Britain’s Closet Keynesian

There is a growing apprehension among Britain’s financial pundits that Chancellor of the Exchequer George Osborne is not nearly as determined to cut public spending as he pretends to be. He sets himself deadlines to balance the books, but when the date arrives, with the books still unbalanced, he simply sets another.

Consider some fiscal arithmetic. When Osborne became Chancellor in 2010, the budget deficit – spending minus revenue – was £153 billion ($239 billion), or 10.2% of GDP. He promised that by 2015 the deficit would stand at only £37 billion, or 2.1% of GDP – equivalent to balancing current spending and revenue. Instead, the deficit for 2014-2015 is expected to be £97 billion. The conclusion of Osborne’s balancing act has been postponed until the 2019-2020 budget.

Osborne talks about the need to cut spending, but his actions say otherwise. Though he vowed to reduce spending by more than £100 billion by now, he has cut less than half of that, simply extending his five-year rolling program of cuts for another few years. As a result, Osborne, the poster child for British austerity, is starting to look like a closet Keynesian.

There is a school of thought that holds that commitment, not achievement, gives a policy credibility. For example, the Bank of England is committed to achieve 2% inflation “in the medium term.” Annual inflation has not been 2% at any time in the last six years, but it is possible that the BoE’s commitment has had some effect in lowering interest rates.

Osborne’s defenders might make the same argument for his fiscal policy. A credible policy of fiscal consolidation, they might say, will have the same exhilarating effect on confidence as fiscal consolidation itself.

Economists call this the “signaling effect.” If you announce that you intend to balance the books over five years and pencil in a lot of spending cuts, consumers, relieved of their fears of future tax increases, will start spending more freely. This will cause national income to rise, and, with luck, the budget deficit will start shrinking, more or less according to plan, without requiring any, or much, retrenchment.

In its emphasis on the importance of the signal, economics enters postmodernist territory. The signal – in this case the promise to balance the books – creates the reality. People start behaving as though the books were balanced, ignoring the fact that they are not. When one believes the narrative, one acts in ways that make it come true.

In fact, I do not believe that Osborne himself ever attached importance to the signaling effects of his pronouncements. He really did want to balance the budget by making the spending cuts that he promised. If he turned out to be more Keynesian than he intended to be, it was for pragmatic reasons.

What free-market ideologues often fail to grasp is that politics eventually makes all policymakers Keynesian to some degree. No matter how much a politician advocates short-term pain for long-term benefits, voters will stomach only a certain amount of suffering. So sensible politicians slow down the cuts that markets demand, and take loans that they know they will be unable to pay, in order to keep public services going.2

To be sure, Osborne must not be given too much credit for his closet Keynesianism. A true Keynesian would have said that what was needed in 2010 was fiscal expansion, not consolidation. Osborne believed, or appeared to believe, that austerity would speed up economic recovery, by restoring confidence in government finance.

But there is a strong case to be made that the cuts that Osborne did make impeded recovery, by removing spending power from an economy already suffering from a deficiency of aggregate demand. The result was economic stagnation from 2010 to 2013, undermining Osborne’s ability to meet his deficit-reduction targets.

Now that Osborne has once again promised new cuts and a new five-year timetable for balancing the books, the question is whether he will keep his word this time. Yes, the British economy has finally started to grow; and, yes, growth is expected to continue. But is there any reason to believe that the recovery will not be undermined by another five years of austerity, leading Osborne (or his successor) to postpone the deadline once again?

We can all agree that what happens to the budget affects the economy. But I would argue, as Keynes did, that “the boom, not the slump, is the time for austerity at the Treasury.” To try to cut spending in a slump, as Osborne is doing, is to prolong the slump. And, as he is learning, to his displeasure, that means postponing the day when the books will be balanced.