Thursday, 23 February 2012

UK recovery policy – Austerity! What austerity?

Note: This blog post was also published at the Adam Smith Institute blog (1st March 2012). For all my other ASI writings see here

Recently a lot of attention has been given to the case against British austerity. It has been blamed for the inability of the UK economy to pull itself out of border-line recession. Krugman, DeLong, Baker and many others attack it claiming that contractionary expansion makes no sense, while on the other hand Sumner and Boudreaux tend to overturn the argument by claiming there is no austerity in the UK. And opposing to both of these views, UK Chancellor George Osborne surprisingly claims it is working. 

Who is right? Well, one thing is certain, Britain isn't experiencing any form of robust economic growth, so whatever policy is done by the government clearly isn't working. 

The UK government is leading an ambiguous recovery policy which is, unsurprisingly, producing ambiguous results. It is sending wrong signals to the private sector. When it is trying to subsidize, this yields no effects as the people expect it to cut further. When it is trying to build high-profile infrastructural projects, it isn't working as the anticipated costs are much higher than the benefits (even though they claim otherwise). When it’s trying to make banks increase lending, it creates less competition in banking making the price of credit still too high. Any intervention it’s trying to make is yielding no positive outcomes. Surprise, surprise. 

Austerity or expansion?

The UK had the one of the strongest fiscal stimuli (relative to the size of its economy) in the world as a response to the crisis, during the premiership of Gordon Brown. The result was making the situation much worse with a rising public debt and the third highest budget deficit in the world behind only Greece and Egypt in 2011, and behind Greece and Iceland in 2010. This comparison is striking since these countries were doing much worse than the UK at the time and were countries with highly unstable economies – Iceland before the restructuring, Greece whenever, and Egypt after a year-long revolution which saw the downfall of a dictator and an inability to consolidate ever since.

So the argument of Keynesists is that this wasn’t enough, and that Britain is crippled with austerity. The media is supporting the former view as well. Britain is running the hardest austerity policy in Europe and this is resulting in terrible growth performance and the inability to start up the recovery. However, Britain is far from austerity. Yes, some painful cuts have been made, tuitions were rising, unions were hit, wages in the public sector are stagnant, a lot of public sector workers have been laid off, but what does the government do with this saved up money? It invests into credit easing, housing subsidies, the youth contract and infrastructural projects. On the other hand, it's guiding private sector investment and centrally planing credit, it announces an increase of the minimum wage, abolishing of the default retirement age, more regulation after claiming to remove regulation, the 50p tax rate and so on. None of these policies are policies aimed at growth. They are all part of a Keynesian response to the crisis. 

After all, if one would just observe the spending data for the UK, it is still increasing, both relatively (as percent of GDP) and absolutely.

Source: ukpublicspending.co.uk 
 As a comparison, during the Thatcher government, spending as percentage of GDP went down from 46% in 1981 (where it stands currently) to 34% by the end of 1989. The New Labour government(s) simply reversed that trend. To be fair, it took the Thatcher government two years to see spending to GDP rapidly decrease, so one might say to give the current government a chance. However, according to the announced policies which haven’t all even kicked in yet, I highly doubt the outcome will be the same.  

The outcomes of the Thatcher government then and the current conservative government are very likely to produce different results. In the 1980s Thatcher removed the dependency of the economy on the government and was able to restore the competitiveness of the private sector. The current government is actually looking how to increase this dependency and yet it naively expects the private sector to step in and grow on its own. 

The initial call for austerity in the UK was a necessary solution for an economy left in dire straits after the previous government’s response to the crisis. They needed to avoid the peripheral eurozone scenario and a possible sovereign debt crisis. They have succeeded in doing so and have sent positive signals to foreign investors. But now they need to be brave enough to send similar signals to the domestic economy. Continuing with the cuts is futile if the dependency on the government isn't removed. Having subsidies for youth hiring, housing, banks or businesses won’t remove this dependency. 

One does not simply enforce austerity without clearing the way for the private sector to grow again on the principles of competition and an unconstrained business environment. This crucial assumption still hasn't been made in Britain. Until we don’t see signs of reducing business and consumer dependency on the government and until we don’t see signs of more competition and less regulatory constraints to foster economic growth, the current situation will extend itself even further than projected. 

8 comments:

  1. Nice graph! A great example of what the UK needs right now - more clarity!

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  2. I agree, the government is offering a weird mix of policies allegedly aimed at growth and keeping a low bond yield. They only managed to achieve the later, only to be able to take on more debt for a lower price. And they call this a success?

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    1. Surely you must agree that having to avoid a sovereign debt crisis is a sort of a success.

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    2. I don't believe the UK would have found itself in the same problems the peripheral eurozone did. There are certain structural differences that make the UK more resillient towards a sovereign debt crisis. In any case of repaying debt the most important thing is credibility, which the UK certainly has a lot. The proof are in fact the low yields and an AAA rating despite having a worse fiscal situation than France for example, whose AAA was cut down.

      I'm not saying keeping the yields low was a bad thing, but it's worrying that this is the only thing they have managed to do with the austerity policy.

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    3. Austerity? You mean wannabe austerity? :)

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    4. Indeed, what austerity!?

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  3. the UK has an obvious austerity policy! how else would you explain so many cuts done by the government? the cuts are in absolute terms the biggest in UK history, and the largest anywhere else in the world (by size at least). Also there has never been more than two years of consecutive cuts in the UK, while Osborne wants to extend this to a total of 7 years! I can think of only one name for 7 years of budget cuts - austerity

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    1. No one is disputing the existence of the more than necessary cuts, but I think the point was made here:

      "Yes, some painful cuts have been made, tuitions were rising, unions were hit, wages in the public sector are stagnant, a lot of public sector workers have been laid off, but what does the government do with this saved up money? It invests into credit easing, housing subsidies, the youth contract and infrastructural projects..."

      That is the unfortunate problem - how was the saved up money used. It was used to engage in a fiscal stimulus of the UK economy. This is why I emphasize the ambiguity in their policies; austerity in rhetoric and stimulus in practice.

      Also, comparing in absolute terms is bound to be biased in this case since the UK economy now is far bigger than it ever was before (GDP trend is always rising), just as it is for almost any country in the world. This is why it's much more precise to look at relative indicators (which I have shown in the graph), as upon them we are able to draw comparisons.

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