The first round of austerity failed. A second round would be insanity
We know the government’s story: austerity was necessary to repair the profligacy of the Labour years and the unprecedented deficit in the wake of the financial crisis. But in spite of savage cuts to jobs, welfare spending and public services, public borrowing has not been repaired. The cuts should now be over, but instead we face more of the same in the next parliament. Opinions vary; our earlier analysis of OBR figures shows that cuts in government demand in the next parliament will be more severe than the last and will amount to the second largest ever imposed on the UK (after the disastrous Geddes Axe of the 1920s).
For Einstein, insanity was “doing the same thing over and over again and expecting different results”. But his advice is ignored with most politicians and commentators still agreeing with cuts (or saying they agree with them). They try to avoid the asylum by arguing that cuts policy was not wrong, but was thrown off course by unforeseen economic conditions. As always if these conditions cannot be blamed on the opposition they must originate overseas, namely the colossal failures in the eurozone (failures for sure, but hardly unforeseeable).
The path to sanity is to understand that deficit reduction has failed because cuts have hit economic growth, severely damaged the labour market, and reduced greatly tax revenues, as well as increasing spending commitments to support low incomes.
1. Withdrawn spending led to weak growth
UK GDP figures show unambiguously that weak growth comes from reduced government spend. The chart compares economic growth, and the composition of that growth, before the crisis (2004-08), after the crisis (2010-13), and the difference (all based on nominal or cash figures– see full paper). Growth slowed from an average of 5.0 per cent a year before to 3.7 per cent after, and it is very clear that the whole of the shortfall in growth of 1.3 percentage points is accounted for by the reduced contribution of government (in fact -1.31 of -1.30 ppts).
Composition of GDP growth, percentage points:
Reduced government spending certainly did not facilitate a revival in private sector spending, as expected by policymakers. Consumer spending slowed, and investment was not greatly different. Moreover blaming failures overseas does not work: net trade makes a negligible contribution in both periods.
A fuller picture of the impact of austerity cannot look at one country in isolation. The following chart replicates the analysis for all OECD economies, but showing only the ‘difference’ column for each country, with only government identified separately and then all other contributions collected together (for clarity).
Contributions to change in GDP growth between 2004-2008 and 2010-2013, ppts:
In virtually all cases:
• there was a significant negative effect on GDP growth from reduced growth in government demand (black diamonds below zero)
• the effect varies in severity according to the size of the reduction in government demand (the red part of the column)
• non-government demand (green) did not expand to compensate for reductions in government demand (the exception being Korea, where a minor reduction in government demand was accompanied by a minute expansion elsewhere)
Countries where government demand growth has expanded – Germany, Israel and Japan – are the only economies where economic growth has increased in the post-crisis relative to the pre-crisis period (the red bit and black diamond both above zero).
Austerity was most severe in the weaker EU countries, and puts cuts in the UK and other richer economies into perspective. This does not vindicate the coalition approach, just shows other countries victims of even more stupid policy.
2. The household analogy and the multiplier
The Chancellor likes to compare the nation’s budget to that of a household. Plainly a household can repair its finances by cutting back on spending without having a material impact on the economy. But the government accounts for around a quarter of overall spending (final demand) in the economy, and cutting cannot help but affect the wider economy.
My predecessor outlined the technical debate on ‘multipliers’, which quantify this relation between a change in government spending and the impact on the economy as a whole. He wondered if the OBR would be deflected from their extraordinarily low multipliers of around 0.7 (so that, as with the household analogy, GDP would be reduced by less than the size of the spending cut – only in Korea, as it turns out), given mounting international evidence of a bigger impact. They were not. Our analysis adds to the evidence that this is a serious misjudgement.
For the UK the reduced GDP growth of 1.3 percentage points is indicative of the multiplier into the post-crisis period, but for other countries the growth reductions (and hence the impact on the private sector) are much larger. Plotting the international figures as a regression of government demand against GDP, the slope and implied multiplier is around three (with a correlation of 0.8; and these are only marginally influenced by Greece).
Change in government contributions against change in GDP growth:
This is a big multiplier, reflecting the devastation caused by austerity (though national estimates must depend fundamentally on the initial conditions when austerity was implemented). The household analogy perpetrates a gross distortion that is the opposite of reality.
3. Reduced growth to labour income and the public finances
Reduced GDP growth translates to reduced income growth for both firms and workers. As discussed in some detail in the previous posts on productivity, the workers’ share of the hit was taken on wages rather than employment.
Reduced labour income obviously means reduced tax growth. But the loss of revenues is even worse because of the adjustment on wages (rising wages are more tax rich than new jobs and vice-versa). And worse still because of various coalition income tax give-aways. In parallel the vast increase in low-paid work and in-work poverty means higher expenditures on tax credits and housing benefit.
The chart below shows how the deficit has turned out relative to the original plans. Arithmetic in the paper shows the cumulative shortfall of £150bn corresponds very closely to what would have been expected if a more realistic multiplier was used.
Public sector net borrowing, £ billion:
Contrary to policymakers’ expectations, cuts hit growth, the labour market and the public finances hard. Sanity can only be restored by reversing this dismal chain of outcomes, and recognising that spending increases can succeed where cuts have failed: boosting growth will increase labour income and repair the public finances. To paraphrase Keynes, look after growth and the public finances will look after themselves (as appears to have been the case in Germany).