Economic Nonsense: 49. Government was wrong to use austerity to deal with the 2008 financial crisis

Gordon Brown as Chancellor and Prime Minister spent money profusely, believing that he could spend the British people's money more appropriately than they could spend it themselves, and by a political desire to have a large section of the populace on state largesse and thus supportive of a party that promised big spending.  The result was to make the UK hugely indebted, with an annual deficit that required borrowing to sustain that spending and increase the debt year by year.

The coalition government that followed him took action to reduce the deficit by a reduction in government spending.  This was the so-called 'austerity' package, although some critics claimed it was more talk than substance, with reductions in the increase in the debt, rather than in the debt itself.

Crucially, though, the policy was not only one of austerity.  It was accompanied by quantitative easing (QE), or increasing the money supply to reduce the more baneful effects of austerity.  Latterday Keynesians claim that government should have increased its spending to stimulate demand instead of decreasing it to tackle the deficit.  Their critics in turn suggest that it is not demand by government that sustains real economic growth, but investment by businesses in anticipation of future private demand.

The United States followed a similar policy of reduced spending combined with QE, whereas the eurozone countries led by a cautious Germany did not.  They imposed austerity on the over-extended countries of Southern Europe, but without the QE used in the UK and the US.

Britain and America experienced significant economic growth after a few flat years, whereas the eurozone countries did not.  Anti-austerity campaigners have suggested that the recovery is weak, perhaps "not even real," but the evidence does not support this.  The empirical result suggests that the combination of austerity and quantitative easing has worked, but that the eurozone policy did not.  Significantly, the QE countries did not suffer the big rise in inflation which some critics predicted.  In 2015, the eurozone countries announced their own quantitative easing, some 7 years after the UK and US did so.

The conclusion has to be that government was right to use austerity and quantitative easing to deal with the crisis.  They did not repeat the mistakes that turned a recession into the Great Depression of the 1930s.

Reading Owen Jones at the moment is really rather amusing

His basic contention seems to be that Syriza's election victory in Greece is a rerun of the fight against the Nazis and this time the left must win. Very slightly overblown that comparison.

Syriza’s posters declared: “Hope is coming”. Its election must represent that everywhere, including in Britain, where YouGov polling reveals huge popularity for a stance against austerity and the power of big business. A game of high stakes indeed: one that, if lost, will mean countless more years of economic nightmare.

This rerun of the 1930s can be ended – this time by the democratic left, rather than by the fascist and the genocidal right. The era of Merkel and the machine men can be ended – but it is up to all of us to act, and to act quickly.

Quite what style he would use to discuss anything actually important is difficult to imagine.

He has, of course, also got the economics of this entirely wrong. Greece's problems do not really stem from "austerity". They stem from membership of the euro. The harrowing internal deflation the country has been undergoing are the result of their not being able to conduct a devaluation of the currency. And far from it being us "neoliberals" arguing that such deflation is necessary we've all been shouting that the devaluation would have been a better idea. Indeed, the absolutely standard IMF (for which read, in Jones' language, neoliberal, Washington Consensus, right wing etc etc) solution to Greece's problems would have been a loan package, some modest budget constraints and a devaluation.

It's not going to work out well, of course it isn't. Partly because it's difficult to see who is going to win that argument over the debt and partly because the actual domestic economic policies of Syriza are so barkingly mad. But before Britain's leftists start cheering this victory over the forces of reaction they'd do well to understand exactly what we all have been saying these years. If the standard, orthodox, economic policies had been followed the Greek situation would never have arisen in the first place. Sure, they borrowed too much, that happens quite a lot. But the deflation would have been replaced by that devaluation and it would all just be a dim memory by now.

Fiscal austerity might not have hurt growth in the Great Recession

I say 'might', but of course I don't think there's any evidence it did. Anyway, a new NBER paper (gated up to date version, full working paper pdf) from Alberto Alesina, Omar Barbiero, Carlo Favero, Francesco Giavazzi and Matteo Paradisi finds that it did not.

The conventional wisdom is (i) that fiscal austerity was the main culprit for the recessions experienced by many countries, especially in Europe, since 2010 and (ii) that this round of fiscal consolidation was much more costly than past ones.

The contribution of this paper is a clarification of the first point and, if not a clear rejection, at least it raises doubts on the second. In order to obtain these results we construct a new detailed "narrative" data set which documents the actual size and composition of the fiscal plans implemented by several countries in the period 2009-2013. Out of sample simulations, that project output growth conditional only upon the fiscal plans implemented since 2009 do reasonably well in predicting the total output fluctuations of the countries in our sample over the years 2010-13 and are also capable of explaining some of the cross-country heterogeneity in this variable.

Fiscal adjustments based upon cuts in spending appear to have been much less costly, in terms of output losses, than those based upon tax increases. The difference between the two types of adjustment is very large. Our results, however, are mute on the question whether the countries we have studied did the right thing implementing fiscal austerity at the time they did, that is 2009-13.

Finally we examine whether this round of fiscal adjustments, which occurred after a financial and banking crisis, has had different effects on the economy compared to earlier fiscal consolidations carried out in "normal" times. When we test this hypothesis we do not reject the null, although in some cases failure to reject is marginal. In other words, we don't find sufficient evidence to claim that the recent rounds of fiscal adjustment, when compared with those occurred before the crisis, have been especially costly for the economy.

The paper comes with a whole load of interesting charts, showing how much newspapers started talking about austerity in 2010, the evolution of Eurozone fiscal policy, the correspondence between different measures of governments' fiscal policy stances, and how much better cutting spending is as a means of belt tightening than raising taxes (contrary to what Keynesian intermediate macro textbooks tell you).

Interestingly, they don't make much mention of monetary policy whether conventional or unconventional. Of course, I believe that fiscal austerity would hurt growth if monetary policymakers weren't willing and able to steady aggregate demand. But so would a particular large firm, for example, reducing investment if this was also coupled with the central bank deciding to cut its nominal target for some reason.

Osborne's cuts take us back to the dark days of, umm, 2001

It's good to see that we're not the only people who have realised that Osborne's cuts are not about to plunge the nation back into the penury of the 1930s. We're actually going back to the dark old days of 2001:

Because the government does not want to raise taxes to fund these plans, public spending is forecast to fall from 41% of GDP today to just 35% by the end of the decade.

That has prompted accusations that the government wants the country to go back to the late-1930s—and the Britain Orwell describes in his cri de coeur against poverty. The Office of Budget Responsibility, Britain's fiscal watchdog, stated that Mr Osborne's plans would force public spending down "below the previous post-war lows reached in 1957-58 and 1999-00 to what would probably be its lowest level in 80 years". "You're back to the land of Road to Wigan Pier", one BBC journalist roared. The opposition Labour party also sensed good electioneering material; on December 17th, Ed Miliband accused the prime minister of wanting to send Britain "back to the 1930s".

Hmm, well, yes:

Stripping away the hyperbole about Mr Osborne's plans shows that in reality they only amount to a reduction to the levels of public spending seen in 2002-03 in real terms, or 2001-02 in real terms per capita. The government could, back then, clearly afford a welfare state, as it will be able to still do in 2020.

You might think this a tad cynical, in fact, so do we think it a tad cynical. But then we are cynical about politics. Blair and Brown were elected: they stuck to the previous Tory budget plans for their first couple of years. Then they let rip: raising public spending as a portion of GDP from the levels it had so painfully been managed down to. No, this isn't bank bailouts, nor is it just the result of the recession. It was a deliberate plan for what they thought would be a better Britain (obviously we disagree on that betterness). All that is being done now is a reversal of that Brown Terror and splurge. You might agree that this should happen, you might think that it should not, but those screaming that it's a return to the 30s well, here's the cynicism: we think they're the people that that extra money has been spent on these past 12 years. No one likes to see the gravy train shunting back into the yard one last time, do they?

Local government cuts needn't be the end of the world

Local governments are having their spending power cut by 1.8% in real terms next year. Local councils pay for things like social care, some education, public transport and roads, and some of the arts. So this cut is not so popular in some quarters.

I hate relying on ‘waste cutting’ as a way of making spending cuts, but local councils really do seem to waste a lot of money. Since 2010 they’ve made £10bn in efficiency savings, and a third of councils say they can make bigger savings. I’m sure at least some of the other two-thirds are just being shy. The Local Government Association estimates that local governments can continue making efficiency savings at between 1 and 2 percent per year. So that’s something.

The big spending items are social care and waste spending. Both of these can be reformed so that people who can afford to have to pay for themselves. Waste collection is often contracted out, and there is academic evidence that doing so results in significant cost reductions. (There’s an easy way for councils who do not already do this to save some cash.) But more significantly there’s no real reason that more of the actual payments for this should not be moved to private residents as well, at least those who can afford it. 

Social care is much trickier and, as the population gets older and lives for longer, paying for it is becoming a bigger and bigger problem. Those people who can afford to pay for their end-of-life care should do so, but there is the problem that this disincentivises saving. Nevertheless it is hard to see a case for people who live in social housing and earn low amounts of money paying for the end-of-life care of people who own the big houses that they live in. Reforming this wouldn’t solve problems in the short run, but it might help stave off a bigger funding problem in the medium run.

Normally everyone focuses in on arts funding. In my view, there is no role for government in arts funding at all. I won’t convince you of this here, but Pete Spence might. And there are all the weird little things that local governments spend their money on that could be cut to save even a tiny bit of money. Where I live, in Lambeth, half the adverts I see seem to be thinly-veiled political campaign posters (paid for by me and my neighbours).

And, funnily enough, there’s one way councils could raise quite a lot of money and solve another problem in the process. The country needs a lot more houses, and planning permission is the main thing standing in the way. In some parts of the country, a piece of agricultural land that gets planning permission rises in value by one hundred times. Councils should be allowed and encouraged to auction off development rights for new houses. That would raise money for them and help tackle the housing shortage.

The problem here is that housing demand is not equal across the country, and it’s the richer places like London and the south east that would benefit the most from this. So there’s probably a case for some minority fraction of the money raised being redistributed to poorer authorities. In general I like the principle of council funding redistribution from rich to poor parts of the country, but that does reduces the incentive for councils to improve the economic prospects of their own areas. Though perhaps they lack the powers to do this anyway.

We have a government deficit that most people want reduced, some very large areas of central government spending that most people want increased (pensions, healthcare), and a general consensus that economic growth is a good thing (so tax rises are out). Something’s gotta give and there is almost nothing that can be cut painlessly. But given some willingness to reform alongside cutting, local government cuts could be the right way to go.

Yes, we do have a large Legal Aid bill; and so we should

It's entirely true that we have a large Legal Aid bill in this country. But it's also true that we should have a large Legal Aid bill as a result of both the way in which our legal system works and also the way that we count the bill itself. The truth being that our legal system works on a rather different basis than that or most other European countries.

Britain’s spending on legal aid dwarfs that of every other country in Europe, a report revealed yesterday.

At £2billion a year, it is 20 times the European average and more than seven times the amount spent by France or Germany.

The Government is pushing through controversial reforms to cut the bloated legal aid budget but the report, by the Council of Europe, warns that this could breach criminals’ human rights.

We do not suggest that there isn't a gravy train for the lawyers in there. Any and every system of public subsidy is subject to the usual capture by the insiders. However, just shouting that Johnny Foreigner pays less so therefore we should too doesn't quite work.

For our legal system is an adversarial one: the State, in criminal trials, uses all the resources it can muster to prove the case against the citizen. It is up to the citizen to produce their defence and it does seem fair enough that the Staten itself (or rather, us other taxpayers) should help those without the resources to mount a defence.

Most other criminal justice systems work on a rather different basis. The court is, rather than being so nakedly adversarial, more the instrument of investigation. So called "investigating magistrates" do not limit themselves to deciding upon the evidence that they are presented with: they actively go and seek out as much information about the case that they can. And they have substantial budgets to do this too.

It is this that leads to our having that, and justly and rightly having that, higher Legal Aid bill. It's not so much that defence in a criminal trial costs more in our system: it's that those costs are differently apportioned. Far more of them, in our system, turn up on the specific citizen's account for his defence rather than in the general running costs of the courts as a whole.

Our outsized Legal Aid bill is thus, at least in part, simply a product of our system of justice. And as we rather like that adversarial system, where it is up to the State to prove, beyond reasonable doubt, its claims, then that Legal Aid bill is something that we'll just have to suck up.

As above there's still room for featherbedding and gravy trains but there really is a structural reason why our bill looks so high in comparison with the court and judicial systems of other countries.