Dr Osborne, the antidepressant has helped my diabetes but will it cure my cancer?

Austerity measures are policies pursued by governments to reduce the size of the budget deficit, requiring either cuts in spending, increases in taxation or both. It has always been a highly controversial topic – a demon of the past, a measure of the present and either the cure or the cancer for the future. Its credibility as an appropriate medicine has been strongly disputed, questioned endlessly during the double-dip recession yet it appears to have pulled through in the light of the Chancellor’s announcement at the start of 2014. But would we have been better off following Keynes’ macroeconomic management policies? Will we forever shake our heads in regret over what could have been?

In 2010, Carmen Reinhart and Kenneth Rogoff published a study of growth in times of debt, with controversial results. They concluded that if the debt-to-GDP ratio in an economy exceeded 90%, economic growth would fall significantly with implications for the GDP and public finances. National debt would reach unsustainable levels, and governments would become more likely to default on their bond repayments. In the UK, economists, politicians and the rest of the population watched as their government “hung” in the balance of a coalition – believing that austerity was the only viable option.

Austerity appeared to be a quick-fire solution to the problem: make cuts now, pay off the debt sooner and reach sustainable growth faster. This relied on the correctness of the theory that high levels of sovereign debt damage economic growth, also allegedly supported by the Ricardian equivalence. The Ricardian equivalence argues that when the public sector is downsized, it stimulates the private sector. This would appear to make sense, seeing that a smaller state would allow private enterprise to flourish and the portion of the labour force cut from the public sector would find jobs in the private sector. The increase in private sector employment would increase the productivity of the economy as a whole and promote growth.

It appears to have worked. George Osborne, the current Chancellor of the Exchequer, made the case for his vindication over the economic downturn of the last three years (including a double-dip recession) with figures indicating a growth rebound – a recovery long awaited. Austerity, after three grisly years, had finally delivered.

The inflation rate has stabilised at 2%, exactly in line with the Bank of England’s target. It has provided the UK’s economy with a gradual increase in employment figures; the unemployment rate, in the three months up to October dipped to levels unheard of since early 2009 – an encouraging 7.4%. Having reached the New Year, companies are head-over-heels in confidence and are rushing to hire fresh blood. Credit is more easily available and house prices have begun to rise.

GDP is still 0.4% below the pre-crisis peak, but its growth has been steady and consistent since the first quarter of 2013 – a definite improvement on the economy’s near-stagnation in 2012. The sharp devaluation of the pound before the crisis helped the Bank of England to neutralise upcoming inflationary pressures over the course of the recession. This worked in harmony with the austerity measures, allowing the Chancellor of the Exchequer to eliminate a larger volume of Britain’s debt in a shorter time period. Austerity appears to have jumped through all of the hoops the economy has thrown at it, albeit slightly later than expected. Surely the country could simply stop moaning about it and look forward to the recovery?

The truth of the issue is that they can’t. Closer inspection of the figures presents an alternative story to the one that the Chancellor has produced. Current proportionate spending is low. The general public has received, on average, a 0.9% increase in salary; the inflation rate is marked at 2%. Salary growth has not matched the pace of inflation and this has the equivalent effect of a lower inflation rate without an increase in salary. This directly affects the cost of living by driving it up, and thus consumers will find it more difficult financially to keep up. A greater proportion will have to make cutbacks, and this could have a domino effect on all the industries supplying to the general public. Even among those with a source of income, a large number are driving up the UK saving ratio to above 7% (the average was 4% between 2000 and 2008) for what could only be seen as a precaution against further economic insecurity. As a result of the increase in the cost of living, retail sales have grown by less than 1% per annum since the recession began; some of Britain’s biggest retailers experienced disappointing figures during the course of the Christmas season. The 2011 VAT increase dealt irreparable damage, destroying consumer confidence at the time and the possibility of economic growth. But there is general consensus that the worst steps taken by the coalition government over the past three years were the deep cuts in public infrastructure projects.

The cuts in the public sector expenditure led, as expected, to unemployment in the public sector. However, the expected pick-up in employment on the private sector did not occur. The private sector was instead hit with the knock-on effect from the unemployment, the main craters in it arising from private contractors not receiving government contracts. This led to the contractors having to also cut back and laying off a portion of their workforce. Workers are a resource, so using basic economic theory we can deduce that the overall increase in unemployment of that resource reduced the economy’s productive efficiency, and this had a negative impact on the GDP. The GDP is an indicator of economic performance, explaining the ensuing slump in economic growth. General public purchasing power was reduced, and as a result the food, clothing, electrical, holiday and many more industries were affected by the reduced consumption of their goods. As all industries began to slump, the general public became aggravated and entered a state of social unrest, a key factor that was unaccounted for in the government’s vision of the UK’s growth trajectory. In 2011, social unrest reached its tipping point and, coupled with the anger at the injustice of Mark Duggan’s death, saw people take to England’s streets to demonstrate their anger at the government in the England riots of 2011. The austerity policy is exacerbating the very problem it is trying to solve.

The government shield away from the one thing that could have turned the economy around much quicker – Keynesian macroeconomic management policy. Baron John Maynard Keynes declared in 1937 “the boom, not the slump, is the right time for austerity at the treasury” (Collected Writings). This policy traditionally proposes that the role of the government and central bank is to smooth out fluctuations in GDP growth. During a period of economic boom, contractionary policies should be used to reduce excessive growth in aggregate demand (e.g. increased tax rates, government spending programmes and cutbacks). During a recession period, expansionary policies should be implemented (e.g. lower tax to increase aggregate demand, lower interest rates to motivate borrowing). Government expenditure should also be increased to create jobs directly through increased public employment and indirectly through the multiplier effect. By following Keynes’ expansionary policies and plugging money into the economy, the coalition government could have created a sustainable economic cycle with steady growth that would have reduced our deficit at a greater rate than that of austerity. The invalidation of the Ricardian equivalence in this case shows that it is simply unsupported by data, and thus has falsely led the coalition government into taking much longer than necessary to turn around our economy, at the great expense of the taxpayer.

The correct policy is evidently Keynes’ macroeconomic management policy. Data provided by independent analysts indicates that the UK’s GDP would be around 0.2% lower than the pre-crisis GDP if it had proceeded to stimulate growth rather than hinder it. Professor John Muellbauer of Oxford University predicted “the failure to invest in infrastructure while borrowing costs were at historic lows will haunt the recovery”. How hard will our failings to act when we could have, hit us in the future? The outcome from austerity will be realised within the next two to three years, but for now we can only speculate. We can only look back in hindsight searching for answers to the future.

Contributed by Abayen Ahilan