When confidence is shattered


In economics, you cannot convict your opponents of error, but only convince them. Economics isn’t like physics; you can’t conduct controlled experiments to prove or disprove your theories. History provides a very partial way of overcoming this weakness. No events repeat themselves exactly, but past events offer some kind of test of current theories about the economy. The main question of current interest is the effect of fiscal consolidation.

The programme of fiscal consolidation has just been unveiled by George Osborne. The claim behind it is that slashing the deficit – removing £123bn from the economy over the next five years, partly by raising taxes, mostly by cutting spending – will make the economy recover faster and more vigorously from the recession. This theory goes under the name of “expansionary fiscal contraction”.

It became popular in the 1980s as a counter to Keynesian orthodoxy at a time when fiscal policy was in flux. President Ronald Reagan, while proclaiming strict fiscal rectitude, in fact ran unprecedented (for that era) peacetime budget deficits. For Keynesians the US boom of the 1980s was the direct consequence of the huge dollops of extra demand being pumped into the American economy, mainly for military spending. Keynesian economists warned against premature curtailment of this stimulus. As Ralph Bryant, John Helliwell and Peter Hooper (in Bryant et al. Macroeconomic Policies in an Interdependent World,1989) put it “an unanticipated cut in US federal purchases could have a substantial negative on the level of US real output for several years”. But two other economists, Gerhard Fels and Hans-Peter Frölich writing in Economic Policy 4 (April 1987), studied a different episode, that of fiscal consolidation in the Federal Republic of Germany. They noted that the “anti-Keynesian” policy there had coincided with a rapid recovery of the economy from the 1981-2 recession, and attributed this “coincidence” largely to the favourable effect of consolidation on expectations in the private sector. A similar conclusion was drawn from Geoffrey Howe’s 1981 Budget. Indeed, it became part of Thatcherite folklore that Howe’s fiscal retrenchment was shortly followed by a resumption of rapid growth, despite the dire warnings by hundreds of Keynesian economists.

The proposition that cuts in government spending can grow the economy relies on “Ricardian equivalence” – the oft-repeated claim, made by the likes of Osborne, that government borrowing is just deferred taxation. If households and investors factor in future levels of taxation when they’re making spending decisions now, a stimulus would have no effect on economic growth. Households will simply cut back on their consumption in anticipation of inevitable tax increases. So public spending “crowds out” private spending.

But now let’s ask: what would households and firms do in response to a cut in government spending? Ricardian equivalence says that reduced borrowing will create an expectation of lower taxes in the future (even if in the short term the deficit reduction includes tax rises). Freed of the burden of future taxes, private agents will happily spend more now, providing the required boost to demand when the government steps back. Increased demand means more jobs created in the private sector. The resulting increase in spending may well be enough to outweigh the money taken out of the economy by the government, and thus increase output overall.

The effect on investor and consumer confidence is likely to be even greater if spending cuts are seen to prevent an even more painful readjustment in the future. This can happen if the national debt is seen to reach an extreme level. Dispelling the fear of a Greece-style debt crisis might contribute more to growth than the loss of public money propping it up.

The other way cutting the deficit can reverse “crowding out” is by leading to lower interest rates. According to this argument, government borrowing drives up interest rates, because at a fixed level of saving the government demand for borrowing increases the price private borrowers will pay for access to finance. As a result, government spending “crowds out” private spending, substituting on a one-to-one basis. So if government borrowing falls, interest rates will fall allowing private firms to borrow more cheaply.

Thus, a reduction in the deficit today might be good for the economy tomorrow under three conditions: if is taken to signal lower taxes; if it leads to lower interest rates; and if it reduces the risk of “bad news” such as default, inflation, and so on – that is, if it leads to greater confidence.

What does the historical record tell us? The OECD claims that in the past thirty years, around half of the fiscal contractions in the EU have been expansionary, followed by an acceleration in growth. There is no shortage of historical episodes offered as models for today’s cuts – Canada, Ireland, Denmark – but here three examples from British economic history seem most relevant.


The last time public spending was cut on the scale proposed by Osborne was in 1921-22, with the “Geddes Axe”, carried out under another Conservative-Liberal coalition government.

During the First World War, government spending, taxes and state involvement in the economy had expanded enormously. The war effort had been financed through borrowing, and the result was a sharp increase in government debt, which peaked in 1919 at 135 per cent of GDP – compare the projected peak of 70 per cent in 2013. The wartime scale of deficit spending brought with it an inflationary boom immediately after the war, while demobilisation and the sell-off of military assets brought fiscal surpluses. But there was a quickening current of middle-class discontent at the burden of taxation, which manifested itself in the “anti-waste” movement.

The Anti-Waste League, founded by 1st Viscount Rothermere, owner of the Daily Mail, campaigned against what was seen as wasteful government expenditure, winning three “safe” Conservative seats in by-elections in the first half of 1921. In the end, the political pressure on the government proved too great. David Lloyd George renounced his promises of “homes fit for heroes” and an independent committee of businessmen, led by Sir Eric Geddes, was asked to produce savings of £100m in addition to the £75m the Treasury had already extracted from the departments. By cutting expenditure, the government argued, it would make room for tax cuts, and find money to pay down the debt.

In the end, Geddes proposed £87m of extra cuts, and while departments did not quite reach the Geddes Axe target, central government current spending fell by about £100bn in today’s value over five years – not entirely unlike today’s projected cuts. Although the majority of the savings were made in defence, the short-sighted focus on reducing waste damaged areas vital for long-term economic growth, notably secondary education for poorer children. The cuts in the Budget hit an economy already suffering from a huge fall in output. Monetary policy was not eased to offset fiscal contraction, because interest rates were kept high to help the pound regain its pre-war parity with the dollar: a tactical blunder that earned the wrath of John Maynard Keynes.

The result was eight years of ultra-anaemic growth, punctuated by the General Strike of 1926, with unemployment of insured workers never falling below 10 per cent. This situation was the origins of Keynes’s later concept of “under-employment equilibrium”. There is a further lesson for today. The shrinkage of the economy in 1921 and 1922 caused the national debt to grow from 135 per cent of GDP in 1919 to 180 per cent in 1923, and though it subsequently came down it was higher in 1929 than it had been at the end of the war.

Move forward to the Great Depression. The Wall Street crash of 1929 brought a global collapse in demand. By 1931 UK unemployment had almost reached 20 per cent. Concerns about the solvency of the Labour government’s finances led the Chancellor, Philip Snowden, to set up an independent committee under Sir George May, formerly of the Prudential, to recommend cuts in public expenditure. Projecting a deficit of £120m for 1932-3, the committee demanded £96m of cuts, mostly to come from benefits and wages, and £24m of extra taxes. The hole in the government’s budget was 10 per cent of public spending, about the same as today’s, though it was to be closed in one year rather than five.

It needed a National Government, formed by the Labour Prime Minister, Ramsay MacDonald, with the support of the Conservative and Liberal parties but against the opposition of his own, to deliver the cuts demanded by the May Committee. But these failed to restore confidence, and Britain was forced off the gold standard a month after their enactment in September 1931, following a “mutiny” at Invergordon of naval ratings facing pay cuts. Keynes wrote in the New Statesman at the time that the May Committee cuts would add some 400,000 to the unemployed, diminishing tax receipts and reducing the “saving” on the budget to just £50m. “At the present time all governments have large deficits,” he wrote. “They are nature’s remedy for preventing business losses from being…so great as to bring production altogether to a standstill.”

One can point to four years of solid growth from 1933-1937, but it is hard to argue that this had anything to do with an “expansionary fiscal contraction”. Rather it was Britain’s abandonment of the gold standard was the decisive event. This had two expansionary effects: interest rates could come down to 2 per cent, where they stayed for the rest of the 1930s, and the pound lost 30 per cent of its value. This first enabled the Treasury to convert the national debt to lower interest rates, and sparked off a private housing boom; the second boosted exports for a year and a half until the United States devalued the dollar, too. The decline in GDP during the Depression years caused the national debt to rise from 160 per cent in 1929 to 180 per cent in 1933, higher than during the war. Despite the recovery, interrupted by a “double dip” in 1937, unemployment never fell below 12 per cent for the rest of the decade.

Osborne’s think-tank acolytes often invoke the spirit of Geoffrey Howe’s 1981 Budget. His savage programme of cuts – designed primarily to help bring down inflation – took £4bn, or 2 per cent, out of the economy when unemployment was already rising. Howe’s plan ran up against the Keynesian orthodoxy of the day. In March 1981, 364 economists, including the current governor of the Bank of England, Mervyn King, wrote an open letter to the Times, predicting that government policy would “deepen the depression, erode the industrial base of our economy and threaten its social and political stability”. Almost before the ink was dry on the letter, the economy emerged from recession, growing by 3.3 per cent on average over the following five years. (Inflation also fell from 17.8 per cent in 1980 to 4.3 per cent in 1982). A textbook example of an expansionary fiscal contraction?

Hardly. In a retrospective debate on the merits of the 1981 budget, published by the Institute of Economic Affairs as the report Were 364 Economists All Wrong? (2006), none of the contributors believes it was the Budget cuts themselves which produced recovery. Rather, it was the monetary loosening which accompanied them: interest rates were cut by 2 per cent and restrictions eased on banking lending. Tim Congdon, the most skilful defender of Howe’s budget strategy, argues: “the [presumably adverse] macroeconomic effects of the £4bn tax increase in the 1981 Budget were smothered by the much larger and more powerful effects of changes in monetary policy’.

Stephen Nickell, formerly of the Monetary Policy Committee, and an unrepentant signatory of the letter, agrees. He does point out, however, that as unemployment continued rising and did not start falling for five years, the fiscal contraction widened the output gap and the economy failed to grow to trend. So the defence of the Howe Budget rests on the assertion that budget cuts were needed to bring down long-term interest rates, with private spending being “crowded in” by the contraction of government spending. With large numbers of people unemployed, this is not very plausible.

Where cheaper money may have had a favourable impact was on asset prices. It was the boom in house prices and financial assets which led the Thatcher recovery. Today, Osborne apparently puts his faith in monetary loosening to offset the effects of his fiscal consolidation.


Some conclusions can be drawn from these episodes. First, the fiscal contraction was never followed by economic growth strong enough to replace the output lost in the preceding slump. In all three cases it is likely that it made the slump worse than it would have been. Second, and because of the last factor, it failed to reduce the national debt. The national debt as a share of GDP rises in periods of stagnation and falls in when times are prosperous. Third, in all cases it led to considerable social and political unrest: we have only to think of the 1926 General Strike, the hunger marches in the 1930s, and the miners’ strike of 1984-5.

Two of the three episodes considered – those of 1931 and of 1981-2 – were followed shortly by economic revival. However, a correlation is not a cause. By general consent it was cheap money, and not fiscal contraction, which brought about the recovery, and the deficit hawks have failed to establish that it was the fiscal consolidation which caused the cheap money. Indeed, on a priori grounds this is highly unlikely. To the extent that Budget retrenchment reduces the national income to less than what it would have been, it reduces saving and money supply, and thus leads to interest rates higher than they would otherwise have been.

So we are brought back to the question of confidence. One can imagine a set of circumstances in which fiscal consolidation will have a sufficiently invigorating effect to cause a recovery. I would suggest, however, that this can only happen in the context of extreme events. If a government is felt to have lost all control, if the size of the debt is so vast that it threatens imminent default, then a decisive change of policy can have a decisive effect. Britain was hardly in this position last April, despite all the efforts of Conservative spokesmen to play up the imminence of the danger facing the country under Labour rule.

This illustrates the point that one cannot, and should not, reduce all economic policy to matters of psychology. It leads to the view that fatuous expressions of confidence, provided they are repeated often enough, can overcome the effects of disturbing events. For this to be true, one has to assume a great deal of irrationality in the electorate. Some irrationality there surely is, but it is surely more reasonable to believe that if a businessman faces a declining demand for his products he will curtail his production, rather than expand it.

So, what are the prospects for Osborne’s cuts? They will directly worsen immediate growth prospects, as the Office of Budget Responsibility concedes, and they will not in themselves bring about offsetting reductions in long-term interest rates. For this, we need quantitative easing (printing money) and it is no secret that this is what the Chancellor relies on to vindicate his policy. Yet one would be wrong to think this is a cure-all. For one thing, it never brought about complete recovery in the past. Second, its main influence is on asset prices. Housing and construction benefit especially from low interest rates, but do we want to stimulate another housing boom fuelled by cheap credit? Moreover, most of an economy’s investment is more sensitive to the level of demand than to the cost of capital, so that even large reductions in interest rates might have quite a small effect on activity.

Quantitative easing is Osborne’s last throw. But the injection of £200bn of new money in 2009 failed to revive lending and borrowing on the scale needed for robust recovery, and it is not clear why the Chancellor and the governor of the Bank of England expect another monetary injection to do any better now. Demand is expected to fall further and new unsecured lending is priced at 10.5 per cent despite a 0.5 per cent bank rate.

Keynes spelled out the alternatives we face today in 1932, in the thick of the Great Depression: “It may still be the case that the lender, with his confidence shattered by his experience, will continue to ask for new enterprise rates of interest which the borrower cannot expect to earn…If this proves to be the case there will be no means of escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidise new investment.” George Osborne be warned.