The fatal error of austerity
The only black hole we need to worry about is recession
Here we go again. The Office for Budget Responsibility (OBR) has discerned an enormous deterioration in public finances, allegedly reaching £70bn a year by the middle of the decade.
Upon this macroeconomic conjecture, it is bouncing the British Government into pro-cyclical fiscal tightening just as the country enters what is forecast to be the most protracted slump since the Great Depression, with an output gap (slack) reaching 3pc of GDP by 2024 under the Bank of England’s forecast. The Sunak-Hunt duumvirate appears willing to be bounced.
They deserve our national gratitude for eliminating the sovereign risk premium on the Truss mini-budget – a fleeting episode, ultimately of no importance – but they now risk committing the greater and longer lasting error of Austerity 2.0. That way lies certain failure.
Perhaps Chancellor Jeremy Hunt is talking up his “eye-watering” cuts as political theatre, only to surprise us on Thursday with milder shock therapy than feared. He clearly intends to push most of the pain into the mid-2020s - backloading in the jargon – which gives him a way out later.
Rishi Sunak backed a rise in public investment to 3pc of GDP when he was Chancellor, the highest since the 1950s and a level closer to the OECD norm, though still far short of the productivity stars (Korea, Nordics, et al) at 4pc or more. But the signs so far are that this target has been abandoned.
The Government plans to hack away at infrastructure spending because it is easy to cut, repeating the core economic mistake of Osbornian obscurantism.
Let us clear up one misunderstanding before it becomes lodged in the public discourse: the UK does not face a sovereign debt crisis, any more than it faced the “Greek” fate alleged by Mr Osborne in 2010. Credit default swaps measuring bankruptcy risk are currently lower for the UK than for the US or France.
The rankings this week are: Sweden (20), Germany (22), UK (26), Belgium (27), France (29), US (30), Japan (31), Canada (56), Spain (56), China (79), Italy (137), Brazil (273), Pakistan (502), Turkey (566), and so forth.
The International Monetary Fund (IMF) says the UK already had one of the most restrictive budgetary policies in the developed world before Jeremy Hunt entered 11 Downing Street, as measured by the cyclically-adjusted primary deficit.
The Fund’s Fiscal Monitor estimated that the UK’s public debt ratio will fall to 68pc of GDP by 2027, while it rises to 118pc for France, and 135pc for the US. The IMF may be wrong but this is not the portrait of a country facing a solvency crisis.
“The reality is that the UK’s public debt position is in the middle of the international pack and there are almost no discussions in other countries with similar debt levels of the need for a new round of austerity,” said Prof Karl Whelan from Trinity College Dublin.
Markets rejected Trussomics because the package was incoherent, not because the deficit was out of line with global peers. The original message of supply-side measures was contaminated by uncovered tax cuts. Global Big Money will finance borrowing that raises productivity. It will not so lightly finance further consumption in a country importing beyond its means with a structural current account deficit near 4pc of GDP.
Liz Truss walked into a minefield. She tried to push through her mini-Budget during the greatest global bond shock for a century, in turn exposing hidden leverage in the UK pensions industry. But that bond shock is already subsiding.
Yields on 10-year US Treasuries are declining as inflation rolls over, restrained by falling commodity and semiconductor prices, and a 70pc fall in oceanic shipping costs, soon to be followed by a wave of goods deflation from China.
This in turn is bringing down the cost of borrowing for the international financial system. Hedge funds are already betting on the Great Disinflation of 2023 and a global bond rally to match. Anybody still fretting about gilt yields has missed the story.
“The problem for the UK’s public finances has been grossly exaggerated,” said Prof Peter Spencer from York University and the Item Club. The one-off inflation spike of the pandemic – or more accurately from money created by the Bank of England during Covid – has whittled down the real burden of the debt. That adjustment in the price level automatically boosts tax revenues via bracket creep.
“There are all sorts of magical effects. Inflation has lowered the debt ratio through the denominator effect, and tax revenues are highly-geared to the rise in money GDP. People have got the wrong end of the stick,” he said.
Prof Spencer said the UK's enveloping recession cries out for rapid activation of ‘shovel-ready’ infrastructure, and the National Infrastructure Commission can oblige with a long list of urgent projects.
The timing is propitious. S&P Global’s new order index for construction is already signalling a building slump, implying rising slack in the industry. The overwhelming global evidence is that infrastructure projects in today’s circumstances have a fiscal multiplier well above 1.0, meaning that they pay for themselves handsomely through extra economic growth.
A recent meta-study by the World Bank concluded that the average multiplier on public investment is around 1.5 over time, and more potent during downturns.
“The worst possible thing we could do right now is to cut investment, but I am afraid that is what is going to happen,” said Prof Spencer.
In my view, the OBR bears much of the blame for deterring investment. It has not updated its model to keep up with the IMF, the World Bank, and global best practice, and still relies on a multiplier of 1.0 or less for infrastructure projects. It has persisted despite informed criticism, and swatted aside calls from the Trades Union Congress for a review.
It is beyond depressing that the dismal Treasury View is once again in the ascendant, and worse yet George Osborne’s austerity overkill is being dusted off as a successful template. Is there no recognition in Treasury circles that this episode is viewed by the global economic fraternity as an awful misadventure, a policy error on a par with the self-defeating fiscal retrenchment of the 1920s, but without the excuse of pre-Keynesian ignorance or the Gold Standard.
It both lowered the growth trajectory of the economy and slowed the organic fall in the debt ratio, and was therefore futile in every respect. The US made the same mistake (up to a point), and the eurozone inflicted a full-blown depression on its southern half. It was this collective error that explains the lost decade that followed in the liberal democracies, and led to corrosive over-reliance on quantitative easing. But the US and Europe are not repeating that mistake today. Only the UK is ramming through such rapid consolidation.
“It is as if we’ve learned nothing: they’re back to the same austerity, using the same models, and the same multipliers, talking about the same imaginary black holes and imaginary bond vigilantes, and the fanciful need to keep the markets happy,” said Dario Perkins, a former Treasury official now at TS Lombard.
“It is all absolute nonsense. We have tried a decade of austerity and if they seriously do it again, they will be unelectable for a generation,” he said.
Chancellor Jeremy Hunt has even gone so far as to recruit the architect of that fiscal squeeze, Rupert Harrison, to help formulate Austerity 2.0.
There is a revealing conversation with Mr Harrison in Aeron Davis’s new book on the Treasury - Bankruptcy, Bubbles, and Bailouts - that captures what happened. “When I asked him directly about the broader inspirations of his economic thinking, Harrison responded that he had no interest in macroeconomic thought. His policy views were ‘shaped by more general reading’ and by being ‘a centre-right leaning person’.”
Indeed, the fiscal squeeze from 2010 to 2015 never had anything to do with economic science. It was an ideological use of the global financial crisis to shrink the state, creating the OBR along the way as a screen of policy legitimacy, and all dressed up with the discredited theory of “expansionary fiscal contractions”.
We will find out soon how OBR came up with a £70bn fiscal shortfall, but a large part of it must come from assumptions of a permanently higher “terminal” interest rate for the Bank of England for this cycle, currently priced by the futures markets at 4.5pc. Each one percentage point rise in rates costs the Treasury £21bn or 0.8pc of GDP under this mechanical accounting.
If so, this is a very bad reason to push through fiscal cuts in a recession. The markets have massively mispriced the Bank of England’s rate trajectory, as deputy-governor Ben Broadbent made crystal clear in a recent speech.
Rate-setter Silvana Tenreyro has since gone further, arguing that the Bank has “already done enough” after raising rates to 3pc in the fastest tightening cycle since monetary independence. “Calibrating the required level of interest rates needs to take account of the rapid pace of tightening to date and the lag before its full impact on the economy,” she said. At least somebody is talking sense.
The OBR and the Treasury seem to think that we are in a new era of capital scarcity akin to the Great Inflation of the 1970s where debt costs bite in earnest. If so, that is a massive historical misjudgment.
The broad money supply in the G7 global economies was growing at a galloping pace all through the 1970s. This time the pandemic money surge is evaporating. The aggregate M3 figures have slowed to crawl. They have been falling in absolute terms in the US since September.
This pandemic episode is more like the inflation spike at the end of the First World War when supply-chains were in chaos and peace led to soaring pent-up demand. By mid-1920 the storm had largely blown itself out. By 1921 the UK and the US were in deflation.
The only black hole we need to worry about is recession eating into the productive economy and eroding the tax base. The OBR’s interest rate scare on the national debt is leading to dysfunctional economic government. This is not how policy should be formulated in a mature democracy.
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