More than four years on from the financial crisis and more than five from the start of the credit crunch, we still are not out of the woods by some margin. The turn to austerity in the UK from 2010 has at the very least proceeded too rapidly, and the economy shrank again in the final quarter of 2012, although the statistics are of course subject to revision. Austerity fever has gripped the governments of many countries across the world. Some, such as Spain and Greece, probably had no choice, but the UK, with its own currency and central bank did have a choice. A chorus of respectable opinion, comprising economic commentators to the chief economist at the IMF, have suggested that if the UK economy continues to stagnate, then it is time for a change of policy. But the government refuses, blaming the mess they inherited from the previous Labour government and insisting that the answer to dealing with your debts cannot be more debt ie increasing the deficit. But these arguments, though appealing, are simplistic and ignore the dynamic links between public debt and private debt in a national economy.
There seems to be a certain kind of obvious logic to saying that ‘the answer to dealing with your debts cannot be more debt’, but some basic economics moves us beyond the conflation between private debt and public debt that this argument creates. The large budget deficit and rising public sector debt in the UK and other economies was largely caused by the recession and the consequent collapse in private sector spending as households started to save more of their income and reduce their exposure to debt. When private sector spending collapses and there is not the prospect of a healthy global economy beyond national borders to generate growth from net exports, the only spender of last resort remaining is the government. When interest rates are already so low that they basically cannot be cut further, then monetary policy is exhausted and fiscal policy plays a vital role in mitigating a balance sheet recession of the kind that we are still going through. Attempts to cut government spending when private sector balance sheets remain weak and firms and households are still saving and paying off accumulated debts will only cause the economy to stagnate or stay in recession, as we are seeing in the UK.
So it would seem to be that part of the answer to economic stagnation in the UK is a temporary fiscal stimulus in the form of increased public investment on infrastructure repair and construction. The stimulus should help the private sector repair its balance sheets and pay off debt at an increased pace and thereby bring closer a real recovery in economic activity. No-one knows how long this process would take, but the sooner an economic recovery begins in the UK and across the developed world, the less suffering in terms of unemployment, underemployment and poverty there needs to be.
So why no major U-turn on the part of the UK government, to continue the austerity policy example? One possibility is that they really believe that they are impotent to improve matters, and that austerity is the only possible course of action. Another is that they are still worried about what Paul Krugman calls the ‘invisible bond vigilantes’, the risk that increasing deficits will only drive up interest rates and the policy will be entirely self-defeating as the private sector is put into an even worse situation. But if the current low long-term interest rates are more the result of economic weakness, rather than due to credibility won through austerity, then there would certainly be room for an effective fiscal stimulus which would work as described above. It is more likely that the government has mistakenly looked at the situation in Southern Europe and become convinced that if we don’t restore economic credibility by reducing the deficit then we will end up in the same situation. It is mistaken because we are not part of the euro, and have our own currency and exchange rate which can bear any necessary adjustments.
It is pretty clear that any public abandonment of fiscal austerity until the economy is recovering strongly would represent a major U-turn and lead to a massive loss of face by the government. So political reputations and non-existent credibility are put ahead of national well-being, growth and employment. But the Labour opposition have not proposed abandoning the policy, only a slower pace of adjustment. It seems that the chancellor has already begun this, as he is failing to meet his targets for reducing the deficit. So austerity is to be extended into the next parliament until 2017-18! He is also blaming international factors such as the eurozone crisis for the UK’s poor economic performance, which is a convenient story but one which is wrong. Exports to the eurozone are simply not a large enough part of our GDP to make them the key factor in the continuing stagnation. While deleveraging continues, private sector spending will remain weak and fiscal policy should support aggregate demand until this process is completed, and private sector borrowing, investment and consumption can rise at a rate strong enough to allow austerity to take place without causing economic and social damage. Once the private sector recovery is underway the deficit will fall even without extra spending cuts or tax rises.
The government’s strategy is exactly the opposite of what should be done. And to the extent that the eurozone crisis is not helping, this is partly due to significant austerity policies on the continent, which the UK government supported.
Labour is in a difficult position as they have a low level of economic credibility due to their being in government when the financial crisis began. And it would be easy for the opposition to argue that nothing has changed on their part if they argue for abandoning austerity policies. It is therefore likely that the austerity will continue, and UK economic performance will continue to be poor for a number of years, and unnecessarily so.