the present tense of a dangerous idea

austerity then and now

[admin note - staff holidays are ongoing, so apologies for the non-appearance of last week’s post. If I had my wits about me I would have prepared some in advance but I didn’t - I hope to be more on top of this going forward. sorry!]

Departing a little bit from the major themes of this newsletter (big abstract pontifications about systems theory) to pontificate a bit about the current state of the British economy.  Which is a subject on which I think a lot of people are confused, and are consequently lining up to do battle over questions which are at best irrelevant and at worst actively opposed to the positions they really hold.  Which, I suppose means that it’s not such a huge departure, as the root of the problem is that the economy itself is a complex system, and different things matter when it is in a different state.

I refer of course to the forthcoming fiscal speech.  This is one in which a “bring out your dead” exercise will be necessary, because in the late stages of the Sunak government, it became distressingly habitual to announce new programs without giving any indication of how they were going to be funded, and even to make significant tax cuts while telling the fiscal watchdogs that they would be matched by unspecified spending cuts in the near future.  Consequently, although everyone kind of knew that there was a black hole[1] in the budget, nobody could necessarily be sure how big it was. 

And if the newspaper speculation is to be believed, our Chancellor intends to deal with this gap by cancelling some public investment projects (the ones I’ve seen are railway programs and what’s described as a “new hospitals” program but which seems to be mainly about catching up on twenty years’ deferred maintenance capex).

Cancelling investment programs as a means of achieving a deficit target is bad.  (It’s one of the key things they teach you in business school that investment and financing decisions have a separation theorem – you can’t make a bad investment good by leveraging it, and a good investment doesn’t become bad if it needs to be debt-financed).  And so, if the news speculation is right, Chancellor Reeves is about to do a dumb thing.  But as far as I can see, it isn’t the specific dumb thing many people are accusing her of, and it’s got a lot less to do with structural bad features of the UK policy system.  Let me expand:

As long term readers will know, I am generally against “fiscal rules”, and specifically think that the UK’s Office of Budget Responsibility is a bad way of implementing them.  (In particular, I think the five year forecast horizon is exactly the wrong way to calibrate a control framework – it means you put too little emphasis on things that are happening immediately, while also ensuring you miss the big and slow-moving trends that really shape the economy).  But as it happens, I think that in the current situation, I would give more or less exactly the same advice as the OBR, even though the phrase “the parlous state of the public finances” has never passed my lips or keyboard without a sneer or vulgar hand gesture.

Consider the disastrous Truss/Kwarteng budget of 2022.  I have two points to make about this, one real one and one drive-by at a target of opportunity.  To deal with the drive-by first, it seems weird to me that supporters of fiscal rules view the Truss budget as demonstrating the need for them.  I think it shows the opposite – that the UK system is already blessed with a bond market, mortgage market and central bank system which ensures that really bad budgets are quickly converted into politically unsustainable meltdowns which remove the offending politicians far faster than any technocrat could manage.  The system works!

But more importantly, this is remembered All Wrong by the writers of the first drafts of economic history. The Truss/Kwarteng budget didn’t lead to a fiscal meltdown because it set the UK on an unsustainable debt path.  The problem with it was that it was a very large deficit budget (big corporation tax cuts, to be allegedly offset with unidentified future spending cuts that were almost certainly politically impossible), proposed at a time when the UK was close to full employment.

That meant it was inflationary – the tax cuts would put more money into the UK economy, nothing was taking that money out, and so the eventual recipients were bound to go out and try to buy more goods and services than the economy was actually capable of producing.  The predictable effect of that would be to put prices up, hence the bond market priced in higher interest rates.  It is really important to understand that this could have happened at any level of debt or of the debt/GDP ratio, including zero.

Deficits matter a bit because they add to the debt stock, but they matter a lot because they stimulate the economy.  If the economy is close to full capacity (as it was in 2022 and is now), then you can’t or shouldn’t stimulate it.  There was an interesting debate over fiscal versus monetary stimulus in 2010, during a recession – when a lot of people formed and seemingly ossified their views about deficits – but there isn’t now.  Stimulus is just the wrong thing to do.

Which means that the problem with the Chancellor cutting necessary investment projects isn’t to do with fiscal targets, the OBR, “prudence” or anything of the sort.  The problem is that in order to continue with those projects, she would need to raise taxes. Not necessarily in a “how are you going to pay for it?” sort of way, but in the sense of “the overall contribution of the government sector to demand has to be neutralised to avoid making the budget inflationary” sense.

And as it happens, our Chancellor has boxed herself in by pledging not to raise any of the big important taxes that could achieve this goal during the election campaign. (Even, in my view unaccountably, endorsing the utterly irresponsible National Insurance cuts which the chancellor who made them would have had to reverse if they had won).

All this, of course, goes back to the original dry semantic dispute over the meaning of the word “austerity”.  Having once referred to the UK government’s post-war demand restriction program which was aimed at preserving foreign exchange reserves. (Recall – the actual National Health Service was founded during the austerity governments!), this was resurrected in 2010 to refer to procyclical spending cuts during a recession, in the service of a more or less arbitrary debt and deficit target which was christened “budget responsibility”.  At the time, smart people like Mark Blyth noticed that it had actually changed its meaning, and by now referred simply to a policy of reducing public investment for the sake of it.  And that’s where we are now

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[1] I will pay the applicable tax for using this phrase – it has, in fact, been a material contributor to the worsening and coarsening of public economic debate in the UK over the last two decades, but that’s mainly because of its use to describe the forecast revisions made by the OBR.  And as I say, the current problem isn’t really anything to do with them.