Austerity in Hindsight

The consensus on UK fiscal policy post financial crisis and how it's changed

Oct 24, 2024

It’s a week until the new government’s first budget and Rachel Reeves, the UK Chancellor, looks set to confirm a major revision to the country’s fiscal rules (there have been seven sets since 2011…) to allow more borrowing for public investment. This is generally considered a positive thing by the great and good of the economics profession. It’s just a shame it's taken 16 years since the financial crisis to work it out.

Which brings me to a book I’m coming to the end of – The Tyranny of Nostalgia: Half a Century of British Economic Decline by Russell Jones. It’s a comprehensive account of UK economic policy over the last 50 years that reads less depressing than the title suggests.

The part I’ve been thinking about recently, given all the budget commentary, is the decision post financial crisis to pursue fiscal consolidation, or as it’s commonly known in the UK - “austerity” – and how broad consensus on what is the correct course of action at the time can in hindsight look quite wrong.

Fiscal expansion: The initial response to the GFC

If you cast your mind back to early 2009, the global economy was in meltdown. Lehman Brothers had collapsed in September the previous year, global output was falling, unemployment rising, and central banks were slashing interest rates and embarking on a vast programme of asset purchases known as quantitative easing.

The UK economy contracted for five straight quarters between Q1 2008 and Q2 2009, during which total GDP shrank by more than 6%. It took five years for the economy to get back to the size it was before the recession.1

This was the deepest recession since before World War II, and consistent with what Keynes had argued for then, the initial response was fiscal expansion, or in other words higher public spending to compensate for the collapse in private sector demand. As Keynes witnessed in the 1930s, economies do not always self-correct when hit by shocks. Instead, they can become stuck in ‘bad equilibriums’ in which high unemployment and low output persist.

With such a bad equilibrium looming, in November 2008 the UK government cut VAT and income tax allowances, and accelerated public infrastructure spending, an expansionary fiscal package totaling £20 billion (1.2% of GDP). But there were ongoing concerns around the budget deficit and borrowing, and from 2009 onwards the UK eschewed further fiscal expansion (although ‘automatic stabilisers’, the built-in mechanism in which as incomes fall, people pay lower taxes and governments spend more on welfare etc., continued to offset the worst impacts of the recession).2

Fiscal consolidation: The shift in policy and the story we were told

The popular story of the GFC in the UK is that the Labour government of Tony Blair and then Gordon Brown let the bankers run riot while spending all the money. This story was helped by a departing Labour Treasury minister leaving a note for his successor saying, ‘I’m afraid there is no money’ – something David Cameron and George Osborne made hay with during the 2010 election.

This narrative paved the way for the austerity programme they led between 2010 and 2015, which aimed to cut government spending by more than 6% over the period. Such cuts, equivalent to well over £100bn in nominal terms, didn’t fully materialise, but there was still a large reduction in spending against a backdrop of a very weak economy. And although spending on automatic stabilisers continued, the cuts resulted in overall fiscal contraction in all but one year.3

It’s unclear to me whether the impetus for austerity was simple politics, poor economic thinking, or some combination of the two. But it’s fair to say that Osborne and Cameron didn’t conjure it up out of thin air; they were in tune with the thinking of the time.

Reinhardt, Rogoff and all that

In his book, Russell Jones attributes the global shift in thinking from one promoting fiscal expansion in 2008 to fiscal conservatism from mid-2010 to a few factors.

First, the sovereign debt crisis in the eurozone concentrated minds on debt levels in Europe, while in the US, the Republican right became more strident in its long-standing dislike of government intervention and spending.

Second, these views were backed up by economic thinking that proved erroneous. Included amongst this was an IMF view at the end of 2008 that put the average multiplier effects of fiscal stimulus post-GFC at 0.3-0.8 (meaning that every £1 of government spending resulted in only £0.3-£0.8 of additional output – not a great return). By 2013 the IMF had changed its view, saying that multipliers could be above 1, admitting it had significantly underestimated the decline in demand from government spending cuts4, but as Jones says:

“By this stage it was too late. The damage to the recovery in the UK and elsewhere from premature fiscal adjustment had already been done.”

There was also a theory of ‘expansionary fiscal contraction’ proposed by the economist Alberto Alesina, in which he argued fiscal contraction could be positive for demand, by lowering long term interest rates and the exchange rate, thereby rebuilding confidence and spending. This was the opposite of what Keynes had argued – and it was strongly criticised as the years wore on and the experience of low interest rates proved otherwise.

The one that sticks most in my mind, however, was the work by Reinhart and Rogoff on the history of financial crises, in which they suggested that once public debt exceeded around 90% of GDP, growth tended to slow5 I joined the asset manager PIMCO in 2012 and remember discussions over the level of government debt looming large, the influence of Reinhardt and Rogoff made clear by the grey cover of “This Time if Different” being peppered across people’s desks (I confess, I never actually read it). As it turned out, there was an error in their spreadsheet and the 90% number didn’t apply at all.

Despite these errors in fact and thinking, the views were influential across policymaking and investment circles. In 2010, Bill Gross, at that stage head of PIMCO, one of the world’s largest bond investors, singled out the UK as a “must to avoid” warning that gilts were “resting on a bed of nitroglycerine” due to high debts and the potential for currency devaluation.

Why it wasn’t right

All this is to say that as I recall it, there was much consensus around austerity being the correct course of action in the early 2010s – or at the least, there was a view that it wouldn’t cause that much harm. There were others arguing differently, but their arguments just didn’t cut through.

The results of austerity have however been dire. The UK economy consistently undershot forecasts, growing only 1.5% in 2011, 1.5% in 2012 and just under 2% in 2013, with the OBR admitting it had significantly underestimated the extent to which austerity would reduce real GDP.6

To go back to Jones:

“It turned out that fiscal consolidation was not expansionary, or even relatively neutral, after all. Rather, it weighed heavily on growth, as standard Keynesian theory suggested it would.”

Furthermore:

“Not only did fiscal restraint constrain the recovery, it also had an enduring negative effect on underlying growth potential and, via the associated cuts to welfare provision and public services in general, it imposed unnecessary costs on society as a whole.”

The basic error was that there wasn’t enough acknowledgement of how cuts to public spending would feed into lower growth, and how lower growth would feed into rising budget deficits. Keynes said in 1937, “The boom, not the slump, is the right time for austerity.”

It was a bad equilibrium and markets knew this. Once the initial debt concerns of the Reinhart and Rogoff era abated, and the eurozone didn’t collapse, investors started freely lending to developed economies at next to nothing for years. In the UK the 10-year gilt rate (the cost for the government to borrow over ten years) fell from just over 4% in early 2010 to just over 0.5% in September 2019. Absent a minor blip in 2013 as the Federal Reserve indicated it might taper quantitative easing, the trajectory of interest rates was firmly down.

Such yields weren’t evidence of alarm over debt levels. Quite the opposite. Markets were crying out for fiscal expansion to promote growth – take our money, build some infrastructure! – but policy thinking couldn’t catch up and it wasn’t forthcoming. The UK remained stuck in an austerity mentality and it took Covid to change that.

Where we are today

I started this post by talking about the budget next week, the now consensus view on the importance of growth, and how consensus thinking can shift. I am hopeful that this time though, the consensus of raising public investment to boost growth is based not on erroneous thinking. I do however worry that the story of austerity – and in turn the story of why we need to invest now – is one that still hasn’t been well told. Maybe Rachel Reeves will do that next week.