Austerity measures are making it harder to cut the deficit

You might have noticed that the UK economy is unhealthy. For one thing, we’re back in recession. Then, there’s the unemployment level, above 2.6 million. Meanwhile our private consumption and investment are still below their 2007 peak.

But not every economy is suffering the same way. As I mentioned in my previous post, Adam Posen admitted at a recent Bank of England speech entitled Why is their recovery better than ours?  (Even though neither is good enough), the US is finally stumbling on its way towards recovery. Unemployment in the US is now slowly falling, and private consumption and investment are well above their pre-crisis peaks.

US1

In the US, private consumption is recovering. In the UK, it is not.

In the US, private investment is recovering. In the UK, it is not.

And why has the American recovery been so much more successful than our own? Adam Posen concludes:

Cumulatively, the UK government tightened fiscal policy by 3% more than the US government did – taking local governments and automatic stabilizers into account – and this had a material impact on consumption. This was particularly the case because a large chunk of the fiscal consolidation in 2010 and in 2011 took the form of a VAT increase, which has a high multiplier for households.

As a result, the US economy has already recovered to pre-crisis levels, whereas in the UK it is still 4% smaller.

But amazingly, despite cutting more slowly, the American deficit has fallen faster than the UK’s. According to the IMF, the US budget deficit is due to fall by nearly 5% of GDP between 2009 and 2012, more than twice the UK rate of 2.4%.

The reason? Well, to quote BBC economics editor Stephanie Flanders,

Because the faster pace of deficit reduction in the US does not seem to come from greater government efforts to cut borrowing. Instead it seems to come from, er, faster growth.

We see the same pattern across Europe. Those countries, such as Belgium and Germany that are cutting the structural deficit (i.e. the deficit adjusted for any point in the business cycle) most slowly have been experiencing faster levels of economic growth and rising tax revenues- and correspondingly the total deficit has been falling faster.

None of this should come as a surprise to us. A recent IMF study of 173 austerity programs in 17 advanced economies since the 1970s concluded that all had led to recession and not economic growth. The authors wrote:

…The evidence from the past is clear: fiscal consolidations typically have the short-run effect of reducing incomes and raising unemployment. A fiscal consolidation of 1 percent of GDP reduces inflation-adjusted incomes by about 0.6 percent and raises the unemployment rate by almost 0.5 percentage point… fiscal consolidations are contractionary, not expansionary. This conclusion reverses earlier suggestions in the literature that cutting the budget deficit can spur growth in the short term.

fiscal consolidationIMF2IMF3

The IMF evidence also suggests that austerity measures are increasing the levels of public debt (and doing little to pay off the deficit). As government revenues decline, and expenditure on unemployment increases, it becomes harder for governments to reduce their deficit and to pay off the debt. In advanced economies public debt has increased since 2007 from 70 percent of GDP in 2007 to about 100 percent of GDP, its highest level since the aftermath of the Second World War. The IMF concludes:

The Great Recession has also been a factor in increasing public debt, in large part because of the collapse in tax revenues as incomes fell.

It’s now clear that Osborne’s Plan A isn’t working. Not only is it killing off out economy’s growth, it’s also killing off our ability to pay off the deficit. Even the British Chamber of Commerce is now urging Osborne to scrap his deficit reduction targets.

With Britain’s infrastructure in desperate need of investment, it’s high-time Osborne adopted a Plan B.

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3 comments

  1. [...] be for the government to slow down its rate of cuts and to stimulate the economy, as I have argued elsewhere. Clearly, the governments is unwilling to do this. There are, however, other ways to stimulate the [...]

  2. [...] strangling the recovery before it has even begun; indeed the economy is weak enough to seriously jeopardise attempts to cut the deficit. Nonetheless, it is significant that the IMF, the architect of austerity, has now come to the same [...]

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