The economics and politics of austerity

Theresa May has called a snap general election. Austerity has been the central policy of Conservative-led governments since 2010. This post looks at the economic and political dimensions of austerity, and Theresa May’s position on the policy.

hsc4903_hi

The economics

RBS was the biggest bank in the world at the time, if that had shut it would have brought down the entire banking system with it … we had to throw absolutely everything at it.

– Alastair Darling, former Chancellor of the Exchequer (2007 – 2010), 20 July 2016

The financial market failure of 2007/8 resulted in a recession and a taxpayer-funded bank bailout of £133billion: a corporate welfare safety-net that increased the national debt. To promote economic growth and increase tax revenues (and so reduce the debt), the Prime Minister Gordon Brown invested £31billion in a stimulus programme, building schools and social housing.

This was, and still is, the recommended approach in such circumstances. After the financial crash almost every government in advanced economies, including Germany, introduced a fiscal stimulus, or fiscal expansion policy, increasing spending. The thinking behind this approach is as follows.

179px-Ha-Joon_Chang_profile
Economist, Ha-Joon Chang

After a big financial crisis like the 1929 Wall Street crash or the 2008 global financial crisis, private-sector spending falls. Debts go unpaid, which forces banks to reduce their lending. Being unable to borrow, firms and individuals cut their spending. This, in turn, reduces demands for other firms and individuals that used to sell to them (eg firms selling to consumers, firms selling machinery to other firms, workers selling labour services to firms). The demand level in the economy spirals down.

In this environment, the government is the only economic actor that can maintain the level of demand in the economy by spending more than it earns, that is, by running a budget deficit.

– Ha-Joon Chang, Economics: The User’s Guide, 2014

During recessions, this additional government spending generates “a multiplier effect, boosting incomes as well as tax revenue, increasing private sector activity, and reducing debt servicing costs and benefit payments.” As the economist JM Keynes put it, “expenditure creates its own income.”

It is during periods of economic prosperity that the debt should be cut back, or as Keynes put it: “The boom, not the slump, is the right time for austerity at the Treasury.”

***

In Britain in 2010 this approach was challenged. The opening sentence of the 2010 Conservative party manifesto read: “Britain needs change: few can doubt that. Our national finances are mired in massive debt.” The change required was clearly defined: “Our belief in responsibility with public finances is the starting point of our plan for economic recovery and growth. We want your consent for a programme of public spending control that will deal with Labour’s debt crisis.”

Given that consent in the 2010 election, the Conservative-led coalition began their “long term economic plan”, known as austerity: rather than investing to grow and increase tax income, cuts to government spending were made to reduce the deficit and eventually the debt. “Responsibility with public finances” meant living within our means: spending no more than was received in taxes and therefore not adding to the debt. By spending less than we received in taxes – running a budget surplus – we could start paying off the debt.

Although this sounds like common sense family finances, what seems “rational for an individual can be damaging when applied on the scale of a national economy.” Economic theory and evidence suggest that austerity, or fiscal contraction, is not the right approach during a recession, for the following reasons.

Cutting spending reduces demand, particularly by the poor, who tend to spend a larger proportion of their income. This adversely affects GDP and employment. This in turn reduces tax revenues … Cutting the deficit will increase the national debt in years to come. This is borne out in the data over the past 130 years or so for the UK and many other countries.

– W David McCausland, Professor of Economics, University of Aberdeen, 23 June 2014

In the first two years of austerity cuts there was indeed some damage to the economy. The Office for Budget Responsibility estimated that austerity took one percent off economic growth in both 2010/11 and 2011/12, delaying the recovery from recession. As a result, the government slowed the pace of deficit cuts in 2012/13, enabling growth rates to rise again (see figures 1 and 2).

Figure - UK Deficit 1995 -2016
Source: Office for National Statistics

 

Figure - GDP growth 2007 - 2016
Source: Office for National Statistics

There was still no stimulus programme though and the cuts continued. In fact, towards the end of 2013 Cameron made it clear that the cuts could continue indefinitely.

 

David_Cameron_official
David Cameron

We have a plan – and we are carefully implementing that plan. Already we have cut the deficit by a third. And we are sticking to the task.

But that doesn’t just mean making difficult decisions on public spending. It also means something more profound. It means building a leaner, more efficient state.

We need to do more with less. Not just now, but permanently.”

– David Cameron, speech at the Lord Mayor’s Banquet, 11 Nov 2013

David Cameron didn’t mention the national debt anywhere in his speech. Since 2010, the deficit has indeed gone down, however, as economic theory and the historic data evidence predicts, the debt has gone up, both in real terms and as a percentage of economic output (GDP). What the Conservative manifesto in 2010 called “Labour’s debt crisis”, amounted to £1trillion, around 62% of GDP. That debt is now more than 50% higher standing at £1.6trillion, around 87% of GDP (see figure 3).

Figure - UK Debt as percent of GDP 1995 - 2016
Source: Office for National Statistics

The politics

Nobody talks about austerity privatisations, only austerity cuts. However, privatisations are also justified by the need “to pay down the national debt.” Since 2010 privatisations of public assets (like the Royal Mail) have risen to record levels, even when those public services are making a profit, drawing accusations of asset-stripping services that have taken years to build up.

Is paying off the debt the real goal though? Some economists see another factor at play.

389px-Paul_Krugman-press_conference_Dec_07th,_2008-8
Economist, Paul Krugman

There were political reasons why many influential players opposed fiscal stimulus even in the face of a deeply depressed economy. Conservatives like to use the alleged dangers of debt and deficits as clubs with which to beat the welfare state and justify cuts in benefits; suggestions that higher spending might actually be beneficial are definitely not welcome.

– Paul Krugman, 29 April 2015

So, is there a political dimension to austerity? Cameron’s notion of “building a leaner, more efficient state”, that he described as “profound”, hinted at a political motivation for the cuts. In fact, the Coalition agreement of 2010 was explicit about a smaller state, saying that the government’s programme could “deliver radical, reforming government, a stronger society, a smaller state, and power and responsibility in the hands of every citizen.”

One of Cameron’s first radical steps was to introduce legislation to “liberate” the biggest state-run public service, the NHS. By law, contracts must now be put out to tender for “any qualified provider” (ie private companies and charities) and NHS trusts can generate up to 50% of their income from private patients. In time, if private provision and private patient contributions rise, then state involvement and responsibility for health will indeed become smaller.

Raising taxes could have contributed to reducing the deficit and paying down the national debt. However, welfare cuts and public service cuts have gone hand-in-hand with tax reductions for higher earners and raising income tax thresholds. In fact, under Cameron for every £100 of deficit reduced, £85 has come through spending cuts and only £15 through increased taxes. In 2015, at the beginning of the current parliament, the government actually legislated “to ensure there are no rises in income tax rates, Value Added Tax, or national insurance for the next five years.”

Reducing the deficit by cutting welfare, underfunding public services, and selling-off/ privatising state-owned enterprises like Royal Mail and the NHS, also goes a long way to implementing a low tax, small state vision. The Conservative’s “long term economic plan” seems to have quite a lot of politics in it.

Theresa May’s approach

In the past, Theresa May has echoed Cameron’s small state views and also expressed the Conservative antipathy to welfare payments and higher government spending described by Krugman.

theresa_may_uk_home_office_cropped
Theresa May

You don’t help people by handing out welfare, but by helping them to help themselves. You don’t make a better society by building a bigger state, but by supporting families and communities. You don’t get economic growth by spending more and more money, but by getting behind the country’s wealth creators.

Theresa May, May 2013

However, four years on from this statement, Theresa May seems to have listened to the economists and academics and had second-thoughts about the economics of austerity. May’s Chancellor, Philip Hammond, has announced that the government will be borrowing £23billion (increasing the national debt) to spend on infrastructure projects (roads, railways, and houses) to grow the economy. She has decided to use a fiscal stimulus approach, albeit on a small scale.

In the main, May seems to agree with the politics of austerity though. Despite acknowledging that “it wasn’t the wealthy who made the biggest sacrifices after the financial crash, but ordinary, working class families”, she is still pressing ahead with the majority of Cameron’s programme of cuts to shrink the state. These include £12billion of welfare cuts (including in-work benefits and disability allowances), a new “two child policy” limiting support to larger families, and a further lowering of the welfare cap.

However, in a departure from Cameron, May has relented and added extra funding in two areas: prisons and social care. In both cases, there have been publicly visible crises as a result of funding cuts. Prisons have seen an increase in riots, attacks on staff, and prisoner drug abuse, self-harm, and suicides. In social care, the problem of hospital ‘bed-blocking’ – patients unable to leave hospital due to lack of social care funds – is widely acknowledged as a serious failing in the system: in addition to the human impact, overall costs end up being higher, not lower.

To fund the £2billion social care increase, May’s chancellor, Philip Hammond, sought to increase taxes, another departure from the previous government. However, this move contravened Cameron’s “tax lock” and Conservative MPs rebelled, forcing the chancellor to back down. For now, the £2billion will be added to the national debt.

Summary

The conventional economic medicine in a recession is government investment, or fiscal stimulus, to prop up demand. The Cameron government’s economics of austerity, or fiscal contraction, from 2010 was a radical departure, justified by the need for “financial responsibility” to reduce the deficit and the debt. However, the deficit cuts and privatisations also contributed to political objectives: a small state with minimal public services and low taxes. Although the deficit has fallen, the debt has risen from 62% of GDP in 2010 to 87% today.

Theresa May appears to broadly share Cameron’s vision, implementing cuts designed under his leadership. However, she has also made cautious, tentative moves away from his approach: a fiscal stimulus for infrastructure, increased spending on some crisis-hit services, and even a (failed) attempt to raise taxes.

If May wins the general election she has called on 8 June she will have much more room for manoeuvre. No longer tied to Cameron’s 2015 manifesto commitments of cuts and tax locks she will be able to chart her own course. Then we will see if she genuinely has a different economic and political approach to Cameron’s austerity. For now, it’s more-or-less business as usual on austerity under Theresa May.


Image Credits
Government bailout cartoon by Harley Schwadron, www.cartoonstock.com
Ha-Joon Chang by Discott, licensed under CC BY-SA 3.0
Figures 1 to 3 by David Clensey, the common good
David Cameron by Prime Minister’s Office, 10 Downing Street, licensed under OGL
Paul Krugman by Prolineserver, licensed under CC BY-SA 3.0
Theresa May, licensed under CC BY 2.0

3 thoughts on “The economics and politics of austerity”

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s