We’re all economists now, part two

How we got here from there; Ben Mitchell finishes his economic primer at the present day.


This government’s main line of attack against Labour is that the latter left the country’s finances in a mess.

They have made political capital out of arguing that Labour borrowed and spent too much, and didn’t save during the boom years. Now in office, the coalition has committed itself to tackling and then eliminating the deficit as its main priority.

The main charge, that Labour built up an unnecessarily huge deficit, is only true if you look at the raw figures but ignore the context.

Labour themselves inherited a small deficit in 1997, and then achieved a budget surplus for the next five years.

But, in November 2002, Gordon Brown, as chancellor, admitted that Britain would have to borrow to pay for a huge public spending programme, as laid out in the 2000 spending review, investing in services that had been chronically underfunded by the Tories, such as the NHS and education.

He was also responding to an economic downturn, caused by world events, such as the global threat from terrorism.

The real spike in the deficit comes in 2008. Borrowing leapt (pdf) from 2.38 per cent of GDP in 2007/08, to 6.75 per cent in 2008/09, and then peaking at 11.1 per cent in 2009/10 (p.7). Essentially, rising from £33 billion to £156 billion in the space of just three years.

Whilst the reckless spending charge is easy to level, it deliberately ignores several crucial factors: 2007/08 saw the beginning of a worldwide economic downturn and then recession, the worst since the 1930s, affecting almost all of the world’s major economies.

It resulted in the collapse and then enormous bailout of many of the UK’s high street banks, crippling the public finances.

The 2009 budget had forecast a growth in revenue. Instead, the government suffered a spectacular loss, with 2009/10 bringing in about £112 billion less than they had expected.

The downturn meant higher unemployment, lower tax receipts, and more people in need of state help. A 100,000 increase in unemployment costs the Treasury about £500 million, with the reverse happening when the economy is performing strongly. This therefore required a surge in public borrowing in order to compensate.

Thus, the bulk of the deficit taken on by the coalition came as a result of events beyond Labour’s control.

Once in office, the coalition has decided to run roughshod over the economic reality.

For the last 21 months or so they have pursued a series of tough austerity measures: aggressive cuts combined with huge reductions in public spending, believing that this is the only way to eat into the deficit.

This despite the waft of evidence that a weak and fragile economy requires an increase in government spending as the best way to stimulate the economy, especially as, naturally enough, in hard times, people choose to spend less. If nobody’s spending, the economy comes to a standstill, or worse.

The last few years has seen a resurgence in support for Keynesian economics: the view, by the English economist, John Maynard Keynes, that fiscal stimulus (more government spending) is essential in a recession. During the Great Depression in the 1930s, he called for governments to invest in infrastructure.

Advocates of this position have consistently warned that cutting the deficit when the economy is weak is dangerously detrimental, and will only serve to harm it further.

As Robert Skidelsky, the acclaimed biographer of Keynes, explained:

The reason for the slack [in the economy] is that the private sector is not spending enough to employ all those seeking work – whether because investment prospects are too uncertain, or because it is paying off debt. In these circumstances government spending is not at the expense of private spending: it compensates for its absence.

If the government were to economise on its own spending at the same time as the private sector was spending less, the result would be a slide into even greater recession. Keynes called this the “paradox of thrift.”

Paul Krugman, the celebrated Nobel Prize winning economist, has been cautioning against rapid spending cuts, both in the US and the UK, for years. He has argued that the coalition are ignoring lessons from history with their severe deficit-reduction strategy, and that such a move will fail to stimulate enough real growth:

Fiscal austerity will depress the economy further…The sensible thing is to devise a plan for putting the nation’s fiscal house in order, while waiting until a solid economic recovery is under way before wielding the axe.”

Why is the British government doing this? The real reason has a lot to do with ideology: the Tories are using the deficit as an excuse to downsize the welfare state. But the official rationale is that there is no alternative.

A stagnating US economy with stubbornly high unemployment has led even staunch Republicans to concede that Krugman may actually have a point.

He is also backed by Carmen Reinhart and Ken Rogoff, authors of the universally-praised book, This Time is Different, in which they documented financial crises in over sixty-six countries, over a period spanning 800 years.

Both agree with Krugman that fiscal adjustment is necessary, just not at the moment, or to the extent that it is being implemented.

Rogoff argued that:

“The important thing to do is structural reform. Make us [the US] grow faster. Improve our tax system, build infrastructure, education, view it as a crisis in that way [but]…I certainly don’t think slashing budgets…is the way to go about business.

Instead, 21 months on, whilst sticking steadfastly to Plan A, this is the current economic reality facing Britain:

A stalling economy; unemployment the highest in 17 years, with an average of 23 applicants for each job; record numbers of people ‘underemployed’ (those working part-time through lack of choice); and the longest ever period of wage stagnation, with analysts warning that the Chancellor’s 2011 autumn statement will see, between 2009/10 and 2012/13, real median incomes fall by 7.4 per cent, levels not seen since the mid-1970s.

Noting a lack of any meaningful recovery has led to an increasing number of analysts to publicly question the government’s chosen path.

One of Britain’s leading economic think tanks told George Osborne to rethink the scale of the cuts, urging something more targeted:

“…fiscal policy is too tight, and a modest loosening would improve prospects for output and employment with little or no negative effect on fiscal credibility.

Another called for spending cuts to be aligned to economic growth, and fiscal consolidation to be less severe in a year where growth is forecast to drop below 1.5 per cent. Cuts should be slowed until the economy was stronger and able to absorb them.

And in recent months, murmurings from various international bodies have got louder, with warnings that austerity drives are in fact harming, rather than healing, sick economies.

This month, the leaders of the IMF, World Bank, and WTO, expressed concern at over-aggressive deficit reduction programmes, and issued a joint plea for governments to:

“…manage fiscal consolidation to promote rather than reduce prospects for growth and employment. It should be applied in a socially responsible manner.”

Finally, the public are starting to turn on the government, with a recent poll finding 59 per cent of voters backing a slowdown in spending cuts.

The trouble for Labour is that more people blame them for the state of the economy than the coalition’s cuts.

In spite of several months of gloomy economic news, and despite the gathering calls for a Plan B, the government seems more determined than ever to press on, with the downturn used as cover for an irreparable and ideological shrinking of the state.
See also:

We’re all economists now, part one – Ben Mitchell, February 3rd 2012

Politics vs Economics: setting the scene for the Fabian’s Next Economy conference – Marcus Roberts, January 13th 2012

Cable falls in line with Beecroft’s anti-worker voodoo economics – Alex Hern, November 23rd 2011

Vindicated Balls gives absent Osborne an economics lesson – Shamik Das, September 15th 2011

An economics lesson for the growth deniers – Ken Livingstone, March 26th 2011

10 Responses to “We’re all economists now, part two”

  1. BevR

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  2. Pulp Ark

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  3. Joe Constitution

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  4. Shamik Das

    @bmitchellwrites Hey Ben, site was down 4 much of yest, all cool now; here's the piece: http://t.co/LfFdx1vE ps. #PakvEng: whatdya reckon?!

  5. Selohesra

    Would labour have run that surplus for 5 years if the PFI liabililities they were taking on off balance sheet were included? – smoke and mirrors perhaps with labour as adept at dodgy accounting as some of the bankers

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