Stephen King: Look beyond the UK for a true guide to economic austerity
If you want to know what fiscal austerity now looks like, look at Iceland or Greece
Monday 22 February 2010
'Biff!" Last week, a letter demanding a credible reduction in the UK's budget deficit was published in the Sunday Times, written by Professor Tim Besley and other eminent economists . "Bish Bash!" In response, two letters turned up in the Financial Times written by, respectively, Lord Skidelsky and Lord Layard, each signed by an even longer list of eminent economists, suggesting that Besley and Co didn't know what they were talking about. "Wham!" Lord Mandelson then jumped into the debate, in effect suggesting that the monetarist cabal responsible for the first letter was not to be trusted under any circumstances (even though many of the policies used in the UK and elsewhere to deal with the crisis could be found in any monetarist's toolkit).
My initial conclusions from all of this are, firstly, that the collective term for eminent economists is "surplus"; secondly, that the term "eminent economist" might be something of an oxymoron; and, thirdly, that there are too many lords a-leaping.
Messrs Besley and Co are making a perfectly reasonable, and not particularly controversial, point. They are asking for "a credible medium-term fiscal-consolidation plan." There is nothing wrong with that. They also note that the plans set out in the 2009 pre-Budget report may not be sufficiently credible. Debatable, perhaps, but Besley and Co have a case.
One way to assess fiscal sustainability is to look at movements in the ratio of government debt to gross domestic product (GDP). The Government's own numbers suggest the ratio will continue to rise through to 2014-15. There is a vague intention to reduce the debt-to-GDP ratio in later years, but there are no concrete plans: in other words, the fiscal position, as it stands, is not very credible.
Lord Skidelsky and his fellow signatories ask how "foreign creditors will react if implementing fierce spending cuts tips the economy back into recession". I wonder if his team of eminent economists has actually read the Besley letter. Besley and Co suggest "the Government's goal should be to eliminate the structural current budget deficit over the course of a parliament".
On the Government's current plans, this particular measure of the deficit declines from 5.5 per cent of GDP in the current fiscal year to 1.9 per cent of GDP by 2014/15, which is when the next parliament will be drawing to a close.
To reduce the deficit to zero, as Besley suggests, is not taking too many additional risks, especially given that the extra effort would be spread over five years. Admittedly, it is not obvious why the cuts should start to come through immediately, but Besley and his colleagues accept that "the exact timing of measures should be sensitive to developments in the economy."
Meanwhile, Lord Skidelsky's letter repeatedly refuses to address Besley's central point, namely that part of the deterioration in the budgetary position reflects structural fiscal weaknesses which will not disappear simply because of a cyclical pick-up in economic activity.
As for Lord Layard's effort, I am a little lost on the logic of the argument. He notes that "while unemployment is still high, it would be dangerous to reduce the Government's contribution to aggregate demand beyond the cuts already planned for 2010-11 (which amount to 1 per cent of GDP)." That's all very well, but if the economy is really so vulnerable, why accept any reduction in the budget deficit at all? Surely, if the economy is still fragile, Lord Layard should be arguing that any amount of fiscal tightening is inappropriate and, thus, that Labour's current plans are faulty, never mind the plans of any future government. His letter ultimately smacks of fiscal fine-tuning, a degree of precision which is only to be found in discredited economic models. For Lord Skidelsky, fierce spending cuts are the big risk and for Lord Layard, it's sharp shocks. They may be right, but I could not find anything of the sort in the original Besley letter.
What started as a perfectly sensible suggestion has descended into a rather silly argument which says more about politics than economics. Besley and Co will be portrayed by Labour as a bunch of nutty monetarists. The Tories will doubtless portray the leaping lords as a bunch of lily-livered Keynesians. All the while, the reputation of the economics profession will be dragged through the mud.
If you really want to know what fiscal austerity looks like, you need to look elsewhere. Countries suffering extreme fiscal contractions over the last couple of years include Iceland, Hungary, Ireland and Greece. In each case, they had austerity forced upon them. Politicians mostly don't choose to go down the austerity route unless they absolutely have to. Austerity, too often, is a product of crisis. Besley's point is not that we need to tighten fiscal policy because the deficit is just a bit too big or the debt level a bit too high. Rather, his desire is to avoid the next crisis, a crisis which might manifest itself in higher bond yields and a much more volatile – and perhaps much weaker – currency related to excessive government borrowing.
But I think there is also a bigger issue. Lord Layard alludes to it in his letter but, in the process, gets hold of the wrong end of the stick. He talks about "premature withdrawal of the government stimulus, from the US in 1937 to Japan in 1997." Fiscal tightening today, however, could be accompanied by persistently low interest rates, thereby reducing the risk of a late 1930s reversal (the Federal Reserve tightened monetary conditions in the late 1930s). And, in Japan's case, a key reason for the slump was, of course, the Asian crisis, which was hardly the responsibility of Japanese policymakers. The policy cock-up theory is nothing like as convincing as some commentators would like to claim.
Japan's experience over the last 20 years is, for me, the big worry. Japan has witnessed a huge increase in its budget deficit and its ratio of government debt to GDP has grown at a remarkably rapid pace. The good news so far has been that bond yields have remained very low and, for the most part, the yen has been strong. Thus the concerns expressed by Besley and Co have not materialised in Japan. Yet Lord Layard's letter fails to address Japan's ongoing stagnation. He notes that in the UK, "since the crisis began, private households and businesses have had to increase their savings in order to reduce their debts...It is this saving that finances the government deficit. If the government did not take up the slack, there would be a deeper recession." That might be true but, in Japan's case, businesses have now been paying off debts for 20 years. Should government borrowing increase for two decades to offset this kind of behaviour?
Japanese policymakers have their own take on this story. Persistent increases in government borrowing have simply underlined the inherent weaknesses in Japan's economy, dampening the entrepreneurial spirit and persuading company managers to pay off debt rather than to invest in the future. Lord Skidelsky's letter argues that "the first priority must be to restore robust economic growth". Japan hasn't managed that after two decades of rising budget deficits. Keynesian demand management policies may well prevent recessions from turning into depressions but, after a debt-fuelled boom, I remain unconvinced that they can deliver the "robust economic growth" that Lord Skidelsky craves.
Stephen King is HSBC Group's chief economist
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