Austerity - an ideological gamble with the British economy

The new British government unveiled its first Budget in June 2010. It includes an extraordinary fiscal contraction with a hike in VAT from 17.5% to 20%, a big squeeze on benefit payments, and an announced 25% cut in public spending over the next five year period. The government wants to almost eliminate a structural deficit of 8 % of national output within five years. It wants spending cuts rather than tax increase to constitute the lion’s share of the contraction (80%). No country has ever chosen such an extraordinary austerity package voluntarily. The retrenchment is as tough as the one IMF has imposed on Greece. In Britain it dwarfs the cuts in the wake of the IMF crisis in 1976 and after the ERM crisis in 1992.

The Spending Review presented in October provides more detail on the spending cuts. Benefit payments will be squeezed even more whereas the 20 % cut in public spending is a little less savage than announced in June. The total spending cuts amount to £82bn which will lead to lay-offs of half a million public employees until 2014-15. Welfare benefits and housing benefits will be slashed. Some universal benefits will become means-tested. International aid will increase significantly. NHS (National Health System) expenditure and funding of research will be ring-fenced and schools expenditure will only decrease moderately. All other areas of public spending will experience huge cuts. Higher education spending will be cut 40% and grants to local governments will be cut 27%. The real growth rate of departmental capital budgets will be minus 30%.

Furthermore, major reforms of several public sector areas have been initiated or announced. The financing of higher education will be shifted to the users through a 250% increase in the cap on tuition fees. The penal system will be reshaped with more emphasis on community service and less on prison sentences. A total of 192 quangos will be abolished and 118 bodies merged. A universal welfare benefit is set to replace a number of targeted working age benefits in order to increase work incentives. Most radically, the NHS will be totally reorganized. The strategic health authorities and primary care trusts will be abolished, and responsibilities for directing patients’ care will be transferred to about 500 consortia of GPs (General Practitioners) covering 8000 doctors’ practices in England. This is poorly planned and initiated in a rush in an apparent attempt to signal will power to cut bureaucracy. It is a stunningly reckless experiment that will no doubt prove costly and counter-productive.

The fiscal contraction, the spending cuts and the public sector reforms are presented as economic necessities but they are also seen as means to realize the vague vision of the Big Society with greater involvement of citizens, individually and collectively, in the running of public services without government interference. In principle the vision has some merits but in combination with savage spending cuts it appears more as making a virtue out of necessity or as a legitimizing device. In addition, the spending cuts seriously impede the realization of the vision. Huge cuts in subsidies to charities tend to erode embryos of the ‘Big Society’ where it may exist. 

It all adds up to a huge gamble with the economy. Will Hutton has expressed this  in a clear and concise way: “Britain is now a laboratory for one of the most startling economic experiments in modern history. Never before has a country of such a large economy, carrying so much private debt, taken the experience of near financial collapse to squeeze its budgets with such severity and speed” (Observer 24 October 2010). The size and speed of the budget cuts exceed any cuts previously experienced in the OECD countries apart from the spending cuts as a result of de-mobilization by the end of WW1 and WW2. This happened in a past era where the role of the public sector was far more limited and the impacts of cuts less widespread, and can hardly be compared to the present day.

The cuts are presented as unavoidable. The budget deficit and the debt burden is seen as unsustainable in a global economy where the financial markets is supposed to subsequently lose confidence in the British economy and punish it by lowering its credit ratings which will increasing its borrowing costs. The spectre of the Greek crisis is presented as a possible future fate of Britain in the absence of radical fiscal consolidation. The main piece of evidence for this extraordinary claim is the GDP share of the current deficit in British which is the highest in the OECD countries and slightly higher than in Greece.

This is political spin. Britain is not on the brink of bankruptcy. The level of national debt is not large by international standards. Actually, it is slightly below the international average as a share of GDP, and the level of interest on the national debt in five years time will be manageable without severe cuts. The repayment terms of the debt are uniquely favourable. The term structure is around 14 years, much longer than the short repayment terms of Greek sovereign debt. Furthermore, most of the public debt is owed domestically. Less than a third of government gilts are held by international investors compared to two-thirds of the Greek debt, so the potential impact of the international sovereign debt crisis on the British economy is modest. 

It is necessary to get the flow of public debt under control by reducing the structural deficit. However, there is no necessity in reducing the deficit so quickly. The previous Labour government had planned a huge and fast reduction of the deficit. There is no convincing argument that even more austerity is necessary. Furthermore, the adjustment does not need to take the form of primarily spending cuts. Tax increases could well constitute a larger share. The government has chosen the maintenance of the triple A credit rating as the ultimate measure of policy success which is absurd even if it was absolutely necessary and it is not.

The policy is a gamble with the economy that will only succeed under exceptional circumstances. In the short run, the net fall in public spending will reduce aggregate demand and it is hard to see where a compensating net increase should come from. Household consumer demand will depend on the total of the other components of demand. It is telling that household confidence has plummeted after the Spending Review. The distorted British housing market needs rebalancing and falling prices is a necessary part of it but the construction sector will suffer in the absence of increased public spending on infrastructure. Already, housing orders are falling and a recent commercial property boost is already petering out. 

Only an extraordinary export and investment boom will do the trick. Increased export depends on foreign markets expanding. The main British export market is continental Europe and domestic demand in the euro zone is held back by spending cuts which are moderate compared to the British cuts but still enough to stifle British export prospects in spite of the favourable current exchange rate. The new round of quantitative easing in the US after the midterm election improves the British prospects. However, without a major export boost in the BRIC countries the increased export will hardly be enough. In particular, China is important with its double digit growth rates. China’s import consists mainly of raw materials and capital goods and British export to China is modest. Unless China embarks on a radically new road of expanding domestic demand through increased consumer spending, including consumption of luxury goods and entertainment, it is hard to see how Britain shall succeed in conquering a larger share of the market.

Investment depends on current and expected future aggregate demand. Easier access to credit may improve the situation but this is not very likely in the short run. The government seems to want to attract foreign direct investment in new businesses in Britain. Even if they succeed it is hardly going to boost total investment enough.

The government sees it differently, at least in public discourse. It does not seem to accept the proposition that aggregate demand constrains, but  rather propagates a vague supply side argument instead. The private sector is seen as capable of expanding as fast as the public sector shrinks, presumably as a result of less regulation and pure optimism. The government seems to believe that it can create enough new jobs to suck up the sacked public employees. This is not much else that merely wishful thinking. Without enough demand it is not going to happen.

Measured in terms of jobs growth the private sector needs to create 2.5 million new jobs in order to secure the tax revenues presumed in the Spending Review. This is highly unrealistic. A comparison is clarifying. In the years 1993-1999 after the 1992 crisis, 1.2 million private-sector jobs were created. Seventy-five per cent of these new jobs were in financial and business services. The accountancy firm PwC has calculated that these sectors will only be modest job creators during the next five years because of the recapitalisation of the banks and the falling public demand for services. Alas, the rest of the private sector, mostly manufacturing and to a lesser extent construction, is supposed to create two million new jobs whereas it only succeeded in creating 300.000 jobs in the five years after the last major recession. This seems highly unlikely. The probability of success is even more microscopic in the current business climate with a huge cut in demand from public spending which is a further complication that the private sector did not have to cope with in 1993-1999.

If anything close to such a jobs boom should happen a manufacturing growth strategy with proper institutionalized support is instantly needed. This is an area where the UK variety of capitalism has always been weak. Britain needs a whole range of new institutions and organizations to help firms invest and innovate. Britain has a strong science base but is relatively poor in translating this into viable businesses. Cities must be given autonomy and means to invest in growth. Manufacturing has been neglected as the needs of the financial services industry have been given priority. Manufacturing has been prospered recently because of the favourable exchange rate but sustainable and significant increase in manufacturing requires institutional innovation and support with apprenticeships and improved technical training. Part of this can be provided by business itself and in other countries it is indeed being provided by the collective action of business. However, this is a less familiar terrain in a British context which only reinforces the need for public support in building the required network of institutions and organizations. Some of the existing institutions that might contribute to such a growth strategy (Regional Growth Fund, Regional Development Agencies) have been dismantled by the new government. The concern for institutionalized support for sustainable growth is clearly of secondary importance to the government if important at all.

A recent IMF study of prior cases of fiscal tightening may be consulted by the government as a proper wake up call. It concludes that a fiscal consolidation equivalent to 1% of GDP leads on average to a 0.5% decline in GDP after two years, and to an increase of 0.3% in the unemployment rate (IMF: World Economic Outlook, chapter 3, October 2010). The cumulative effect of the British fiscal consolidation should then be a contraction of GDP of 3-4% and 2% increase of the unemployment rate. However, the effect can easily be worse because two mitigating circumstances that tend to weaken the austerity effect in other cases are not present in the British case. Typically, interest rates declines and furthermore exports rise because of real currency depreciation. However, there is little room for lower interest rates when interest rates are close to zero and export expansion is less likely in case of simultaneous cuts in export markets.

The Spending Review applies heroic assumptions of growth in its calculations of tax revenues and spending on benefits and there is a strong likelihood that tax revenues will be significantly lower and unemployment benefits higher than predicted. This may well initiate a vicious circle similar to what has happened in Ireland where austerity has resulted in negative growth, higher than predicted deficits and ultimately the worsened credit rating which was what the austerity measured was meant to prevent in the first place.

Of course, it may not go as bad if the government is willing and able to change course if the process does not proceed according to plan. At least one member of the Cabinet (the Liberal Democrat, Chris Huhne) has indicated that this might happen. However, a proper well-timed redirection is unlikely and the government has made it difficult to achieve this through the composition of its deficit cuts. It is difficult to see how the government should be able to intervene with proper timing when you take into account that it sees hardship as an indicator of success in a conscious long run process. The coalition parties have locked itself into a full five-year period of government and the positive effects are only expected to emerge by the end of the period where voters are presumed to have forgotten earlier hardship. Furthermore, there is no Plan B. There is only little flexibility in implementation which would have been the case if the mix of spending cuts, taxation and borrowing had been different. If taxation had constituted a larger share of the policy mix it would have been much easier to correct course by means of deferred tax increases. It is much more difficult to reverse planned spending cuts.

However, the macroeconomic effect of the deficit reductions is not the only success criteria for the government. It is obvious that there is another ideologically motivated policy goal. The demands for deficit reduction constitute a unique opportunity for shrinking the state. For many of the coalition party politicians this is what they entered politics to achieve. This explains the zealous efforts to cut more than is required. The pain inflicted on the population is not only a temporary measure to solve macroeconomic problems experienced as a result of the costly efforts to bail out the banks and to avoid a recession. It is a cure for entering the promised land of a much leaner state. In an article in the Guardian (18 October), George Monbiot argues that the financial crisis has provided the conservatives with a long-awaited opportunity to trash the state and to reshape the economy in the interests of business.

He uses the bonfire of quangos as an illustrative example. Almost all the public bodies, whose purpose is to hold business to account for, for instance, protection the environment, animal welfare and consumer safety, have been axed. On the other hand, the public bodies whose purpose is to help boost corporate profit are maintained. He further argues that the government’s policy is a typical example of disaster capitalism, as conceptualized by Naomi Klein is her book ‘The Shock Doctrine’. In normal circumstances, those who suffer as a result of neoliberal policies will outvote the neoliberal politicians. Therefore, an actual or a perceived crisis is needed to create openings for major policy change needed. The openings for change initiatives will be limited in time, but the period may be extended by exacerbating the crisis that creates such unique opportunities.

It is not difficult to see parallels with the deficit cuts and the associated reforms of the public sector, However, in recent years the conservatives have invested much effort in wiping out the popular image of them as the ‘nasty party’. This may to some extent be pure marketing and posturing, but it is not only image management. The efforts are reflected in policy proposals and now also in government policies which the Thatcher governments would have considered soft and intolerably political correct. Furthermore, it is difficult to see the Liberal Democrat coalition partner as deliberate proponents of ‘disaster capitalism’ policies. For both parties it is seen as crucial to achieve fairness in its policy design.

The evidence presented to show that the policy is fair has a prominent place in the Spending Review documents, and the policy mix is constructed in a way to substantiate the claim of fairness. The proposal to withdraw child benefit for families with a higher rate taxpayer was announced at the recent Conservative party conference before the Spending Review. It was no doubt meant to exorcise some of the remaining vestiges of Tory nastiness even if the price was a muted atmosphere among the conference delegates who were not able to mobilise much enthusiasm for such policies.

The increase in personal tax allowance takes a large proportion of low income families out of the tax system and has a significant redistribution effect. Schools who take on pupils from disadvantaged areas are awarded a pupil premium which is one of the budgetary concessions to the Liberal Democrats. A bank levy totalling £2.5bn is introduced in an effort to make banks contribute a significant share to the austerity package. The increase in tuition fees is accompanied by measures to support students from low income families and to exempt graduates at lower subsequent income levels from repaying tuition fee loans. A serious effort is made not only to project an image of fairness but also to redistribute fairly and to restructure in a balanced way with concern for the poorest.

However, the fairness of the total package is disputed. The Institute for Fiscal Studies has published an authoritative analysis that the policies hits the poorest the most and increases the Gini coefficient. Furthermore, new evidence of disproportionate hardness for the poorest as the effect of specific policies is published daily. Cuts in housing benefits will force more than 19.000 low income London households to leave their home. Disability allowances will be cut with serious consequences for some of the weakest benefit recipients. The deficit cuts will have a district regional dimension in the sense that some of the most deprived regions are heavily dependent of public sector jobs and will suffer more in terms of unemployment than richer regions. And, so on and so on. 

Until now, the austerity plans have met very little resistance. Opinion polls show widespread public acceptance of the plans. The government has successfully nurtured the perception in the general public that cuts are unavoidable and that we might as well swallow the necessary medicine to get over with it. However, this is deemed to be a temporary respite. Until now it has merely been about numbers and plans. Soon it becomes very real deterioration: reduced welfare payments, higher VAT, unemployment, rising train fares, higher tuition fees, lack of police presence in local communities, rising accident and emergency waiting times, closure of local hospital units and libraries and children centres, prisons turning away criminals, cancelled school building projects, crumbling infrastructure, increased charges for reduced council services, increased fees for swimming and sports, switching off streetlights at night, leaving potholes unfixed, etc. Unavoidably, dissatisfaction will mount and the pressure on the government will increase.

Until now, there has been little active resistance and only little visible backtracking. However, the cross-party local mobilisation against the abandonment of the former government’s plan for school building renovation and the government’s subsequent concessions give an indication of things to come. The outcry against the withdrawal of universal child benefit may also have led the governments to maintain the universal benefits for pensioners, winter fuel allowances, bus passes and free television licenses; popular but hardly essential benefits in hard times.

Still, the actual effects of the spending cuts are somewhat theoretical and unreal to the general public. In one important respect the cuts have not yet been fleshed out. The unprecedented 27% cut in grants to local authorities over the next four years and the total freeze on local capital spending are still only figures on paper. When the concrete impact becomes clear in all its painful and irritating detail the flavour of it all suddenly changes a lot.  Furthermore, the ring-fenced NHS will contribute its very own austerity backlash. A real growth of 0.1% over four years appears to be relatively advantageous and it certainly is in comparison with the severe cuts in other sectors. Although the healthy annual 7% increase in NHS budget under the previous Labour government did improve services it did not improve standards to the extent that it should have. It rather led to a hike in salaries and no doubt some bureaucratic waste as well. However, the modest real increase in spending will be far from enough to match the imminent pressure on costs as a consequence of rising medical and pharmaceutical costs and population aging which is estimated by the King’s Fund to be on average 4% a year above inflation.    
   
There is little doubt that the general mood will change when the cuts begin to bite. This will strengthen the resistance which has until now been very low key. Hitherto, there have been only sporadic strike activities from radical and politically isolated unions and more recently from student unions. The comparison with the French protests against a comparatively much less far-reaching planned increase in the pension age has amused and bemused the British public. The planned industrial action among public sector workers may impose some pressure on the government but such traditional forms of resistance will hardly have much effect on the government.

Neither will Labour will able to inflict much damage on the government in the foreseeable future. The reorganized team around the new leader Ed Miliband has presented sensible alternatives to the government’s austerity package. It has not backed off from the previous government’s pledge to cut the deficit but it is now in favour of a rebalanced policy mix with a higher share of the taxation component (from 66% spending cuts and 33% tax increases to 50%/50%). It criticizes the government for cutting too much in a fragile situation with a modest and uncertain recovery. Furthermore, it scores points on the fairness variable by means of strong critique of some of the welfare cuts. In addition, it presents policies to strengthen growth and jobs creation.

 The most eye-catching new policy is a call for a big increase in capital spending on road building, infrastructure and construction, funded by a proposed higher bank levy of £7bn, supplemented by action against bank bonuses. This is all very well but the fact that the previous government had itself planned unprecedented cuts, and the memory of its lenience towards City fat cats, even in the wake of the credit crunch, makes it hard for Labour to take advantage of the otherwise ripe opportunities for political gain by mobilizing against the unpopular effects of cuts.

This may change in a couple of years but the most probable cause for disruption comes from within the government itself. Until now, the cooperation between the coalition parties has been surprisingly smooth and painless. The only major discord hitherto in the cooperation within the government was the foul play (leaking of information and independent international lobbying) of the conservative Defence Secretary in his efforts to protect the military from cuts. However, the subsequent resentment seems to be equally shared among the other conservative members of the Cabinets and the Liberal Democrat members.

This relative harmony cannot be expected to last. The Liberal Democrats have already had to endure several u-turns in major policy areas, of which the most prolific is the support for increased tuition fees. This is not unusual for a junior partner in a coalition and, in general, the coalition policies have been more balanced and favourable for the Liberal Democrats than you might have expected. However, the u-turns tend to erode the support from the party’s left-of-centre base, and it has potentially fractious effect on the party’s leadership with its variety of views from traditional liberal to social-liberal positions.

 The strains of coalition policies on the Liberal Democrats will accumulate but it will be kept in check, at least until next year’s referendum on election reform (Alternative Voting). This is the big prize for the Liberal Democrats. If the referendum supports the proposal, this will fundamentally change the political system in favour of the third party, and all the trouble will be seen as worthwhile. If it does not, which at present appears highly probable, it is unlikely that the Liberal Democrats will be capable of enduring the stress of coalition compromises for long.