Britain and the limits of austerity
The British economy has experienced the most rapid growth in the G7 over the last few months. It increased at an annual rate of more than 3 percent in the last quarter — even as the U.S. economy barely grew, continental Europe remained in the doldrums and Japan struggled to maintain momentum in the face of a major new valued added tax increase.
Many have seized on Britain’s strong performance as vindication of the austerity policy that Britain has followed since 2010, and evidence against the secular stagnation idea that lack of demand is a medium-term constraint on growth in the industrial world.
Interpreting the British strategy correctly is crucial because of the political stakes in Britain, the question of future British economic policy and, most important, because the British experience influences economic policy debates around the globe. Unfortunately, when properly interpreted, the British experience refutes the austerity advocates and confirms John Maynard Keynes’s warning about the dangers of indiscriminate budget cutting during an economic downturn.
Start with the British economy’s current situation. While growth has been rapid recently, this is only because of the depth of the hole that Britain dug for itself. While the U.S. gross domestic product is now well above its pre-crisis peak, in Britain GDP remains below previous peak levels and even short of levels predicted when austerity policies were implemented. Not surprisingly given this dismal record, the debt to GDP ratio is now nearly 10 percentage points higher than forecast, and the date when budget balance is predicted has been pushed back to the end of the decade.
The common excuse offered for Britain’s poor performance is its dependence on financial services. Yet the New York metropolitan area, far more dependent on financial services than Britain, has seen GDP comfortably outstrip its previous peak. Though the euro area has performed poorly, even a casual look at trade statistics confirms that this cannot account for most of Britain’s poor growth.
The U.S. economy grew at a rate of 9 percent for a number of years after the trough of the Great Depression in 1933. Such rapid growth in peacetime is unheard of in U.S. history. Why did it happen? Only because of the depth of the Depression. No one has ever taken the pace of the U.S. recovery from the Great Depression as any validation of the austerity policies that helped create it. Similarly, part of the story of British growth is that it is simply catching up after a major crisis caused a huge output gap to develop.
History shows that deeper recessions are followed by stronger recoveries. For example, the New York metropolitan area, though falling relative to the rest of the country in the 2008 fiscal collapse, enjoyed more rapid growth after.
Two additional points about Britain’s growth require emphasis. First, the acceleration in growth has less to do with austerity spurring growth than with a slowdown in the pace at which austerity is imposed. Whether one looks at the deficit itself, or the various structural deficit measures advanced by local and international organizations, the pace of fiscal contraction has slowed over the last two years. Slowing fiscal contraction means the decrement to growth caused by fiscal policy is becoming more attenuated.
All things being equal, this would be expected to produce more favorable growth performance. Ironically, the greater the fiscal multiplier is, the greater would be the predicted turnaround when the pace of contraction slowed. So the turnaround in growth over the last 18 months is as much evidence against austerity as it is pro-austerity.
Second, in the face of deficit reduction’s potential damage to demand and economic growth, the British government has been forced to introduce a number of extraordinary measures to support lending. Most significant is the so-called Help to Buy program that gives low teaser rate mortgages to some households and guarantees the mortgages of others so they can put only 5 percent down. There are also special programs to reward banks for lending to small business and involve the central bank in export finance.
Especially in the case of Help to Buy, which manages to encompass most of the sins of the U.S. government-sponsored enterprises, all these programs are highly problematic. The austerity program’s stated goal was to improve confidence in Britain as a sovereign credit. Yet, guaranteeing mortgages en masse is actually creating a huge potential government liability, as do other loan guarantee programs.
In addition, subsidized credit for mortgages risks recreating real estate bubbles — house prices in London have increased much faster than GDP over the last year. And of course, programs that benefit homeowners rather than renters have perverse distributional consequences.
Britain’s growth then reflects a combination of the depth of the hole it found itself in, the moderation in the trend toward deeper and deeper austerity and the effects of possibly creating a bubble through government loans.
It may still be better for the citizens of Britain than any alternative. But it certainly should not be seen as any kind of inspiration to other countries.
PHOTO (TOP): The Bank of England is seen in the City of London. August 7, 2013. REUTERS/Toby Melville
PHOTO (INSERT 1): A protester holds a placard during a rally in Trafalgar Square in central London, May 1, 2013. REUTERS/Toby Melville
PHOTO (INSERT 2): Demonstrators protest outside the Houses of parliament in central London, March 21, 2012. REUTERS/Paul Hackett