Austerity: When is it a mistake and when is it necessary?

By John Fender

Austerity has dominated economic debate since the financial crisis of 2008. Governments have implemented austerity policies by reducing their spending on goods and services, increasing taxation and cutting welfare budgets.

John Fender explains how austerity (or "fiscal consolidation") works in theory and how it has played out in practice especially in the UK and the eurozone. He provides a clear and rigorous guide to the principles and mechanisms of austerity economics and offers a balanced account of the economic thinking behind contentious policy decisions.

Boris Johnson has said that the UK government "has absolutely no intention of returning to the 'A-word'", but with the Covid-19 crisis likely to result in much more government debt, it will be difficult to avoid more austerity. Understanding the impact of austerity policies is more important than ever and this book offers a first step on that path. For anyone seeking answers to such questions as: "What can we learn from the UK’s economic history that is relevant to current policy?", "Is austerity ever necessary or desirable?" and "Can the harmful effects of austerity programmes be mitigated?" then this book will be welcome reading.

• Language: English
• Publisher: Agenda Publishing
• Release date: Sep 10, 2020
• ISBN: 9781788213776

John Fender

John Fender is Professor of Macroeconomics and leader of the Macroeconomics and Finance Research Group at the University of Birmingham. His books include Understanding Keynes, Inflation: A Contemporary Perspective and Monetary Policy.

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The Economy | Key Ideas

These short primers introduce students to the core concepts, theories and models, both new and established, heterodox and mainstream, contested and accepted, used by economists and political economists to understand and explain the workings of the economy.

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John Fender

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Bounded Rationality

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Degrowth

Giorgos Kallis

The Gig Economy

Alex De Ruyter and Martyn Brown

The Informal Economy

Colin C. Williams

The Living Wage

Donald Hirsch and Laura Valadez-Martinez

Marginalism

Bert Mosselmans

The Resource Curse

S. Mansoob Murshed

Austerity

When is it a mistake and when is it necessary?

John Fender

© John Fender 2020

This book is copyright under the Berne Convention.

No reproduction without permission.

All rights reserved.

First published in 2020 by Agenda Publishing

Agenda Publishing Limited

The Core

Bath Lane

Newcastle Helix

Newcastle upon Tyne

NE4 5TF

www.agendapub.com

ISBN 978-1-911116-92-9 (hardcover)

ISBN 978-1-911116-93-6 (paperback)

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library

Typeset by JS Typesetting Ltd, Porthcawl, Mid Glamorgan

Printed and bound in the UK by TJ International

Contents

Preface and Acknowledgements

1.Introduction

2.The economics of austerity I

3.The economics of austerity II

4.The term structure of interest rates

5.A simple model

6.Austerity in the United Kingdom

Addendum: options for raising taxation in the UK

7.Austerity in the eurozone

8.Austerity in the rest of the world

9.The optimal time path of government debt (or how should fiscal policy be conducted?)

10.Policy in a world where severe deflationary shocks are possible

11.Conclusion: when are austerity measures necessary or desirable?

Appendix: UK Debt–GDP ratios, 1695–2020

References

Index

Preface and acknowledgements

This book provides an economic analysis of the effects of austerity policies. It is intended to be comprehensible to advanced undergraduates in UK universities. Hopefully it will be comprehensible and relevant to others too. Its aim is to provide an assessment of what is currently known about austerity programmes, in the light of the considerable amount of literature that has appeared on the topic, particularly since the Great Financial Crisis (2007/08). Austerity has, of course, been a controversial focus of interest, both amongst economists and in the political arena. It is fair to say we are nowhere near consensus on the subject in the profession, and there are several unresolved issues. Hopefully, this book will constitute a modest step towards a better understanding of austerity policies. It should be stressed that austerity is not an easy topic, and some of the arguments are quite complex and subtle. However reaching a better understanding of austerity and its ramifications is vital, given the huge costs that austerity policies have imposed on many poor and vulnerable people in many countries, and the likelihood that further such policies may be implemented in the future. Proponents of austerity policies may argue that there are no viable alternatives to such policies, or that the policies suggested are less painful than the alternatives. Whether or not this is the case, it does seem necessary to analyse such policies carefully and implement them only if it is indeed the case that they are the best options available.

The final draft of the book had almost been finished in mid-March 2020 when it became clear that the emerging Covid-19 pandemic was going to be an event of massive importance for the world economy and, indeed, for all aspects of our lives. Accordingly, I decided to review the draft carefully, and take into account the implications of the pandemic for the message of the book. However, at the time of writing (the middle of May) the pandemic is far from over and it will be some time before we are able to come up with a definitive account of the multifold economic consequences of the crisis.

I have given seminars related to the subject of this book to a number of audiences, including presentations to the Birmingham Economics Department, the University of Manchester, the University of Hull and the University of Cambridge Marshall Society. Several people have provided helpful comments and feedback on previous versions. These include two anonymous referees as well as George Bratsiotis and Alison Howson, my publisher whose patience I trust is being ultimately rewarded. I’d also like to thank Martin Ellison for the data he has provided. Additionally, I would mention Therese Gleitman who read the typescript and made numerous helpful suggestions.

The book is organized as follows: after an introductory chapter, the second chapter discusses conventional approaches to fiscal policy. Chapter 3 reviews literature which considers the possibility that fiscal consolidation policies can be expansionary, whilst Chapter 4 discusses the term structure of interest rates, understanding of which is essential to the account offered as to why fiscal consolidation may be expansionary. Chapter 5 presents a model in which a condition is derived for fiscal consolidation to be expansionary. Chapter 6 moves on to consider the history of government debt and deficits in the United Kingdom; in particular, it discusses why recent levels of debt should be of concern, whereas in much of the last 300 years, the UK debt–GDP ratio has been higher. Chapter 7 considers austerity in the eurozone, where the impact has been especially painful. The fact that euro-zone members have not been able to adjust their exchange rates has been of crucial importance. Chapter 8 considers austerity in several countries beyond Europe. In the final chapters, some lessons for policy are considered. Chapter 9 discusses a central issue in fiscal policy, that of the optimal time path of government debt, and in particular, whether we should deviate from a fundamental result, derived by Barro, that the debt–GDP ratio should optimally follow a random walk. Chapter 10 discusses an important question – how should government policy take into account the possibility that severe deflationary shocks may occur in circumstances when both monetary and fiscal policies are severely constrained in their ability to react? – and draws some conclusions. Some conclusions are drawn in the final chapter.

1

Introduction

Austerity is a hugely important and controversial topic in contemporary economics and in current political discussion. By austerity, we will mean a programme of planned reductions in a government’s budget deficit over a period of time, brought about by some combination of reductions in government spending and increases in taxation which will, if successful, stabilize or reduce the government debt–GDP ratio. Governments that have large debt–GDP ratios, or ratios that are increasing rapidly, may be under considerable pressure to adopt austerity policies.

To be clear on terminology at the outset: the budget deficit is the difference between the government’s total spending and its total revenue from taxation and other sources.¹ The debt is the total amount of its outstanding borrowing. The deficit is a flow measure; the debt is a stock. The deficit adds to the debt. Usually, what matters is not the absolute size of deficits and debt, but their magnitude relative to a measure of economic activity, such as GDP. Other important concepts are the primary deficit, which is what the deficit would be if interest payments on the debt were excluded, and the structural deficit, which is what the deficit would be were the economy at full employment (or at some other reference level of output).

The appropriate levels of taxation and government spending (and the consequential budget deficits or surpluses) have always been important issues. However, they surged in importance in the aftermath of the Great Financial Crisis (henceforth GFC) of 2007–08, when many countries experienced large increases in their budget deficits. A fall in tax revenues as output fell, increases in expenditure (such as social security) due to the decline of output and employment, discretionary measures undertaken to combat the deflationary effects of the crisis and the bailing out and support of financial institutions all contributed to the rapid increase in fiscal deficits.

Many governments were in an acute dilemma. On the one hand, interest rates had been reduced by as much as they could feasibly be, so conventional monetary policy could not be used any further for stabilization purposes. Hence there seemed to be a strong case for expansionary fiscal policy. But on the other hand, the large fiscal deficits meant rapidly escalating debt, with extremely damaging consequences if that were to continue.

The controversy that austerity often creates is exemplified by the letter below, and responses to it. Published in the Sunday Times on 14 February 2010 and signed by 20 prominent economists, it seems worth quoting in its entirety:

It is now clear that the UK economy entered the recession with a large structural budget deficit. As a result, the UK’s budget deficit is now the largest in our peacetime history and among the largest in the developed world.

In these circumstances a credible medium-term fiscal consolidation plan would make a sustainable recovery more likely.

In the absence of a credible plan, there is a risk that a loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability, which could undermine the recovery.

In order to minimize this risk and support a sustainable recovery, the next government should set out a detailed plan to reduce the structural budget deficit more quickly than set out in the 2009 pre-budget report.

The exact timing of measures should be sensitive to developments in the economy, particularly the fragility of the recovery. However, in order to be credible, the government’s goal should be to eliminate the structural current budget deficit over the course of a parliament, and there is a compelling case, all else being equal, for the first measures beginning to take effect in the 2010–11 fiscal year.

The bulk of the fiscal consolidation should be borne by reductions in government spending, but that process should be mindful of its impact on society’s most vulnerable groups. Tax increases should be broad-based and minimize damaging increases in marginal tax rates on employment and investment.

In order to restore trust in the fiscal framework, the government should also introduce more independence into the generation of fiscal forecasts and the scrutiny of the government’s performance against its stated goals.²

Note that the letter does not use the word austerity. Instead the term fiscal consolidation is used; we regard this as a synonym for austerity.

This letter captures some of the themes that will be explored in this book. However, the letter was not greeted with unanimous approval. In fact, on 19 February 2010 the Financial Times published two letters, also signed by some very distinguished economists (the total number of signatories of the letters was 67!), arguing against the view that there should be an accelerated programme of fiscal consolidation. It was contended that withdrawing fiscal stimulus rapidly would be likely to worsen the recession, and that Britain’s level of government debt was not out of control. It was also pointed out that the UK’s debt was, in fact, modest compared with its level in much of its history.

Nobel prize-winner Paul Krugman has also contributed forcefully to the debate: in his 2012 book End This Depression Now he writes, What we need for a rapid, powerful recovery is precisely what we’ve needed in crises past – a burst of government spending to jump-start the economy (Krugman 2012: cover). He quotes Christina Romer, a fellow economist and adviser to the Obama administration, approvingly: The evidence is stronger than it has ever been that fiscal policy matters – that fiscal stimulus helps the economy add jobs, and that reducing the budget deficit lowers growth at least in the short term (No reference given!). Hopefully, the analysis in these pages will shed light on some of the issues raised by these economists and their divergent points of view.

It is clear that fiscal consolidation policies will often be controversial. Cutting government spending and raising taxation affect people directly and adversely, by cutting public services, reducing welfare payments and reducing disposable incomes, so presumably there must be some offsetting benefits of the policies if they are to be justified. Austerity policies are sometimes implemented in periods of economic recession, rising unemployment and falling output, circumstances in which Keynesian analysis would suggest that the recession will be exacerbated by implementing such policies. So it can be argued that austerity in such circumstances is undesirable for two reasons: there is the effect of the measures on the individuals directly affected (i.e. those who suffer the effects of the reduction in government spending or who pay any tax increases that the policy entails), but also by worsening the recession, the policy may make more people worse off by, for example, raising unemployment.

What, then, are the arguments in favour of austerity? It is by no means the intention of this book to argue either that austerity is always necessary or desirable or that it is never necessary or desirable. The answer to the question whether austerity should be introduced in certain particular circumstances starts with the words, as do the answers to so many questions in economics: it depends. However, of course, the next question then is: what does it depend upon?. This whole book might be thought of as attempting to provide an answer (albeit incomplete) to this question. Related questions, such as if austerity is necessary, then how much? and what sort of austerity? also need to be addressed.

The central issue is the following: take a situation where there is spare capacity and unemployment in the economy. (This is where the implementation of austerity policies is most problematical.) Assume, further, that much of the unemployment is involuntary, in the sense that many of those unemployed would rather work at prevailing wages than remain unemployed.³ Can austerity ever be desirable in such circumstances? We will take it for granted that measures that do reduce unemployment and raise output, without negative side effects, would be desirable. In particular, suppose that inflation is low, and that the inflationary consequences of such a policy are not a concern. There would seem to be a strong case for adopting a standard Keynesian policy of raising government spending and cutting tax rates in these circumstances.

However, this conclusion may not be warranted in three types of scenario:

1.The policy will not, in fact, raise output and employment.

2.The policy will raise output and employment, but