Labour must expose the fallacy of George Osborne’s ‘recovery’

Where has the conference silly season left the debate on economic policy? George Osborne claims to have routed his critics: fiscal austerity has produced recovery. Labour, seemingly amazed that recovery has happened, has promised that a Labour government will continue to cut the deficit, albeit a little more slowly. The Liberal Democrats would join them in the slower lane. The main point of difference seems to be that “Labour cuts” will be fairer than “Tory cuts”.

The budget outcomes tell a different story. Osborne will have failed by a wide margin to meet his deficit-reduction targets in this parliament. The deficit is now likely to be more than £70bn in March 2015, when it should have been zero. This is a prima facie indication that the theory linking fiscal tightening with recovery was wrong.

The theory was that cutting government spending would cause the economy to grow. The growth of the economy would increase government revenue sufficiently to balance the budget over five years. The still-gaping hole in the budget is the result of the economy’s failure to grow to plan since 2010.

But still, Osborne’s defenders argue, the economy has finally started to grow. Is that not proof that austerity has finally started to work? This is a good example of the post hoc, ergo propter hoc – “after this, therefore because of this” – fallacy.

There is no reputable theory that says that cutting public spending in a slump will induce a recovery. In fact, theory tells you the opposite. A slump comes about because, for one reason or another, the private sector is spending less than it was. If the government reduces its spending at the same time, this will make the slump worse, not better.

There is one possible exception: if wealth-holders believe that the government needs to cut its deficit – because otherwise, say, Britain would “go the way of Greece” – then the announcement of a credible deficit-reduction plan might increase their confidence in the future and cause them to increase their spending.

However, one would need to argue that such confidence-boosting effects would fully offset the demand-destroying effects of actual and anticipated cuts in public spending. The empirical evidence is that they do not, and for good reason: there are many more people whose spending would be reduced by the cuts than those whose “confidence” would be boosted by them.

But still, is not the recovery of the economy sufficient vindication of Osbornism, even if the mechanism of recovery is not quite as he depicts it?

Certainly not. The most important point to understand is that all economies recover from a slump sooner or later. After a lapse of time, the rundown of existing capital stock, together with disinvestment in working capital and surplus stocks, will make new investment more profitable; a Pigou or “real balance” effect will come into play as wealth-holders benefit from the fall in prices (or inflation rate) and start buying depreciated assets and consumption goods. These are the “automatic” recovery forces. John Maynard Keynes himself never denied they existed. His argument was that after the kind of shock we have experienced, they would be too slow and too weak to produce a quick or full recovery.

In addition to these “automatic” forces, a deliberate economic stimulus in the form of quantitative easing (QE) made the slump of 2008-09 shallower than it would have been, and helped the subsequent recovery in 2013-14. The Funding for Lending scheme, introduced in 2012, has also helped. It is QE, not confidence in government finance, that has kept the cost of government borrowing down to near zero.

Despite these automatic and deliberate offsets to fiscal austerity, the recovery has been the slowest on record. It has taken six years for the UK to regain pre-recession levels of output. Osborne’s supporters argue that, given the damage to the banking system, no quicker recovery could have come about. What this amounts to saying is that the “automatic” recovery forces were weaker than one might have hoped. But this was no argument for weakening them further by fiscal contraction, rather for offsetting the banking weakness by fiscal expansion.

Thus the coalition’s policy is doubly damned. It has prolonged the recession and promoted a lopsided and unbalanced recovery which promises another collapse in the not-distant future.

It is still open to Labour (and the Lib Dem sceptics within the coalition) to attack Osborne’s policy on these lines.

Instead of vying with him in his cutting zeal, confining its criticism to the “fairness” of the actual measures proposed, Labour should be arguing two things. First, it should point out that the policy of balancing the budget by Osborne cuts has not balanced it at all, and holds out little hope of balancing it in 2017-18, since the £38bn of extra cuts he needs to do hit the source of future government revenues.

Second, it should argue that the budget should be balanced by investing in the economy. Now is an ideal time for the state to build new housing; renew infrastructure; prevent, mitigate, and adapt to climate change; equip schools and hospitals with broadband; and reverse cuts to local authorities’ capital spending. It should promise that every pound saved from cutting current spending on public services will be added to the capital of Vince Cable’s Green Investment Bank. This would boost its capital from £4bn to £41bn over five years, and in addition, it would immediately be allowed to borrow.

Will Labour do this? Probably not: it is too scared to offer an alternative narrative based on principle and good theory. Thus the debate is not properly joined, and Labour will pay the electoral price.