Austerity was necessary in 2010, but we don’t need much more

“Read my lips: lots more austerity” Andrew Matthews

Somewhat inevitably, austerity looks set to be one of the key themes of the upcoming election. Five years after the UK coalition led us down this route, Labour is coming under pressure from the Left to sharpen its anti-austerity rhetoric.

The surge in Green Party membership is partly as a result of opposition to austerity – and the Scottish Nationalists are using it as one of their leading arguments for driving Labour to the Scottish margins – potentially costing Ed Miliband 10 Downing Street in the process.

Meanwhile David Cameron used his speech at the Scottish Conservative conference over the weekend to hit back. He said:

Our opponents bleat on about austerity but I tell you – if we don’t get a grip of these debts, they will grip us.

Pertinent questions

So who is right and who is wrong? What follows is a rundown of the vital questions about austerity, and my responses to them.

Have we experienced austerity, and if so how much?

Government spending was about 47% of GDP in 2009-10; by 2013-14 it had declined to 41.5%, and the Office for Budget Responsibility (OBR) expects it to fall to 37.8% by 2018-19.

The budget deficit was 11% of GDP in 2009-10. It is now about 5.5% and the OBR predicts a surplus by the end of the decade. So it seems we have experienced a considerable amount of austerity en route to paying down the budget deficit – and yet more is in prospect.

The UK budget deficit over time

yellow = actual, orange = forecast. OBR

Was austerity necessary?
It can be argued that a rapidly rising public debt is dangerous and that if a country’s public debt is excessive, its economic performance suffers. So it is necessary to stop the public debt rising inexorably and to put it on a downward path.

The longer one delays implementing necessary austerity, the more painful the cuts will be when they come. So the fiscal problems the UK faced in 2010 meant that some measure of austerity was necessary.

Should austerity have been postponed?
The economy experienced several years of sluggish growth after the financial crisis of 2007–8. More recently growth seems to have picked up (see chart below) and unemployment has fallen.

GDP growth over time

red = actual, blue = forecast. OBR

Some economists have argued that austerity was implemented too soon. They claim that had the government not sought to cut the deficit so rapidly – perhaps delaying the onset of cuts until the recovery was more firmly established – the economy would have recovered more quickly. But we should be sceptical about such arguments.

Postponing the introduction of austerity until the economy had recovered sufficiently would not have been credible. The markets would have taken the view: “If the government can find one excuse for failing to implement austerity immediately, it will surely find another excuse in (say) a couple of years – perhaps it will then argue that the recovery ‘is not yet fully consolidated’.” So a promise to introduce austerity “when the time is right” is unlikely to have been believed.

What would have happened if we had delayed austerity? The likelihood is that the budget deficit would be expected to be higher over the next few years, meaning a much higher stock of government debt in the future. In order to induce investors to hold this debt, the government would have to offer a higher rate of return. So long-term interest rates would be expected to be higher in the future – and this should push up current long-term interest rates.

As future returns from holding assets such as bonds, equities, property and foreign exchange would be worth less as a result, these higher actual and expected interest rates would tend to reduce the prices of these assets. This is likely to make people and companies feel less wealthy, meaning that they will probably spend less. This would weaken the output of the economy, largely if not completely nullifying the expansionary effects of the extra government spending funded by higher budget deficits.

So it is doubtful that delaying the start of austerity would have worked. In fact it could have made things much worse – there might have been a full-blown fiscal crisis, and the outcome could have been far more painful than what actually transpired, painful though this was.

Are there different types of austerity?
Yes. The government’s strategy has concentrated on reducing government spending and not raising taxation. Certain sectors including the health service, foreign aid and education have had their budgets protected.

But this has meant that unprotected areas such as local government expenditure have been very severely affected, at a time when council tax is frozen. Other types of austerity might have put more weight on raising taxes, or on spreading the cuts differently.

Do we need more austerity?
The chancellor, George Osborne, certainly plans more austerity, hoping to achieve a budget surplus and a rapidly declining debt-to-GDP ratio by the end of the decade (four years later than he originally predicted).

The debt-to-GDP ratio is still rising, and it is important to reverse this. It is now over 80%; it would be reasonable to expect nominal GDP growth of about 5% per annum over the next few years, so a budget deficit of about 4% would be sufficient to stabilise the ratio – a budget surplus is by no means necessary.

But a policy of trying to stabilise the debt-GDP ratio at a level that is not far below the 90% level that some economists have argued to be dangerously high would be risky. It is impossible to rule out the possibility that something might happen that would cause the ratio to rise, and it would also be desirable to leave some fiscal room in case there is a need to cut taxes or raise spending to combat the effects of a deflationary shock to the economy some time in the future.

It would therefore be advisable to reduce the debt-GDP ratio. But a policy of eliminating the budget deficit completely might be extremely painful, with severe costs to vital services and vulnerable groups. A better policy might be to seek to reduce the budget deficit to (say) 2% until the debt-GDP ratio reaches a more satisfactory level.

So some more austerity is necessary. One possibility might be to reduce the deficit to below 4% quite rapidly, and then reduce it further at a somewhat slower pace until 2% is reached.

But not as much austerity is needed as is currently planned – and it should be possible to revert to very gradually rising levels of real government expenditure before too long. This would enable the large reductions in some components of government spending to be partially reversed.