it makes no sense to think of a ratio of GDP, which is the fiscal deficit as a fiscal stimulus per se. To do that would mean that if a tsunami hit Japan and GDP plunged, they would be considered to be stimulating the economy even if current spending was constant. The government using discretionary fiscal measures would be a fair definition of fiscal stimulus. Targeted tax cuts or additional spending are both fiscal stimulus. However, I think it is a pretty weak argument to say that the absence of fiscal stimulus is austerity. So although some people are calling spending stimulus when it is not, others are using very weak definitions for austerity. What do we call the halfway house between not cutting total managed expenditure and not stimulating? That seems to me where we are in the UK.

    If the anti-austerity argument is the government fiscal decisions are negatively impacting national GDP, and that usually is the argument. Only criticisms of the cuts in public sector capital spending and the VAT rise make much sense with regards to negative impact on national GDP. All the micro impacts of some departments spending being cut and some increasing are pretty much cancelling each other out in GDP terms. Therefore, the lack of a clear definition for what is meant by austerity leads to the situation of people concluding there is no austerity if total spending is rising.

    The rail fares issue could have been dealt with by moving away from rail fares increasing using the discredited RPI calculation. Moreover, the government are wasting at least £3 billion a year on extra debt interest payments on index-linked gilts using the same discredited RPI. A bonus for international investors and usually prosperous domestic pensioners, but an unnecessary cost for taxpayers. Surely the government could find a more productive use for that £3 billion while at the same time the impact on total spending would be neutral.

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  2. Right off your main thrust, so possibly OT, but what commodity prices, over what period, what effect, are you referring to in last para? Just in brief.

    It startled me as I wasn't aware, depending on your starting point(s) over the volatile late noughties of course, that commodities had been contractionary.

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    1. Well, when Osborne made his emergency budget in June 2010 the oil price was $60-65. Within 9 months it had almost doubled to over $120.

      That's the sort of thing that really screws up your household consumption forecasts,

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  3. In one of your previous blogs, I cannot remember which, you had a chart showing the decline in real government purchases. I thought that was a terrific demonstration of how austerity has happened, since the decline in purchases has been offset by increased safety-net expenditures if one looks at the overall view.

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  4. "According to the OBR, between 2009-10 and 2011-12 taxes went up by more than 1 percent of GDP, while public investment fell by 1.7 percent of GDP."

    Hi Jonathan - do you have a link to this?

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    1. I'm glad you asked me that..

      Let me take this opportunity to recommend one of my favourite data sources, table 2.33 ("Historical series of fiscal aggregates") from the "EFO Supplementary Fiscal Tables" produced by the OBR:

      http://budgetresponsibility.independent.gov.uk/pubs/Copy-of-December-2012-EFO-fiscal-supplementary-tables4.xls

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  5. Andrew Lilico from Europe Economics has responded:

    http://conservativehome.blogs.com/platform/2013/01/andrew-lilico-what-jonathan-portes-gets-wrong-and-why.html

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  6. If government stimuli can indeed rescue an economy then there should be a record somewhere in the data of increasing public spending increasing private sector growth. Does public spending ever increase private sector growth? If Keynes was right then there must be a record somewhere in the UK and US data of a public spending binge that stimulated industry.

    If you look at the actual data, it is surprising, see: Sydenhams Law of public expenditure and GDP growth

    Whether the public spending is for wars, economic intervention or welfare the answer is NO, furthermore the New Deal seems to have been a myth, there was a strong private sector recovery in the USA before the New Deal.

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  7. “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. “

    There obviously has been fiscal consolidation in the UK since 2010. How much effect this has had on growth and job creation is the real debate. The other factors mentioned, (Euro austerity, Oil etc) probably had significantly more impact on growth than fiscal consolidation in my view.

    The “predictably adverse consequences” you mention is where I would disagree the most. The level of employment and jobless claims are far more important to the majority of the population than the notoriously inaccurate (in the near term) and revised statistical composite that it is GDP.

    Judging the economy on the GDP alone would seem to be rather unwise. The consistent record of large revisions to data from previous recessions and the issues the ONS has experienced since 2008 will probably make the data even less reliable than normal.

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  8. The "Definition of Austerity" debate has predictably and rapidly descended into angels-on-pinheads territory. Lilico's blog yesterday was a masterpiece in pedantic semantics obscuring the core content of the discussion.

    It really doesn't matter whether the current fiscal position equates to "Austerity" or "Stimulus" by one person's idiosyncratic definition. What matters is what the effect of the fiscal position is.

    But the Consolidators have a very persuasive and simple argument in claiming that the fact that our current high deficit AND lack of growth "proves" that fiscal stimulus does not work. It seems to me that those who veer more to the Keynesian outlook require an equally simple and persuasive argument.

    How about the following metaphor.

    You are driving a car and the road starts to go uphill. You respond by pushing the accelerator harder. The car more or less maintains speed but you now start to worry about your fuel consumption. So you ease off the pedal a little and the car stalls. But when the car stalled, you were still pushing the pedal harder than you would have done on a level road. Do you conclude that pushing the pedal harder than normal cannot get you up a hill?

    That, in a nutshell, appears to be the Redwood/Lilico approach.

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    1. But governments do not trade, Lefty, the public sector are not drivers, they are passengers. It seems that it is the increase of growth of public expenditure that is the key variable. If you look at the historical data a steady growth of public expenditure is beneficial to total GDP and does not have an excessive adverse effect on private sector. Where governments go wrong is that they rapidly escalate public sector growth. This results in a continuous diversion of private sector capacity to servicing the government rather than to servicing other parts of the private sector. Basically, once you are in a recession accelerating public spending damps the private sector - just look at how the New Deal suppressed private sector growth rate in the US. See Sydenjam's Law of public expenditure and GDP.

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    2. That does explain why the Scandinavian nations were plunged permanently into poverty in the mid 1930s. Good point.

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    3. The 1930s Swedish public spending binge did indeed follow a private sector recovery and stifled it. Governments always claim that it was their measures that caused a recovery, even when it caused the opposite.

      Scandinavian GDP fell in the mid 1930s along with their spending binge but it is difficult to find public spending data for this period. Do you know of any links?

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  9. Andrew Lilico has indeed responded- googled to find out who he was and this gem came up:
    http://www.thisismoney.co.uk/money/news/article-1702363/Interest-rates-may-reach-8-by-2012.html

    10% inflation by 2012...

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    1. For anyone who wants to see his powers of prediction, from the above article (august 2010):
      "Mr Lilico said: 'Given the constraints of late 2008 and the absurdities of subsequent fiscal, finance and regulatory policy, if we can get away with a recession of only 6.6%, deflation of only 2% and [subsequent] inflation of only 10% for one year, [Bank of England governor] Mervyn King will deserve a medal.'

      The radical economist also predicted Britain would endure a brief 'double-dip' recession early next year, followed by a boom in the economy. But he added that this boom would quickly run out of control.

      Reflecting on the past 30 months, whilst anyone can be forgiven for not getting future prediction spot on target, the hubble telescope is needed to see how far wide of the mark Andrew Lilico's analysis and predictions are.

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  10. It is a misnomer to actually call Lilico's blog yesterday a 'response'. Rather as it is a mass of misdirection, misinterpretation and as LL (above) states "a masterpiece in pedantic semantics obscuring the core content of the discussion", in which his own opinions,definitions and obscurely constructed interpretations disprove and supposedly trump many of the arguments in Portes' original article.
    He begins by raising the question of bias on the part of the NIESR. Take a quick look at the title of his webpage (Conservativehome)! I'm sure he thinks he has written an unbiased 'response'.
    On the question of the deficit reduction plan, his argument becomes laughable, where he firstly cites Portes "He claims the causality runs the other way - deficit reduction stalled and therefore the government abandoned its deficit reduction targets. But there's no economic causality there.The government wasn't obliged to abandon its deficit reduction targets because of stalling deficit reduction by anything other than politics. With full policy freedom, the government could have cut spending faster, to keep to its targets. Deficit reduction is stalling because the government has stopped trying to cut the deficit."
    So the government's own policies have nothing to do with the missed deficit targets? Self-defeating austerity policies as highlighted by numerous other economic bodies and studies have not reduced tax receipts and caused various forms of G, including transfer payments to rise? It has simply been through policy choice alone to abandon the deficit reduction plan? The target could have been kept if the government had cut spending faster? So a greater dose of poison would fix the patient then.
    I'll leave the rest to Jonathan and perhaps others, as its simply not worth spending any more time on this.





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  11. The left will never admit that the public sector became far too bloated to be sustainable by the Taxpayer which had to fund hence having a massive structural deficit towards the latter part of a boom (I don't think Keynes would have approved of that Mr Brown).

    The facts are quite simple. Put aside the complexities you talk about or whether you are left or right or whether or not cuts contribute to growth it is patently obvious that we are still living way beyond our means. If you cut capital spending unless you are replacing or automating a function the taxpayer incurs costs later on so using that argument is short term.

    If you cut day to day department spending those departments must learn to live within their means, it happens all the time in business, public servants often don't have these skills (I've seen it first hand) so by definition if it leads to a small cut in the size of the economy (and there are varying shades of opinion on this) further down the line it will always lead to financial stability.

    If your theory that borrowing and splurging (making out the likes of Redwood etc were evil) was right then why did the UK economy go into decline before the banking crises? If you stealth tax and regulate everyone to death then all you do is scare business away.

    You are also forgetting that if they don't stop printing money to fund this borrowing we are heading for big inflationary trouble which will impact us all - by this definition the cuts and EU red tape have been nowhere near what they need to be.

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    1. Your comment is full of unsubstantiated assertions stated as if they were self evident truths

      For example

      Structural deficit? The UK government has run one for decades never mind "towards the later part of the boom." (ref HMT or IFS)

      "Stealth tax and regulate everyone to death" Tax as a proportion of GDP wasn't high under the Labour Government...I think on average it was lower than under Margaret Thatcher (Ref HMT or IFS). And of course, the UK labour market is one of the least regulated in the world – third in the OECD area (ref OECD index of labour market strictness).

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    2. You might also want to clarify:
      "whether or not cuts contribute to growth"
      Is there actually a real possibility that the cuts implemented have had no impact on our economic growth?? (Bear in mind we are over 4.5 years below the pre-crisis GDP peak, with the real possibility of entering a triple-dip recession, and various studies have shown the negative economic impact of austerity).

      "we are still living way beyond our means".
      Who is exactly?

      "If you cut day to day department spending those departments must learn to live within their means, it happens all the time in business..."
      Realise that contrary to much of current doctrine and practice, private sector business practices are often completely inappropriate for the public sector, given the very nature and purpose of public sector functions. Cuts and 'learning to live within their means' for a hospital translates into less life-saving drugs and equipment, fewer beds, doctors and nurses. People's dignity and lives are at stake, unless of course one has private medical cover, eh Mr Cameron, Mr Osborne?. (Though cuts to bureaucracy and numbers of managers should be carefully looked into, as they seem to almost outnumber doctors and nurses!).

      "small cut in the size of the economy...further down the line it will always lead to financial stability". Does it? Any studies with data and evidence to show this?
      And I made the mistake of thinking that a too lightly regulated banking sector, unresticted global capital flows, the euromarket and the whole offshore system enabling and promoting capital flight and thus constraining government policy destabilised the financial and economic system a little more than a large public sector does.

      Whilst I'm sure that there are valid cuts which can and should be made in certain areas, is there really no limit to the range of reasons/excuses put forward, no matter how ridiculous (as this one is) in the ultimate pursuit of the tory ideological goal of small government?

      "why did the UK economy go into decline before the banking crises?" You might want to check the ONS quarterly GDP data on this one, but it was not in decline - it was rising for a full year until Q4 2007, only declining in Q2 2008!

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    3. "The facts are quite simple."

      Simple facts for simple minds?

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  12. It doesn't take long for the austerity crowd to reveal that their austerity policies aren't rooted in sound macroeconomics (they aren't) but in their social values and theory of state. They don't like the welfare state and they see scaremongering over the deficit and the debt as their opportunity to pare it down.

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    1. Yes. And they pick any contradictory non sequitur or fact free arguments they can find,to blame all problems on the state. These tendentious people are annoying.

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  13. Distinguish between discretionary and induced {cyclical} expenditures.

    The government have chosen to cut capital expenditure. {Discretionary expenditure}.

    See June Budget 2010 P45

    This, of course, has adverse effects on GDP, leading to falling tax revenues and increases in induced {cyclical} expenditures.**


    This would lead to current public spending rising in cash and real terms?

    According to S.Keen:

    In the USA, in the  'Great Depression' aggregate demand fell and GDP declined by 28%.
     In the USA, in the  'Great Recession', aggregate demand fell by a greater amount than it had in the 'Great Depression' but GDP declined by  'only' 5%.
    http://www.scribd.com/doc/116293469/Keen-2012-Fiscal-Cliff-Lessons-From-1930-s

    The initial increase in discretionary expenditures {plus induced expenditures} prevented, in this case, the U.S. economy falling by more than 28%.

    **{The government were expecting the Barro/Ricardo equivalence proposition to generate extra aggregate demand? The new 'Voodoo Economics'?}

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    ReplyDelete