Sunday, 15 February 2015

The Confidence Fairy

George Osborne has presented himself as the “Iron Chancellor” willing and able to make the tough decisions required to see-through the Tories “long term economic plan”.  With an Election 80 days away it’s time to assess his track record in this regard as he is now promising (with some glee) another 3 years of austerity, as he tries to achieve a budget surplus in by 2018. Osborne believes the winning narrative goes like this: Labour wrecked the economy, we inherited unsustainable debts, we then embarked on un-popular but necessary polices to restore confidence in the UK economy and bring down the deficit, these policies took time to work but supported by monetary policy (QE) the plan is now paying dividends.  One would have to be a dumb fish to swallow this story hook line and sinker.

Taking the bait

Let’s rewind the clock to 2009 the year before the Coalition government came to power.  18 months after the financial crisis things were pretty black.  The Labour government had bailed out two of the three major UK banks because of their unwise lending and derivative trading.  Alistair Darling, the then Chancellor, had cut interest rates to 0.5% and reduced taxes on expenditure  and as a results an enormous structural deficit opened-up.  The deficit in the UK ballooned from 3% of GDP in 2007 – 08 to 11% in 2008-09 this added £120bn to the UK’s overall debt in one year.  Due to our disproportionate exposure to the banking sector and soaring welfare bills, caused by Gordon Browns obsession with tax credits, Britain was the lamest duck of all the major economies “the sick man of Europe”.  Things were pretty black at home and abroad there were genuine concerns that Greece would default and that other peripheral Euro-zone economies might follow suit – short term interest rates were rising and the UK was in the spotlight.  Against this back-drop the election of May 2010 was fought in a febrile atmosphere.  Whilst both major parties offered some form of austerity The Tories pandered to the fear that existed and won the election and (what they believed) was a mandate to sort out the public finances through austerity.
As with an historical analysis timing is everything and there are three specific milestones that need examination:

  1. In the summer of 2010 were the Tories correct in their analysis of the problem and was austerity the first best option?
  2. In 2011-12 should the Tories have changed to plan B when we were in danger of a double dip recession?
  3. Was the recovery in 2013 unnecessarily delayed due austerity or was our recovery (earlier than other major economies) the direct result of government policy?

On point one it was pretty clear that in 2010 there were pretty awful scenarios that were a real danger to the UK economy, our credit rating was under watch, we had the biggest deficit in Europe and other countries, in less dire circumstances, where in danger of default – Ireland, Greece and Portugal.  The great wealth and prosperity of the UK, built up since 1980, was at risk and there was a real danger that things could end badly.  It was therefore important for the markets and business confidence (what Krugman dismissively call the confidence fairy) that the new government was seen to be tough on the deficit.  There is no doubt that this worked, the ratings agencies lost interest for a time, business confidence and investment returned and private sector growth in 2010-11 more than compensated for the first round of public sector austerity.

On point two things are less clear cut.  The main mistake the Tories made was to leave large sections of the overall budget out of the austerity plan (welfare and Health) this meant that the saving had to come from a some number of spending departments and this forced minister to cut the investment budget – many school build programmes were shelved, transport improvement were put on hold and so on.  It is always easy to cut the capex budget but when falling demand is one of the main problems it should not have been the focus.  This meant structural change was delayed and aggregate demand unnecessarily reduced.  But we should also remember the Eurozone crisis rumbled on until Mario Draghi finally offered to” do whatever it takes” in July 2012.  It was only at this point that long term interest rates started to fall across Europe and the specter of defaults on the continent faded away.  So whether plan B should have been adopted in 2012 is probably a moot point.  Up until the summer of 2012 economic catastrophe was still possible because of uncertainty in the Eurozone and by the autumn on 2012 Osborne had at any rate given up on is spending targets – and we were is a world of austerity-lite

On the third point it is fair to say that the way austerity was implemented was poor – cutting investment budgets and “ring fencing" major spending departments from the programme of cuts caused unnecessary pain.  Having said that we were the first major economy to achieve “escape velocity”.  Maybe we might be slightly better off but claims made by Paul Krugman and Simon Wren-Lewis that we are all £2,000-£1,500 worse off due to the Coalition government’s economic policy is hard to fathom.

The balance of argument hinges on the issue of confidence, the macroeconomic models used by academic economists made a good fist of most variables by they are unable to factor in the impact of confidence.  If there had not been a willingness in 2010 to tackle our huge debt there is little doubt that domestic business and overseas investor confidence would have been knocked, this would have led to massive out-flows of money from the UK.  The Coalition policy did at least restore confidence and this was indirectly responsible for recovery as in 2011-12 as the instability in Europe allowed a stable UK to draw in a very large of Foreign Direct Investment (FDI) - the main reason for recovery.  So we should be thankful for the “confidence fairy” and broadly ignore the Keynesian revisionist s who, egged on by dubious Greek claims, are so loud in their assertion that austerity failed in the UK and elsewhere.

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