Misunderstanding about the UK's Austerity Budget

Ahead of Chancellor George Osborne’s budget for 2013 which is supposed to come out on the 20^th, there has been a lot of criticism of the “austerity” being imposed by the government.  Many are calling for a change of direction; Nobel Laureate Paul Krugman said that the austerity drive is “deeply destructive.”  As a friend of mine noted (and rightly so), growth should be the main priority, so how can growth happen if the government is cutting back on spending?  However, this is only part of the story, so I wanted to put this all in prospective as most people are still of the wrong mentality.

First, government spending is still growing, as shown in the table below, so the government isn’t actually shrinking spending, only shrinking it as a percentage of GDP.

Second, even with the cutbacks, government spending as a percentage of GDP is still near the top of its historical range over the past 40 years (see table below)…hardly austerity.  The main problem is that the previous Labour government increased spending significantly as a percentage of GDP even though the UK was going through its best and longest growth period for the past 40 years.  They ran significant fiscal deficits during the good times, leaving nothing for the bad times.  They compounded this problem by financing a big part of the spending increase with taxes on the financial sector and encouraged the financial sector’s growth with “light touch” regulations and increased consumer indebtedness.  The Labour opposition are currently proposing more of the same, which has been shown to be detrimental to the economy.  So before people start running towards the Labour Party because they like what they hear, be careful…Ed Miliband and Ed Balls have the economic credibility of Argentina…or Venezuela.  Growth by borrowing is always easier than real growth via increasing economic productivity; this is a lesson learnt time and again in emerging market economic crises and being learnt now in the Eurozone and other developed market crises.

Third, the UK’s private sector debt has more than doubled as a percentage of GDP over the past 15 years, which is obviously unsustainable.  Basically, people have been spending beyond their means, and government spending, regardless of an austerity budget or not, isn’t going to change the fact that UK consumers will implode upon themselves if they continue this trend.  In this way, the austerity budget is useful in that it is as least forcing the debate of debt consolidation and spending within one’s own means.

These three reasons show that the government is right to sound the austerity alarm bell.  It’s not a matter of opinion; it’s a mathematical fact.  Anyone who tells you differently just simply doesn’t know what they are talking about.  But we come back to the question, how do you grow the economy if you have to cut back on borrowing and spending?  This is where the current Tory-Lib Dem government falls down on.  It has done a good job explaining the need for austerity in terms of consumption, but it doesn’t have a coherent strategy (or much of a strategy at all) for how you improve economic growth.  They hope that growth will come through confidence from austerity.  President Herbert Hoover in the US tried that during the Great Depression…it didn’t work too well to put it mildly.

There are generally three answers to this conundrum.

One is that the main way of truly increasing sustainable GDP growth is through improvements in productivity.  The UK economy, like other developed economies, is dominated by the service sector and by government (77% of the economy).  It should also be noted that these two sectors are notoriously the least productive in the economy (the table below provides an indication of how service sector productivity lags significantly).

As any foreigner will tell you, services in the UK are expensive, the quality is terrible, and the transport system is positively Third World.  There is a lot of scope for improving productivity here, and the government needs to have a plan to tackle inefficiencies in a wide variety of areas.

The second answer is devaluation of the pound sterling.  If your industries are generally uncompetitive, then making them cheaper will attract business.  This is what happened after the pound left the Exchange Rate Mechanism in 1992 and sharply devalued (see the graph below).  The UK economy, which had been held down by the imposition of high interest rates to defend an overvalued currency, recovered quickly after the devaluation (in fact, this was the last recession prior to the financial crisis).

However, benefitting from a devaluation is easier said than done.  The US and the Eurozone are weak and so are trying to devalue as well, while the many emerging market countries are purposely trying to hold their currencies down to prevent themselves from becoming uncompetitive.  Also, the UK has lost a significant portion of its export sector since the early 1990s, so the benefit of a devaluation will take time.  Still, the UK is doing a better job of devaluation than most (see graph below); the Bank of England has pushed the pounds to near the bottom of its trading range over the past 20 years.

Finally, government should cut back on consumer-related spending, but it doesn’t necessarily need to cut back on spending overall for the time being.  As shown in the graph below, UK government debt to GDP is high but not excessive compared to historical standards (though it should be noted that the prior periods had strong population growth which helped economic growth, something which is not likely in the near future).  Spending on investment which can increase productivity or economic capacity if done in the right areas, can be easily offset by the benefits.  The UK has significantly underinvested over the past 15 years (effectively living off of its past investments), part of the reason why the economy has difficulty growing and why inflation is high for a period of such slow growth.  So if the government maintained spending levels but redirected it from consumption to investment, then the economy should recover more strongly (though note, this stills means consumption spending on things like benefits, NHS, etc will need to go down as a percentage of GDP, so the message of austerity still rings true).

So the Tory-Lib Dem coalition are half right and half wrong in their economic policies (whereas the Labour Party are just completely wrong, but then, I can’t recall Labour’s economic policies ever being right after Clement Attlee’s government).  The government has rightly cut consumption spending, but it has not developed a strategy for improving investment spending and increasing productivity.  This is what George Osborne’s new budget should focus on.