Austerity v Stimulus

The Northern Ireland Economic Conference, Belfast


How much do people mind the deficit? Do they lie awake at night worrying about it? Do they have nightmares about it?

I tended to dismiss such thoughts as fanciful. Households and businesses, I thought, naturally worried about their own budgets, but not about the government’s budget.

I therefore tended to assume that the government had enough freedom over its own budget to do what it thought best for the country, without coming under undue popular pressure to ‘balance its books’.

Of course there were the ‘markets’. But it didn’t seem to me the markets were putting pressure on our government to ‘balance the books’. After all they have been lending to Treasury long-term at 3% This is historically very low. It does not suggest any great fear of default or inflation. The markets can certainly make their displeasure felt, as Greece, Portugal, Ireland, and Spain have discovered. But it did not seem to me that a British government, of whatever stripe, faced this particular problem.

But I was brought up short by Alastair Darling in his speech of 27th September at the Labour party conference. The Evening Standard’s headline was: ‘Failure to cut debt would be electoral disaster, says Darling’. He is reported as saying:

‘Whatever our message, it’s got to strike a chord with millions of ordinary people as being realistic and credible. People know there is a deficit. They know it needs to come down. If we deny that, frankly people will not listen to you’.

So, it seems, people do worry about the deficit, perhaps even have nightmares about it. The Coalition, Darling implied, has struck the right cord.

Darling comes across as a solid citizen, in tune with ordinary people. So I ask myself: what is it that ordinary people fear or dislike about the deficit? I have come up with two answers.

First, people think of the government’s finances very much as they think of their own household’s finances.

Every household knows that it has to balance its books. If it is spending more than it’s earning, it either has to earn more or spend less. Spending less means saving more. Yes it can borrow, but borrowing is for emergencies, and has to be repaid. It is better to stay out of debt. True enough, households went on a huge spending spree. Now is the day of reckoning: the wages of sin have to be paid. Households also know that a lot of their spending is ‘wasteful’ –things they can do without. And they assume the same is true of governments.

Ordinary people, I suspect, think of the government as a huge household, which is currently spending much more than it is earning. Its collateral –the national economy – has shrunk in value. So it has to increase its earnings –raise taxes –or reduce its spending, or some mixture of both, and make provision for repaying its debt out of its surplus, just like the millions of smaller households in the land.

I believe that an analogy like this underlines much of the popular feeling that it’s time for the government to start balancing its books.

But the analogy is not, perhaps, enough to create the demand. People also think of the impact of the national debt on their own finances.When they think of the government ‘paying back’ the national debt, they understand that it is they –the taxpaying citizens –who will be doing the paying. So they want to stop the growth of the National Debt, and that means reducing the deficit as quickly as possible. It’s the debt not the deficit which looms largest in people’s minds. Unless the books are balanced now, the burden on present and future tax payers will skyrocket. In fact it already portends a new age of austerity.

So the demand for retrenchment comes both from the analogy between households and governments and from the implied financial link between the two.

These are instinctual responses. But they are inflamed by politicians. David David Cameron has said that ‘the government deficit is just like credit card debt’. George Osborne has repeatedly pointed out that borrowing is simply deferred taxation.

However, these are not the only instinctual responses. There is also, I would say, a strong instinctual understanding that cutting the deficit is likely to cost jobs. This is the trade union position. It was the great fault of the Labour Party leadership that it failed to develop a persuasive narrative capable of giving this instinct voice.

One should not underestimate the effect of language. Politicians use language to create a particular kind of narrative. The phrase ‘deficit denial’ is a conscious echo of the phrase ‘Holocaust denial. A ‘denier’ is someone who refuses to acknowledge the existence of a disagreeable fact. A deficit denier is someone who minimises the deficit problem, and therefore the need to take urgent action. The cutting narrative can also be seen in the emphasis of the cutters on the ‘structural deficit’. By some alchemical process which is far from clear the pre-recession deficit of 2.5% of GDP has been transmuted into a ‘structural deficit’ of 7.4%. This, the cutters say, is the real legacy of the last government – of its wastefulness and extravagance. ‘Deficit deniers’ are those weak sisters who blame most of the deficit on the collapse of the economy rather than on thirteen years of Labour government and say that most of it will shrink naturally as the economy recovers.

A second example of language structuring the argument is the appropriation by the cutters of the word ‘confidence’. Only a ‘credible’ programme of deficit reduction, it is claimed will restore the ‘confidence’ of the markets in the government’s solvency. Indeed the Coalition argues that it is only the announcement of the austerity package in June which has kept borrowing so cheap and allowed the UK to retain its AAA rating. This is despite the fact that the Labour government was able to borrow just as cheaply.

An alternative narrative was readily available but was not used. A Keynesian would say that the slump was caused by the excesses of an under-regulated banking system. This led to a collapse of profit expectations which spread from the financial sector to the real economy. A Keynesian would say that the enlargement of the deficit is the natural counterpart to the collapse of private spending. It was only the government’s willingness to allow public deficits to grow as the economy shrank that prevented another Great Depression. If, before recovery is secure, the government cuts its own spending, everyone in the economy will have less to spend, and there will be a further decline in aggregate demand, which will prolong or even deepen the recession. There will be no ‘crowding in’ of private spending if aggregate demand is too low. A Keynesian would certainly recognise the importance of ‘confidence’. But he would say that the most important ingredient of business confidence is a full order book.

The reason the Labour leadership could not use this alternative narrative is that it was committed to a deficit reduction programme almost as drastic as that introduced by the Coalition. A cogent Keynesian stance would have been to avoid any commitments to cutting, and simply say the deficit would be managed in the light of economic circumstances. Intellectual room should have been left for a further fiscal stimulus if the recovery showed signs of stalling.

By not taking a principled stand of this kind, the last government lost the rhetorical battle. It couldn’t openly say ‘without a large deficit there will be no proper recovery’. It left the running to those who simply said that ‘you can’t spend money you haven’t got’ and there is ‘no more money in the kitty’. This is rubbish. The rise in the deficit and national debt is mainly a consequence of the shrinking of the economy: as the economy recovers –partly because of the stimulus afforded by deficit spending – both will shrink simultaneously as a proportion of national income. Here are some interesting figures. In 1919 the National Debt stood at 135% of GDP -as a result of heavy wartime borrowing. By 1920, after a year’s inflationary boom it was down to 130%. By 1922 it was up to 171%? Why? Because there had been a huge deflation and rise in unemployment in 1921. In the deflationary decade of the 1920s, the debt hardly reduced at all. Nothing could more clearly illustrate the fact that the debt falls when the economy rises and rises when the economy falls.

There are other points which could have been made. Unlike households, governments don’t have to repay their debt. They can borrow almost without limit, especially from their own people. If interest rates go up, they can print more money to force them down again. Printing money won’t cause inflation to go up if there is a lot of unused capacity. Another myth is ‘the burden on future generations’. Provided the debt is mainly held by British citizens, there is no net loss of income from any debt repayment: it is a matter of future taxpayers repaying future bondholders.


In practice, most expert opinion expects that cutting the deficit will reduce Britain’s growth rate in the short and medium term. But they say this is the price we will have to pay for longer-term benefits. Some of them try to manipulate expectations downwards by talking of a ‘new normal’ of tepid growth. In this view, the boom was the illusion, the slump the return of reality.

The experts offer one escape route from the deflationary effects of the cuts: printing money, or quantitative easing. This is supposed to have two effects, both supportive of recovery. Both come about through forcing down interest rates. The drop in Treasury yields will lower borrowing costs for customers and businesses, helping to stimulate consumption, business investment and housing. It will also cause the exchange rate to depreciate, helping exports. But both effects are highly uncertain.

Here is some evidence from the United States:

The Fed purchased $1.25 trillion in mortgage assets last year. Figures show it didn’t go into bank lending. As it turns out, it went back onto the balance sheet of the Federal Reserve. ie., banks simply paid back the Fed. Similar evidence from UK, hence increasingly desperate calls from our politicians for banks to ‘start lending’.

How much of an impact would $2 trillion in QE2 give the US economy? Not much, according to former Fed governor Larry Meyer. Meyer estimates that a $2 trillion asset purchase program would: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, Meyer admits that these may be ‘high-end estimates’. That is not much bang for the buck.*

If banks are not lending now, with what seems like lots of reserves, then what is to make us think that another couple trillion dollars or billion pounds in QE will make them feel like they have too much money in their vaults?

If it is because they don’t have enough capital, then adding liquidity to the system will not help that. If it is because they don’t feel they have creditworthy customers, do we really want banks to lower their standards? Isn’t that what got us into trouble last time? If it is because businesses don’t want to borrow all that much because of the uncertain times, will easy money make that any better? As someone said, “I don’t need more credit, I just need more customers.” Keynes made the same point in the 1930s: it is not the printing of the money, it is the spending of the money which stimulates the economy.

But what about the other escape route: exchange rate devaluation? Sterling has fallen by 20% against the dollar and Euro since the beginning of the crisis, but the UK’s current account deficit has widened to £8bn. Currency depreciation is good for exports if one has something to export.

Here we come face to face with one of the great fantasies of the Thatcher revolution, fully shared by New Labour: viz that the service economy can provide a complete replacement for manufacturing industry. The main cause of our growing current account imbalance is our growing trade deficit in manufactured goods. On past trends the trade deficit will continue to grow. This will cause the pound to fall further.

But as Dr. Alan Reece, chairman of Pearson Engineering wrote in 2007:

‘the UK will no longer have the ability to increase significantly the output of exports: there are no longer the factories or skilled workers and scientists and engineers required for this. There is no sign of any reduction in the rate at which manufacturing is being moved overseas….This is the main reason for the disappearance of manufacturers of power stations, ships and ship repairs, motror cars, trucks, tractors and other farm machinery, medical scanners etc.**

Manufacturing has once more borne the brunt of the recent collapse in output, and despite some recovery is still ten percent down on pre-recession levels.


My conclusion is that we can’t rely on QE2 or exchange rate depreciation to counter the effects of deficit reduction on aggregate demand. We should not commit ourselves to a definite programme of deficit reduction until we have definite evidence of substantial economic recovery in UK, USA, and Eurozone –which is lacking. What we can do is to switch the emphasis of deficit spending to infrastructure projects. In other words, we should revive the distinction, however fuzzy it has become, between the current and capital spending. We should aim to balance the ‘normal’ budget, but grow the capital budget. We would then come out of the recession with new assets. A time of unemployed resources is the ideal time for the accelerated investment in schools, universities, hospitals, houses, transport infrastructure, and green technology. A programme like this will not only lift the economy out of recession; but it will create a demand on the manufacturing sector which will better secure our long term growth than reliance on financial and ‘creative’ services and outsourcing. This is a programme which will more easily commend itself to the public than what it believes is purely wasteful spending on current consumption. It combines intellectual cogency with at least the chance of popular appeal. It provides an opportunity to show what the government can and should do.

Will it happen? Probably not, unless the austerity programme itself is de-reailed by events and opposition. As Harold Macmillan famously remarked when asked what decided policy: ‘Events, dear boy, events’. Continuous recession will reduce the attractions of the hair-shirt; and the succession of ‘dips’ which always accompany a fragile recovery will create a new environment in which politicians will be able to talk a new language.

* I am indebted to investment analyst John Maudlin’s weekly newsletter, Thoughts from the Frontline.
** APR Newsletter January 2007.