How well is fiscal austerity working in the UK?

With the Wednesday release of a mediocre gdp report, we are hearing that the United Kingdom austerity program is proving a macroeconomic failure.

Let’s look at the timing of the cuts:

So far, about GBP9 billion of the government’s fiscal tightening has occurred. However, around GBP41 billion of tax increases and spending cuts will begin to take affect from the start of the new fiscal year on April 5.

Some of the particular cuts were announced in October and at that time Ken Rogoff doubted whether half of them would end up taking place.  So the cuts are in their infancy and arguably their credibility is still somewhat in doubt or at the very least has been.

A lot of the weak gdp report is blamed on construction, with some excuses drawn from snowstorms.  There does exist an extreme rational expectations view, in which the last-quarter weakness of construction was based on the expectation that government spending cuts would start arriving later in April and thus new houses should not be built.  Alternatively, it could be that after the greatest real estate bubble in history, the UK market is overbuilt.  Weak UK growth dates to some time back.

Also recall that in many open economy Keynesian models, fiscal policy AD effects are to some extent — or completely — offset by exchange rate movements (pdf).  And the fiscal multiplier is basically zero when the central bank targets inflation.  Furthermore it is not obvious that the UK has been in a liquidity trap.   When it comes to drawing Keynesian conclusions about practical fiscal policy, the theory here is a house of cards.

The UK economy suffers from a more serious technological stagnation than does the United States, in this case more forward looking than backward looking.  Their pharmaceutical innovation seems to be drying up, they are overspecialized in finance, the “residential tax haven” status of the country may not yield continuing growth at high rates, tourism is OK but not enough, and their manufacturing base eroded some time ago, with nothing like a German-style comeback.  The teacup sector aside, why should anyone be optimistic about that economy?

Two other considerations:

1. The case for the cuts is not that they will spur growth, but rather forestall a future disaster.  That’s hard to test.  A second part of the case is that not many political windows for the cuts will be available; that’s hard to test too.  On that basis, it’s fine to call the case for the cuts underestablished, but that’s distinct from claiming that poor gdp performance shows the cuts to be a mistake.

2. Let’s say the cuts lower government consumption and raise private consumption, and that government consumption is wasteful but private consumption isn’t (and long-run growth is given by the Solow-like expansion of the international technological frontier.)  That’s a good case for making the cuts, but they still won’t show up as higher gdp.  The government consumption is valued into gdp figures at cost, so even cuts proponents with a good case don’t have to be predicting higher gdp.

I doubt if the UK fiscal austerity program will much boost their growth rate, which is likely low in any case and for non-Keynesian reasons.  Simply citing a low UK growth rate is not a test of their fiscal policy, for a number of reasons detailed above.

Comments

"Alternatively, it could be that after the greatest real estate bubble in history, the UK market is overbuilt."

Unlikely. The real estate bubble hasn't really burst yet - London property prices are up on pre-crash levels, and even the rest of the UK hasn't seen more than a few percentage point falls in house prices. Some localities may have seen severe falls, but only due to very localised overbuilding and/or the closure of significant local employers. In general, the UK is still densely populated and "needs" more housing. The reason that demand is low is largely because nobody can get a mortgage and property speculators/developers are nervous about getting back into a market in which prices haven't actually fallen much despite the economic malaise.

The other points are fair enough though. The UK economy has real problems and it's not clear that anyone has much of a plan for fixing them (given that the "spend more public money" option is temporarily off the table).

Suppose it turns out that government policies more friendly to the FIRE economy than to manufacturing turn out to have been a mistake, at least as big as the "national champions" policies of the 60s and 70s. However, when policymakers realize that, most of the manufacturing sector is gone. Should a country in that situation try to "bring back" manufacturing, and if so, how?

Or would it be imperative to shrink the FIRE industries, even if there is nothing around to replace them?

Let's say your debt is ginormous. UK is 23rd here (http://en.wikipedia.org/wiki/List_of_sovereign_states_by_public_debt) and 4th here (http://en.wikipedia.org/wiki/List_of_countries_by_external_debt). If the cause of both austerity and the recession are the debt vs ability to repay, then more austerity meaning more recession is just a correlation.

Rather I should say 5th on the second list ranked by %GDP, at ~400%GDP versus the US at ~100%GDP.

"If the cause of both austerity and the recession are the debt vs ability to repay, then more austerity meaning more recession is just a correlation."

Indeed. If I went back in time 200 years and saw a seriously ill patient being bled with leeches, I'd tell them to get rid of the leeches. The fact that the patient still felt horrible for quite a while afterward wouldn't make me change my mind.

Alright, bad GDP figures arent necessarily because of austerity. I can understand that. But is there any economic indicator that would make you come to the conclusion that contractionary fiscal policy was a poor choice?

IMHO no, or at least not by just looking at UK figures, in the same way that US expansionary policy can't be shown to have been a poor choice - all we have is that things would have been worse in a counterfactual world.

Only comparisons with other countries will work, and there you need to be lucky to get convincing evidence, e.g. if the UK economy plummets and every other economy around it, including Ireland, does well, then I guess we can infer that the UK did something wrong.

Btw, isn't 'announcing' short-term spending cuts about the exact wrong way to go about things? Never underestimate the incompetence of government.

I guess Rational Expectations only matters every now and then.

Really interesting post.
As for the UK being densely populated, sure it is, but this in itself does not necessarily lead to higher house prices. Outside of London, the number of people per household is still relatively low. In the 1970s, allowing a spouses income to be considered when arranging a mortgage led to a rapid increase in house prices. As employment becomes more scarce (combined with food and fuel inflation) and household incomes decrease, surely a big drop is possible?
To me, it seems that the UK housing market is developing into a two-tier system. One part is driven by wealthy baby boomers and foreign investment and is still healthy, the rest is not...and its bad health is masked by the former.
So much of the country's wealth locked up in property. With the top-end intrinsically linked to the health and presence of the financial sector, long term the UK is doomed.

"Alternatively, it could be that after the greatest real estate bubble in history, the UK market is overbuilt. "

My jaw hit the floor. Greetings from south east London!

The UK is not Spain, Ireland or Nevada. The UK's houses are horrendously overpriced precisely because we haven't had a construction boom, we have had a price boom because planning laws are too restrictive.

I would be really interested in your opinion were you to go back to the housing data from the UK and revise this part of your view of the UK, because it is jarring with reality.

Other than that, interesting post.

"we have had a price boom because planning laws are too restrictive."

Yeah, right, it's just supply (I say skeptically). How's the rent/price ratio doing?

A better Q1 GDP report than the US! The market was surprised on the upside too: Sterling rose against all major crosses.

Increasing spending by >5% is hardly 'cuts'. There are real cuts in services but these are being subsumed by increased transfer payments. Not because of more claimants - unemployment has been static - instead social security increases (CPI at 4%+) have vastly outstripping wage inflation (currently an annualised average of 2.2%).

In what sense was the report "better" than the one for the U.S.?

The excuse/explanation of "it hasn't really gone into effect yet," was also used to explain why the economy wasn't recovering better in the US in 2009 shortly after the stimulus package was enacted. Next up, I predict that people will be saying, "the problem was that the cuts weren't large enough!" and, "but we we don't know what it would have been otherwise, it probably would have been worse without the plan."

In other words, we're going to be hearing the same reasoning as before only all the people that thought they were valid arguments back then won't think they are now (and vice versa).

Isn't the entire point of austerity to defend the pound?

"1. The case for the cuts is not that they will spur growth, but rather forestall a future disaster. "

While I like spending cuts, I think this is critical issue, and I have no idea how to test for it. Spending cuts are, all else held equal, bad -- in that, it would be good if we had an unlimited supply of resources. As an individual, if I need to make spending cuts, I will of course be worse off without my car/tv/vacation. But we all accept that I am better off without those things and not going bankrupt.

Unfortunately the same argument works for the other side.

Theoretically, the UK government will never turn bankrupt as it controls the Pound Printing Press, unlike you and me.

"Unfortunately the same argument works for the other side."

Well, I must be really thick because I have no idea how that argument would look. Can you clarify what you mean?

As one commenter noted, the UK's main problem is that we rely on the FIRE industry. Much of the proceeds of growth are simply extracted by them. Until we reform the sector (properly), things will continue to be crap.

If a lot of people still fear that prices will fall, at the very least the market is *perceived* as overbuilt and that is a natural fear at this time, that is all I meant to say. It is clear that construction activity is low, I am not trying to outguess the builders' estimates of market fundamentals.

Right on the money i think Tyler. We have already had a large experiment in fiscal expansion in the UK, that was during the boom (in hindsight a big mistake). It succeeded in pushing up public sector wages and pensions and lowering productivity in the public sector. None of this was what Keynes had in mind, but I regretfully conclude this is the political reality of modern-day UK Keynesianism.

http://haskelecon.blogspot.com/2010/10/can-240000-public-sector-workers-really.html

I love that Obama's explosive spending binge of the last 2+ years needs to continue for longer before we can judge it, but tiny spending cuts can be called "proving a macroeconomic failure" six months after they are merely announced.

Obama’s explosive spending binge

You mean the one that barely canceled out state-level cuts, right?

To the extent there was any kind of "binge."
http://krugman.blogs.nytimes.com/2011/04/27/2021-and-all-that/

Also, from the original post: "The case for the cuts is not that they will spur growth, but rather forestall a future disaster."

This is goalpost moving, is it not? Was this NYT quote unfair?

the view of Britain’s top economic official, George Osborne, that during a time of high deficits and economic weakness, the best approach is to aggressively attack the deficit first, through rapid-fire cuts aimed at the heart of Britain’s welfare state.

Doing so, says Mr. Osborne, the chancellor of the Exchequer, secures the trust of the financial markets, and thereby ensures the low interest rates necessary for long-term economic growth.</blockquote.

"The case for the cuts is not that they will spur growth, but rather forestall a future disaster."

Is this the case? It's not the way I've heard it. The best case I've heard for the UK's current course is that cutting the budget will spur future growth because it will signal the government is on a sustainable fiscal track and reassure investors. As Tyler says, perhaps the UK isn't ideally suited to take advantage of growth industries, but that's another matter.

I thought the psychological impact of the cuts was supposed to have a greater impact than the cuts themselves (sort of the reverse of the ever-popular self-financing tax cut here in the U.S.). If that's not the case - and it may be too soon to tell, but the early signs aren't great - then what's the argument for the cuts? You'll never cut your way to prosperity if the best you can manage is a stagnant GDP. You'd probably be better off going full-Keynesian and defaulting down the line if you needed to (the Argentinian plan?).

" You’d probably be better off going full-Keynesian and defaulting down the line if you needed to (the Argentinian plan?)."

Any Argentines here who can tell us how that's working out for them? If it is, then I say let's start stiffing the US bondholders.

I would love the UK government to become more efficient so London becomes more affordable. It's unfair that one of the greatest cities on earth is ridiculously expensive.

whrere does the logical link between government efficiency and affordable city life stem from?

How about regional corporation taxes, like they have in Switzerland?

I see some regions with a static population, some regions with a falling population (north east, north west, parts of Scotland), and the south east with strong population growth.

Someone mentioned a two-tier country, and that sounds about right.

But if the regions were allowed to set their own corporation tax rates, employers would gravitate to lower tax regions. That would have a balancing effect on house prices.

Tyler, as far as I can tell the UK government in fact IS making the case that the cuts are going to spur growth because they will restore business confidence. So you are wrong to say the case for spending cuts was not to generate economic growth, that was the case and on that count they have failed.

"Also recall that in many open economy Keynesian models, fiscal policy AD effects are to some extent — or completely — offset by exchange rate movements."

Like else where in economics, this is based on the assumption that government spending is accompanied by a rise in interest rate, which attracts foreign capital, which leads to exchange rate appreciation, which leads to contraction in export receipts, which eventually offsets the initial expansionary effects of government spending. But in most developing countries (save Zimbabwe) governments borrow and spend at will and the interest rate remain more or less unaffected. If this is the case, Tyler's statement quoted above will be a house of cards, too.

Don't ya luv economists.

Watch any statement that begins with an assumption like Tyler's comment: " Let’s say the cuts lower government consumption and raise private consumption"....what's the support for that little ditty? Is this a teeter totter, where if one goes down the other goes up? Have you asked why private consumption would increase with a decline in government consumption? Have you posited that government consumption (e.g., educational spending , for example, was wasteful?) didn't actually help the economy.

And, it continues: " and that government consumption is wasteful but private consumption isn’t" ...what's the support for that little ditty. Maybe it is the author's assertion, but is it supported by evidence as to England? And, if this is true, than was PAST English expansion (pre-2008) caused by government consumption, or was it the private sector had allocated resources optimally then and subsequently went off the cliff 2008? Which is it?

And, so as to protect onself, the statement concludes: "That’s a good case for making the cuts, but they still won’t show up as higher gdp."

And, when there isn't evidence or a support for the austerity program, you say: Well, What we're going to do is something that won't show up as higher gdp.

Pretty low standard to meet.

And, one that will easily be met.

Let’s say the cuts lower government consumption and raise private consumption, and that government consumption is wasteful but private consumption isn’t

The claim that government consumption is wasteful but private consumption is quite extraordinary. How much private consumption is wasted on stuff we never use, presents we don't want, food we throw away, toys that we break, cars that we crash, clothes that don't fit? And that's just households. When it comes to business, capitalism is built on trial and error. Who hasn't worked in companies where you waste half your time on bidding for business that you don't get, or developing products that go nowhere? Shops fail, companies go bust.

Of course there's government waste too but hard to believe as much as private consumption.

Agreed.

I was thinking of calling this post an introduction to teeter totter economics: lower government consumption raises private consumption.

Would have been a book-end to Trickle Down Economics.

Maybe it is.

Dear Mr Cowen,

As a Brit, I am happy with our return to sustainable finance. Well over half the growth in the 1997-2010 Labour government period came from either private borrowing or excessive government spending during an economic boom. We need to avoid falling into a debt trap, and we need our best brains to be working in the private sector generating wealth. The growth will come from increased investment over wide areas of business - the same as it did under Margaret Thatcher - another period when everyone said that our island was doomed.

Thank you for your interest in our country - please visit soon.

Grrr,

You say we need to move away from debt, well you might be interested to know that the Coalition's plans rely on a 250bn increase in household debt: http://falseeconomy.org.uk/blog/household-debt-up

Capitalist economies are based on debt. The crisis was caused by private debt, and the public sector now needs to pick up the slack as the private sector deleverages. This is not 'hair of the dog', it is an accounting reality (the other way is that our BoP goes up, but good luck with that).

The Coalition will simply make our economy even more reliant on the financial institutions and will not solve any of the real problems the UK has.

Here's a politics/social policy article from the political quarterly which tries to answer the question:

http://onlinelibrary.wiley.com/doi/10.1111/j.1467-923X.2011.02169.x/pdf

You ought all definitely to read this http://pitchpress.blogspot.com/2011/01/varnished-supremacies.html

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