Austerity

When is it a mistake and when is it necessary?

John Fender

• Publisher: Agenda Publishing
• Year: 2020
• ISBN:
  9781788213776
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

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.

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 there are better ways of raising output and employment.

3.The policy will raise output and employment and, indeed, it is the best way of doing this, but it will have negative consequences that more than outweigh the benefits of the increased output and employment.

Of course, ascertaining whether a policy increases or reduces output may be by no means straightforward, as the comparison must be with what would have happened had the policy not been implemented, and the difference made may not be at all clear. If the policy is enacted to avoid some sort of economic catastrophe, then it might be deemed expansionary even if output falls, since the alternative would have been an even greater fall in output.

As far as the first point is concerned, the Keynesian IS–LM model suggests one possible way in which an expansionary fiscal policy may not raise output and reduce unemployment – if the LM curve is vertical, higher government spending or lower taxation will merely raise the interest rate without changing output; interest-sensitive spending will hence fall to offset exactly the increase in government spending or higher consumption of those who receive the tax cuts. The same conclusion is reached for an open economy with flexible exchange rates under perfect capital mobility (here, the exchange rate will adjust to ensure that there is no increase in output). But such models do not predict a fall in output and a rise in unemployment in response to a higher deficit; they merely predict it will have no effect. So standard Keynesian analysis does not admit the possibility that expansionary fiscal policy can be contractionary. However, this result is derived in an atemporal model with many restrictive assumptions. It might be that expectations of future fiscal policy matter as well, and if the policy changes these expectations, the results might change accordingly. This is going to be crucial in explaining how austerity policies may work in an expansionary direction. Austerity is a sequence of planned reductions of the budget deficit, and the impact of the policy by changing expectations may be crucial in explaining its effects. So we need to go beyond standard Keynesian analysis to explain why austerity policies may work (in the sense of raising output and employment).

However, currently there seems to be no widely accepted economic theory which suggests an austerity policy can be expansionary let alone gives insight into the circumstances under which this might happen: that is a major focus of this book.

The second reason for not pursuing an expansionary fiscal policy mentioned above is that there might be better ways of raising output and employment. In “normal” economic times, one might expect monetary policy to be just such a tool to achieve this objective. Indeed, in the years before the GFC, a consensus seemed to have emerged that it was appropriate to use monetary policy for stabilization purposes, and that fiscal policy should be determined by other considerations. However, the response to the financial crisis led to interest rates being reduced to very low levels, and it was thought that they could not be reduced any further – they had reached the zero lower bound (ZLB).⁴ So if interest rates cannot be reduced any further, monetary policy, it would seem, cannot be used to stimulate the economy anymore, so expansionary fiscal policy might seem to be the only remaining option to raise output and employment.

In circumstances where the ZLB is not binding, there might be a case for using monetary policy in conjunction with fiscal policy. One argument is that using just monetary policy for stabilization purposes puts excessive reliance on changing interest-sensitive expenditures to achieve the desired effect. It might be argued that it would be better to use monetary and fiscal policies together for stabilization purposes – this means that interest-sensitive expenditure (and interest rates) need change less, and other components of spending (by government and consumption affected by taxation) could fluctuate as well. Standard economic arguments can be used to support using such a combination of monetary and fiscal policies for macroeconomic purposes rather than just one type of policy alone.

The third possible reason for not wanting to use expansionary fiscal policy when it would reduce underutilized resources is that it may have undesirable longer-term effects. What might these be? One possibility is that if the expansionary fiscal policy raises the budget deficit for a number of years, there will be a higher stock of government debt at the end of the period, and this may have harmful economic effects in several ways. The higher stock of government debt will tend to raise interest rates, and this may reduce investment spending; the capital stock, and hence the economy’s level of potential output declines relative to what would otherwise have happened.

In addition, the higher future stock of government debt entailed by the higher deficits could increase the likelihood that the government will default on its debt sometime in the future, with serious, and possibly disastrous, consequences. Although many economists would argue that the probability of the UK government defaulting on its debt is effectively zero, we will argue later in this book that this conclusion is perhaps excessively sanguine. What would most likely happen instead is that if a government were pursuing policies that would, if unaltered, lead to default, it would in due course be compelled to change these policies.

Even if there is no increased probability of default from the government pursuing a more expansionary fiscal policy, it implies (from the government’s intertemporal budget constraint) higher taxation and/or lower government spending sometime in the future, which do of course have costs which need to be taken into account when evaluating the policy. Questions of intergenerational justice also arise if the higher deficits benefit the current generation at the expense of future generations.⁵

So, it seems that, in principle, there are a number of reasons why it might conceivably be wrong to pursue expansionary fiscal policy at a time of underutilized resources. However, in the central case of interest, when there is a severe downturn and the ZLB to interest rates is binding, there would seem to be a strong case for using expansionary fiscal policy – this is what Christiano et al. (2011) conclude. Their fiscal policy multiplier is much greater than unity and the nominal interest rate stays unchanged when spending is increased; however, since there are price increases due to the extra demand caused by the higher government spending, the real interest rate falls and this induces a further increase in overall expenditure.

What could possibly be wrong with such an argument? Fender (2013) suggests the following counterargument: suppose a fiscal consolidation plan is introduced which involves a reduction in budget deficits over a number of years. This means that the stock of government bonds in several years’ time will be much lower than it was previously expected to be. Assuming these bonds are long term, their prices will be higher than initially expected, so future expected long-term interest rates will be lower. With foresight, current long-term interest rates will be lower as well, and this can be expansionary for a number of reasons: investment and consumption may rise as a direct consequence of the fall in interest rates; asset prices such as share prices an...

Table of contents

• Cover
• Title Page
• Copyright Page
• 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
• 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