Written by Luke Paterson
7 July 2020
Reading time: 10 minutes
This article explains the myths and factors that led to the strict austerity policies across advanced economies following the 2008 financial crash. In addition, it discusses why the UK probably won’t return to austerity during the Covid-19 crisis.
The Current State of The Economy
As lockdown begins to lift, the government’s response in the coming year will be, in many ways, the most crucial plan regarding the long-term recovery for the economy.
Currently, things are looking pretty bleak; councils are on the verge of going bust, there’s speculation about a second wave in the fall, and the only true certainty is that debt is soaring in the same direction as Elon’s rockets – to space. In fact, the national debt has become more than Gross Domestic Product – the value of all finished goods and services in the economy – for the first time since 1963, tipping over at 100.9% of GDP earlier this year. This is largely attributed to the government deficit being predicted to be at its highest level – £300 billion – since the Second World War. However vile it may appear, it is not a surprise that the government deficit has soared during this artificial, self-inflicted, economic recession. That is how the taxation and benefits system behave: revenues plunge when the economy down spirals, whilst some forms of spending, like the furlough scheme and universal credit, rise automatically. The deficit is facilitating a good, and crucially important, role to prevent a complete meltdown of the economy and livelihoods.
Austerity’s Meaning and History
The term “austerity” likely sends a chill down most people’s back. The term has a few definitions, none of which are pleasant, but the most applicable, by the Cambridge Dictionary, quotes austerity as “a difficult economic situation caused by a government reducing the amount of money it spends”. Let us be clear, we are obviously going to need some form of control of public finances in the future, otherwise the country will go bust, but when, how, and who pays for it are fundamentally important questions.
“The boom, not the slump, is the right time for austerity at the Treasury”.(John Maynard Keynes, 1937).
Most of us know austerity as the lasting legacy of the conservative-led government from 2010-2015. Following the aftermath of the economically crippling global financial crisis, the then Chancellor of the Exchequer, George Osborne, declared that the UK was “living beyond its means” in his 2010 budget to Parliament. The government proceeded to cut spending for the police, libraries, courts, prisons, road maintenance, and housing support for senior citizens. The obvious question is, why?
Initially, in the subsequent year after the fall of the Lehman Brothers investment bank in 2008, economic policy, in most of the developed world, was surprisingly on the correct course; woefully inadequate overall, but nevertheless we were heading in the right direction. The then Prime Minister, Gordon Brown, internationally called for “fiscal action” to stimulate demand in the economy. Domestically, the government announced an aggregate total of £500 billion worth of stimulus packages. The bank rescue packages were mainly paid for by various future tax hikes following the economic recovery. For instance, the top rate of income tax would increase from 40% to 45% from 2011, as well as national insurance contributions rising for everyone.
When everyone in the economy, out of a lack of confidence, is spending/investing less, a vicious contraction occurs because what they spend is your income and vice versa. The logic behind a fiscal stimulus (increased spending and/or cutting taxes) is that the stimulus can offset this downwards freefall, which becomes especially important, as in 2008/09, when conventional monetary policy – pushing the interest rate down to boost demand – becomes ineffective.
Even though the UK was leading the global effort, criticism inevitably came from the opposition, with George Osborne (then Shadow Chancellor) stating that “this would be the final chapter of the age of irresponsibility”. Osborne’s comments were actually reflective of the growing concern amongst many Western politicians. The fear that rising deficits may be damaging began to outweigh the issue of mass unemployment. Generally speaking, when interest rates are low (as they were in 2009), this signals that investors are not worried about debt or “crowding out” (when government borrowing prevents private investment), so rising deficits should not have caused any major concern (at least in most countries).
Look at Greece!
Alas, there were genuine (and not so genuine) reasons for concern. The first, probably the most memorable, was Greece. Greece in no uncertain terms had a massive – and genuine – budget deficit problem! The Greek economy joined the Eurozone in 1999, on self-proclaimed fudged budget figures – big mistake! Essentially, the Eurozone did wonders for Greece, initially. The Greeks received huge amounts of money from lenders (mainly Germany) who deemed Greece a safe investment – why? Because it was in the Eurozone of course! Under normal circumstances, lenders most definitely would not have invested so much money.
Unbeknown to most over this period, Greece, like many other countries, was experiencing a huge housing bubble before the crash. Nevertheless, everyone was benefitting from the Euro currency at the time so this bubble went unnoticed. Then the housing bubble burst. Since the Greek economy was largely propped up by the construction industry, where jobs virtually disappeared overnight, the unemployment rate pretty quickly sored.
As previously mentioned, when revenues plummet we would expect the budget deficit to climb (due to automatic stabilisers). In addition, compared to most advanced economies at the time, Greece had an abnormally large informal economy of around 30% (tax evasion etc). Therefore, tax collection, in addition to the many other problems, was fundamentally weaker. Mix all of these factors into a pot – a lot of debt, a growing budget deficit, and a structurally weaker economy (among other major issues) – and what you get is a debt crisis!
Greece’s Unemployment Rate peaked at 35% of workers!
To make matters even worse, if having nearly a third of your workforce unemployed within 4 years and over half of youths unemployed was not bad enough, there was nothing Greece could do about it. Essentially, to save Greece, and Spain for that matter, the European Central Bank would have been required to buy up a lot of bonds in those countries to bring the cost of borrowing down – which would have shot Germany in the foot with substantially higher inflation.
On a side note, if Greece still retained the Greek Drachma – its own currency – it could have devalued it to increase its international competitiveness. In addition, they would have benefitted from more flexible monetary policy matching their economy. Obviously, Greece adopted the Euro so was unable to devalue or benefit from the flexibility of having its own currency. Internal devaluation (forcing wages down) was possible, though it is not a quick response and it simultaneously worsens private debt – because incomes are falling yet the debt remains mainly unchanged.
Greece was forced, eventually, to adopt strict austerity measures which have undoubtedly left the country impoverished. The Greek economy is now a fraction of its former self today. Greece’s genuine budget deficit problem facilitated a huge catalyst for deficit scaremongers; an incredibly good reason to promote austerity. Though, as most will be able to see, Greece’s situation was quite unique compared to that of most other advanced economies (especially those with their own currency).
The Excel Mistake
Early in 2010, an academic paper, published by Carmen Reinhart and Kenneth Rogoff, two highly accredited Harvard economists, began to circulate. This, later infamous, study titled “Growth in a Time of Debt”, basically claimed that growth drops off (goes negative) when a country’s debt rises above 90% of GDP. If politicians were scared of debt before, then this paper inevitably gave all more reason to be petrified. This was an excuse for most countries, especially across Europe, to impose destructive cutbacks since there was ‘credible’ academic research hinting towards it.
This publication in question was published in the American Economic Review (an extremely credible economic journal), but not subject to the extensive peer-review standards which are normally applied – presumably due to the academic’s statuses. Subsequent examinations later found that the findings were not just incorrect, but the paper had huge flaws.
“It is sobering that such an error slipped into one of our papers despite our best efforts to be consistently careful”.Reinhart and Rogoff Statement to the BBC, 2013
Due to mounting criticism, the academics eventually allowed other researchers, who could not replicate their findings, access to their original spreadsheet. They found in short, that they had omitted some countries from the sample causing biased results, used questionable statistical methods and, there was an Excel code error. This was just one example (possibly the most famous publication of the period) of the growing problem of indirectly advocating robust austerity measures. Eventually, Reinhart and Rogoff acknowledged their mistakes; however, it was already too late – austerity had been adopted instead of stimulus packages across most of the advanced economies.
Finally, and probably one of the most important factor, throughout the whole period the public’s fear of debt began to rise. Public worry about budget deficits are a genuine issue that can easily resonate with voters. The majority of voters partake in some kind of budgeting themselves. It is relatable, even though public finances have a very different rationale than family finances. Nevertheless, when the calls came to vote to make sacrifices to get “unmanaged spending” under control, the majority of voters agreed in a General Election.
Thus, we moved to austerity. The Conservative-Liberal Democrat coalition was to carry out austerity cutbacks to eliminate the ballooned budget deficit. Reminiscent of John F. Kennedy’s State of the Union address in 1962, George Osborne repeatedly referred, particularly in his second term as Chancellor of the Exchequer, to “fixing the roof when the sun is shining”. Obviously, “shining” in relation to the economy would imply close to full-employment, yet fiscal austerity was implemented when it was still raining; ‘pouring down’ in fact. British austerity, under Cameron and Osborne, would mainly be implemented during the first two years of the coalition’s power – although it was nothing like the severity of what the Greeks would face.
Nevertheless, the subsequent fiscal policies would lead to very nasty consequences and direct hardship for ordinary people. A special report conducted by a United Nations poverty expert in 2019, found that austerity had inflicted “unnecessary misery” on the British population. For the average person, 2010-2020 could be described as a “lost decade” – average wages only recovered from the financial crisis in 2020! Another damning fact is that crime rose – more worryingly, violent crime. Foodbank use became increasingly common every single year, to where over 1.6 million people (that’s not a lie!) are using food banks services compared with 25,899 in 2008. Also, as of 2019, 4.2 million children or 30% of all children live in relative poverty in the UK (below 60% of median income). Although, it must be mentioned that select statistics do not do justice to the widespread damage austerity has undoubtedly inflicted on UK society, it also does not do justice to the division that it is most likely responsible for.
The procedure across Europe to adopt austerity measures contributed to the rise of far-right movements across lots of European states and a credible academic paper – Did Austerity Cause Brexit? – found a significant association between the support for the Leave vote and areas hit hardest by austerity-induced welfare reforms. It is undoubtedly clear that the austerity-driven agenda across many Western countries, following the post-crisis stimulus packages, has inevitably shaped today’s world.
Following a lot of the revelations leading to the adoption of austerity in 2010, it is clear to see, especially in the case of the UK, that austerity was an option, not a requirement. Today the financial economy, at large, is stronger, but, due in part to low-interest rates, the economy is in a less than ideal position to adequately deal with the Covid-19 recession. Fiscal stimulus will likely be of great importance for this recovery, especially due to the weaker monetary policy position. However, a lot of the damage that persists in the economy – long term unemployment for instance – will only become apparent when the Furlough scheme concludes.
It is highly doubted the government would attempt austerity again, at least not to the same degree or before the economy has sufficiently recovered. Firstly, it is really unpopular, not surprising given the statistics above, to the extent that you could elect the opposition yourself. In addition, the detrimental effects a second round of (tough) austerity could have on the UK, politically and socially, may not even be worth the risk! Thus, the news that Boris won’t return to the “austerity of 10 years ago” is welcomed, but let’s not forget what politicians say and do are two distinctly different things.
The National Archives
The New York Times – What is Austerity and How Has It Affected British Society
International Monetary Fund
The New Yorker
BBC – Wages back above pre-economic crisis levels
Did Austerity Cause Brexit? – T Fetzer 2019
Office for National Statistics – Crime in England and Wales: year ending September 2018
Statista – Foodbanks: emergency food needed United Kingdom (UK) 2008 -2019
Child Poverty Action Group