Andrew Lilico: Let's get a few things straight regarding "austerity"

The debate about "austerity" in the UK and Europe rages on.  But let's grasp a few things.

• Some significant folk (e.g. the IMF) appear to be calling for the UK to "slow down" the pace of its deficit reduction programme.  Well, the UK's planning to have a £120bn - £120bn! - deficit for three years in a row.  That's right: from 2011/12 to 2013/4 the British government has planned to have no deficit reduction whatever.  How much "slower" a pace of fiscal consolidation than "none whatever" do folk have in mind??

• Some folk are claiming that "austerity" has slowed UK growth.  They appear to believe that the fact there hasn't been any growth proves their point.  It does no such thing!  Why do they assume the economy wouldn't have shrunk (more) if the deficit had been allowed to be even higher?  If you enter chemotherapy you'll feel very ill.  Does that mean the chemotherapy is bad for you?  No-one said cutting the UK's deficit was going to be any fun.  But the reason the austerity was so necessary was because the growth outlook was so bad.  Observing that growth was indeed as bad as advocates of austerity said it would be and then blaming the austerity for that is like blaming the treatment for the cancer.

• The early phase of the government's deficit reduction programme - 2010 through to Autumn Statement 2011, when it was still cutting the deficit (the deficit hasn't fallen at all since then) - was mainly tax rises.  Advocates of early spending cuts (e.g. me) said, in terms, that raising taxes early could damage growth and retard deficit reduction - e.g. here page 3 paragraph 5 we said:

        tax-rises-based fiscal consolidations often fail — growth falls so much in the short-term, for 
        the reasons explained above, that tax revenues fall, spending on welfare increases, and deficits increase 
        instead of diminishing.

• It's simply preposterous, therefore, to allege that, even if there were evidence that tax rises had damaged growth (which there isn't) that would be evidence that our theories about the impacts of spending cuts would have been proven wrong.

• The Reinhart and Rogoff paper from 2010 that has been recently attacked for involving an Excel error was not a significant part of the intellectual foundations for the argument for spending cuts.  The Conservative Party's switch to advocating spending cuts may or may not have been triggered by my June 2009 paper "Controlling Public Spending - the Scale of the Challenge", but it was certainly June 10th 2009 that Cameron's famous PMQ switch to advocating spending cuts occurred.  The widely-discussed November 2009 Policy Exchange paper Controlling Spending and Government Deficits - Lessons from History and International Experience that the BBC described as providing the "essential theory" behind the Coalition's 2010 deficit reduction strategy (and which Reinhart has quoted as one of five key papers on fiscal consolidation) was again long before Reinhart and Rogoff's piece.  The Reinhart and Rogoff result that has unravelled was not one anyone took literally anyway - the notion that growth fell off a cliff, going suddenly negative, at a specific debt to GDP ratio wasn't something I've ever claimed or believed.  On the other hand, the Reinhart and Rogoff claim that higher governments debts are, at some point, associated with lower growth is a very old result that has been confirmed in multiple other empirical studies both before Reinhart and Rogoff (2010) and since - the most authoritative recent example of which is Cecchetti et al 2011 from the Bank for International Settlements.  And there have been many studies showing that deficit reduction programmes are as often associated with higher as with lower growth, including many produced before the Great Recession - e.g. see this from the European Commission in 2003.

• The rise in the deficit relative to GDP post 2007 was not because GDP fell or because the tax take fell during the recession. It was not an automatic consequence of recession; neither was it typical of what happens in recessions. The overwhelmingly main reason for the rise in the deficit was that spending rose - as I detailed in the table at the end here. And the considerable majority of that spending rise was not increased capital spending or benefits and such "automatic stabilisers" - as I etailed here.  If certain economists are fans of raising capital spending or benefits in recessions, then that accounts for a little over 40% of Gordon Brown's spending rise - that leaves a useful £75bn billion of spending cuts - reversing the non-capital non-benefits spending rises between 2007 and 2010 - we should therefore be able to agree on straight away, no?

• The reason spending (and hence the deficit) rose so much was that Gordon Brown had, in the 2007 Comprehensive Spending Review, before anyone knew there was about to be a recession, scheduled a rise in public spending from 41% of GDP to 45%.  Then when the recession struck he continued with this massive spending rise even though it placed an additional burden on an overstretched economy, inducing a huge spike in UK spending relative to GDP, virtually unrivalled in any developed economy, and seriously damaging the underlying growth rate of the UK economy. I regard that as wingnut crazy.  The notion that it can be considered macroeconomically foolish to reverse one of the most stupid macroeconomic blunders I've ever heard of - a blunder almost no economist would support, if asked to do so explicitly - is bizarre.

• Some advocates of running even higher deficits like to pretend that all mainstream economic opinion is with them, whilst folk like me are, at best, interesting eccentrics.  Exactly the opposite is true.  The folk like me are the mainstream economics profession, reflecting the mainstream orthodoxy in macroeconomics as it has been taught for the past 30 years.  The paleo-Keynesians like to quote economists such as Paul Krugman and Joseph Stiglitz neither of whose central expertise lies in fiscal policy - Krugman is a trade economist who's dabbled in monetary theory, whilst Stiglitz is an expert on asymmetric information models in finance theory.  But if we really must get into an infantile "my economist has a bigger publication list than yours" argument, I would recommend reminding oneself of the great minds that produced modern orthodox macroeconomic and finance theory - Robert Lucas Jnr, Eugene Fama, Robert Barro.  And if we want "New Keynesian synthesis" thinkers then be aware that in New Keynesian models fiscal policy just doesn't work the same way the paleo-Keynesians that are so vocal in current debates imagine it does, as John H Cochrane never tires of reminding us.  The "New Classical" and Rational Expectations revolutions in macroeconomics in the 1960s and 1970s destroyed the intellectual foundations of the sort of old fashioned Keynesianism that is presented by many as "mainstream opinion" today.  And indeed even an old-fashioned Keynesian would have quailed at most of the proposals of today's Keynesians.

• To put the point another way: if it were 2005 and you asked almost any mainstream economist: "Are there plausible conditions under which running a deficit of 15% of GDP will (a) provide more stimulus than a 12% of GDP deficit; (b) even if it did boost GDP, would be a Good Idea?" he or she would have said No.  It simply isn't true that the mainstream opinion has been that running vast deficits of the size we have seen in Europe was either harmless or helpful.

• Precisely the contrary was true.  In late 2008 I wrote many blogs arguing for a temporary tax cut - which subsequently became the UK Labour government's policy but which the Conservatives opposed.  I considered the one setting out the theory more than a little daring - there was some evidence from the Bush tax rebates that my recommended policy could work, but I regarded the orthodox position as being that it was doubtful whether active fiscal management, beyond the support to demand provided by "economic stabilisers" such as taxes falling as profits fell or spending rising as benefits to the unemployed rose, had any efficacy whatever.  Even Gordon Brown in theory accepted the concept that active fiscal management did not boost output up until 2008.

• Think: does it make any sense whatever to believe that mainstream macroeconomic opinion was that running 12% and more of GDP deficits could be a good way to boost growth, when the Maastricht Treaty constrained governments never to run deficits above 3% of GDP?

• Think: can the popular UK narrative that mainstream macroeconomic opinion is that deficit reduction damages growth and is a bad idea in a recession really be plausible when cutting deficits, despite recession, is the policy of virtually all European countries?  So the government economists and main economic advisors to virtually all the governments of Europe are strange eccentrics, far from mainstream opinion??   Wolfgang Schäuble, German finance minister, recently said: "No one in Europe sees this contradiction between financial policy consolidation and growth".  I'm with Wolfgang.

• Some folk might be inclined to say - "Ah, buts doesn't the US experience demonstrate that less deficit reduction boosts growth?"  Quite apart from the fact that the experience of one country would prove very little, since special factors could be at work, in truth the deficit reduction in the US has been almost identical to that in the UK.  On OECD figures, the structural deficit for the US fell 2.60% of GDP between 2009 and 2012, whilst the structural deficit for the UK fell 2.68% of GDP - surely no-one can seriously claim that that 0.08% of difference, over three years, equivalent to around £400m per year, is macroeconomically significant?  The difference between the UK and US fiscal approaches lies in rhetoric, not reality.  (And furthermore, as can be seen in the table, the UK and US plans over the next two years are also almost identical.)

• I continue to stand behind my arguments of late 2008, namely as follows.  (1) The key reason fiscal policy does not provide big boosts to output in a well-functioning economy is not old-fashioned "crowding out" of investment of the sort discussed in the early 1980s (i.e. interest rates are driven up by government borrowing, and higher interest rates mean lower investment) - though that might happen if one got that far.  Things never reach the point of "crowding out" in a well-functioning economy because "Ricardian" effects kick in first - i.e. households anticipate that higher deficits now mean higher taxes, to pay off debts, later, and so households save now, precisely offsetting the impact of any "injection" that would otherwise be provided by government borrowing.  In a well-functioning economy governments can only increase growth by either spending on things that enhance longer-term growth (e.g. competition authorities, police to protect property rights, infrastructure) or by cutting spending on things that damage growth though they may involve other positives (e.g. healthcare for the poor).  In an economy with a bust banking sector, some housholds may become liquidity constrained (they can't borrow when they ought to be able to) and under those conditions government borrowing can serve as a second-best form of financial intermediation (households borrow today, via the government, paying back tomorrow, in tax), increasing economic efficiency and hence output.  The correct form of fiscal stimulus is therefore a tax cut.  Increasing government spending on inefficient things damages growth, whilst cutting taxes assists with financial intermediation.  If governments really want growth, they should cut back on growth-damaging welfare spending (e.g. on health or education), which provides socially valuable things at the expense of growth and, to the extent that government balance sheets are not over-stretched, be willing to borrow to fund temporary tax rebates.

• The UK is not an economy like Greece.  It is an economy like Ireland or Spain, with a banking sector vastly larger than the government could afford to bail out.  Banking sector problems in Ireland and Spain ruined those governments.  In May 2010 Spanish yields were lower than those in the UK.  Ireland was AAA until 2009 and Spain AAA until 2010.  There was no guarantee that the UK would not have gone the way or Ireland and Spain already, and there is no guarantee that we shall not go the way of them yet.  It may well be true that QE and inflation have saved us so far.  It is simply false to say that the fact that the UK prints its own money makes it impossible for us to go the way of Ireland and Spain in the future.  Printing money in the early 1970s did not prevent the Secondary Banking Crisis of 1973-5 - if anything, it caused it.

• The UK needs higher medium-term growth, to prevent its banks from going bust.  Higher medium-term growth cannot be created by loose fiscal policy (nor indeed by loose monetary policy).  Advocates of ever-larger borrowing say they want growth, but all that fiscal policy can do (even to the extent it is effective at all - which isn't much) is to boost growth for a quarter or two at the expense of a little less growth later.  No serious economist has believed that running massive deficits could boost medium-term growth for forty years.  It's simply absurd for some economists to imply there is any orthodox opinion that running larger deficits would increase the medium-term growth rate, and that those of us that deny that are fringe eccentrics.  Precisely the opposite is true.  The orthodox opinion is there can be no positive impact on the medium-term growth rate from loose fiscal policy, but that overly-loose fiscal policy could damage the medium-term growth rate.  It's those that claim that the medium-term growth rate could, via convoluted mechanisms, increase the medium-term growth rate that are the interesting eccentrics.

• Truth isn't a numbers game.  One could be heterodox and right.  But it ill-behoves the interesting minority that is today's old-fashioned Keynesians that they have attempted to paint themselves as the orthodox opinion - either in academic or in policy-making terms.  They aren't.  They just aren't.