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The Osborne audit: what have we learned?

Ahead of this week’s budget, the economic historian Robert Skidelsky examines how four years of austerity have affected Britain.

George Osborne by Ralph Steadman

On Wednesday, for the first time in four Budgets, George Osborne will be able to claim plausibly that Britain has come out of the Great Recession. Growth was 1.8 per cent in 2013 and is expected to be between 2.4 and 2.8 per cent in 2014. That’s the good news. The bad news is that the economy is still 1.4 per cent smaller than it was in 2008 and 14 per cent smaller than it would have been had the recession not struck.

That lost output, amounting to £210bn, is gone for ever. Every household is almost £2,000 poorer on average than it would have been; the government’s revenue is £70bn less – that is (say) 70 hospitals, 1,000 schools and 250,000 housing units not built. Or, to take another number: 650,000 people now unemployed would have been in employment.

This is not all. Every year of the recession has reduced our growth potential. Economists use the word “hysteresis” to describe the rusting away of economic resources through misuse or underuse. Hysteresis has to do not just with the output lost during the slump but with the potential output lost in the subsequent period of near-zero growth. Headline unemployment is an incomplete measure of such rusting, because it also occurs when people work less than they want to, or are in jobs below their skill level, or just leave the workforce. A physics graduate may be able to find employment as a taxi driver or waiter. But how much physics “potential” will he retain after years of doing such jobs?

These are heavy costs. Just as George Osborne did not cause the recession, he has not caused the recovery. Intertwined economies usually fall and rise together, and Britain has been lifted off the rocks by the global upturn. Yet policy does make a difference – to the speed of recovery, its strength and its durability. On all three counts, the Chancellor’s policy is open to severe criticism.

Fiscal austerity slowed and weakened the recovery; monetary looseness ensured that it would be highly unbalanced and therefore fragile. Significantly, the official independent watchdog, the Office for Budgetary Responsibility (OBR), in its December 2013 Economic and Fiscal Outlook, judged the “surprising” growth surge of the past year to be “cyclical . . . rather than indicating stronger underlying growth potential”. That the bank rate needs to be kept near zero shows that the economy is still on life support. 

Missed budget targets

Let’s start with the targets Osborne set himself in his first Budget of June 2010. He inherited a prospective deficit for 2010-2011 of £149bn, equivalent to 10.1 per cent of GDP. He promised to get this down to £20bn, or 1.1 per cent of GDP, in 2015-2016, mainly through spending cuts. By 2013-2014 the deficit should have been £60bn. In fact, it is projected to be £111bn, or 6.8 per cent of GDP this year. Now the Chancellor must cut spending by another £62bn over the next four years to meet his original target, two years later than promised.

There were no growth targets – those were abandoned years ago – but there were growth forecasts. Fulfilment of Osborne’s budgetary targets depended on the economy growing at 2.3 per cent in 2011, 2.8 per cent in 2012 and 2.9 per cent in 2013. In fact, the growth rates achieved were 0.9 per cent in 2011, 0.1 per cent in 2012 and 1.8 per cent in 2013. In other words, Osborne’s failure to meet his deficit targets was caused by the failure of the economy to grow to expectation.

The official explanation for this failure is “bad luck”. In familiar language, policy was “blown off course” by unexpected events. Chief of these was said to be the eurozone sovereign debt crisis, which started with fears of a Greek default in March 2010 and then spread, by contagion, to Ireland, Spain, Portugal and Italy. For the next three years the eurozone slumped almost as badly as Britain. The eurozone slump, it is argued, stymied the British recovery.

There are two things wrong with this. First, with its own currency and control of its exchange rate, Britain should have done better, not worse, than the members of the eurozone. Second, although the eurozone financial crisis undermined confidence, and hit British exports, the European slump arose in part because European finance ministers were pursuing exactly the same policy as was George Osborne. So it makes more sense to say that the coincident slumps of the eurozone and Britain between 2010 and 2013 were the effects of a single cause: the policy of cutting public spending. The “unexpected” element in the situation was the failure of so-called fiscal consolidation to deliver growth.

Why should anyone expect a policy of cutting public spending in a recession to produce growth? It is counterintuitive. A recession is caused by businesses and households spending less. If the government also spends less, one would expect this to worsen, not reverse, the recession. This, I think, is exactly what happened.

Making the case: George Osborne on his first Budget Day, 2010

Primitive economics

Over the past four years, I kept asking myself: what did Osborne have to believe to convince himself that cutting government spending was necessary to “get the economy moving again”? His core belief, I concluded, is ideological. This is that state spending is heavily wasteful. From this, it follows that the smaller the share of GDP spent by the state, the larger GDP will be, because the private sector allocates resources more efficiently. It’s as simple as that.

This ideological fundament generates three seemingly common-sense, short-run propositions, which I call “primitive economics”. The first, known by the cognoscenti as “real crowding-out”, states that if the government commandeers an extra quantum of “real” resources such as workers and factories this will deprive the private sector of their use.

Second, there is the idea of “financial crowding-out”. If the government borrows additional financial resources (money) to fund its spending, this will force up interest rates and oblige businesses to pay more for their money.

Finally, there is “Ricardian equivalence”. This says that government borrowing is just deferred taxation. Expecting to pay more taxes tomorrow, people increase their savings today. So increased government consumption “crowds out” an equivalent volume of private consumption.

Eighty years ago, John Maynard Keynes pointed out that this trade-off view of the relationship between public and private spending may be valid at full employment, but is quite wrong in a severe recession.

In such a situation, extra government spending does not necessarily “crowd out” real resources. Where there is slack in the economy – the labour supply exceeding labour demand as today – extra government spending can bring into use the idle resources by creating more employment. There is no displacement; the public spending is not done at the expense of private spending. Rather, the public spending compensates for a lack of private spending.

Second, it is not true that whatever the government borrows is a subtraction from a fixed pool of savings that would otherwise be invested by the private sector. Many savings are just lying idle in bank accounts, because the private sector lacks the confidence to invest them. By offering investors a risk-free rate of return, the government can put these savings to active use. And by generating employment, this “crowds in” additional savings.

Finally, “Ricardian equivalence” ignores how government spending can pay for itself, not just by increasing national income (and therefore government revenue) but by investing in projects that create value for the economy, such as schools, houses, transport infrastructure, green energy, and so on.

Probably few policymakers today believe these “crowding-out” stories literally. I doubt whether even George Osborne does. But they believe that governments need to behave as though they believe these ideas in order to retain the “confidence” of the markets.

So, the question is: why do the markets believe them? Why do they scream “Default” whenever government borrowing goes up? Why did Osborne feel that unless he got the deficit under firm control, he would be spooked by the markets?

The reason is that, for the past 30 years, all economically literate or market-savvy persons (who do not generally include politicians) have been slaves to “models” of the economy which ruled out severe recessions by assumption. Even social democrats, who wanted to use the tax system to redistribute the wealth created by the private sector, bought in to the dominant view that, on average, markets do not make mistakes. This was the tragedy of Gordon Brown; it is also why Labour under Ed Miliband has been unable to deploy a convincing case against Osbornite economics.

Consequently, it is not surprising that governments and central banks failed to take precautions against a slump happening; more surprising that they did not thoroughly revise their beliefs when it did happen. To some extent, they did. When the world economy crashed in the winter of 2008 all the main governments came in with bank bailouts and stimulus packages. But as soon as the danger of another Great Depression was removed, the old orthodoxies reasserted themselves. In particular, as it was bound to do, the slump left a legacy of rising deficits and taxpayer liabilities. In this kind of climate, fears about the solvency of governments seemed reasonable.

And mainstream economics offered no help at all. What was going on, the economists said, was just a readjustment of economic life from one optimum equilibrium to another. Thus there was no “output gap” that needed to be filled by extra government spending. Rather, what needed to be done was to cut down state spending in order to make the existing output more productive. The Chancellor is no economist: but this presentation played to his ideological preconceptions. In a world-view of this type, there is no distinction between the short run and the long run. We always live in the long run, and if we leave the long run to the markets, all will be for the best. 

Delusions

A world in which beliefs and facts have come so far apart will be particularly prone to delusionary thinking. The delusion was that policies that made the recession worse would produce recovery. This delusion was abetted by reputable economists. Three years ago, the doctrine of “expansionary fiscal contraction” was all the rage and a huge research effort went into trying to prove its core proposition: that the less the government spends, the faster the economy will grow. The econometricians produced some striking correlations. One claim was that “an increase in government size by 10 percentage points is associated with a 0.5 to 1 per cent lower annual growth”. In April 2010, Alberto Alesina of Harvard University assured European finance ministers that “many even sharp reductions of budget deficits have been accompanied and immediately followed by sustained growth rather than recessions even in the very short run”.

An International Monetary Fund paper in 2012 brought Alesina’s hour of glory to an end. Going through the same data as he had examined, the IMF authors pointed out: “While it is plausible to conjecture that confidence effects have been at play in our sample of consolidations, during downturns they do not seem to have ever been strong enough to make the consolidations expansionary at least in the short run.” Fiscal contraction is contractionary, full stop.

George Osborne has said publicly that he was influenced by Carmen Reinhart and Kenneth Rogoff. These two Harvard economists claimed that their data showed that countries’ growth slows sharply if their debt-to-GDP ratio exceeds 90 per cent. It turned out that their findings were skewed by the vast overweighting of one country in their sample. But a much more important error was their confusion between correlation and causation, also seen in the work of Alesina. High debt levels may cause lack of growth but a lack of growth may cause high debt levels; or both may be due to some other factor(s). How, one asks, can good statisticians make these kinds of mistakes? Only, I think, because their theory or model already tells them that this is the way the causation has to run, so that their only task is to establish a correlation.

Quantitative easing to the rescue?

With the failure of fiscal “consolidation” to revive the economy, the Chancellor increasingly turned to monetary policy. This fitted his ideology. Orthodox monetary policy works by the central bank targeting short-term market interest rates, providing banks with the reserves needed to keep the rates on target and, by varying the rates (or expectations of future rates), influencing the volume of private-sector lending and borrowing. It bypasses fiscal policy, which is why it is attractive to those who dislike state intervention. Since 2008, monetary policy has been ultra-loose or “unorthodox”. Not only has the bank rate been kept at 0.5 per cent for a record length of time, but the Bank of England has injected £375bn of “new money” into the economy, £225bn of it before Osborne became Chancellor. This is known as “quantitative easing” (QE).

How big a part has QE played in producing a recovery? The quick answer is that no one knows for sure. Unlike government spending, which has a direct effect on the economy, monetary policy works indirectly by inducing private households and businesses to change their behaviour – to save more or spend more. QE is supposed to work through two “transmission channels”: the bank lending channel and the portfolio rebalancing channel.

The central bank activates both channels by buying government bonds (gilts), mainly from non-banks. The sellers of the bonds receive cash; they deposit their extra cash with the commercial banks. In the first transmission channel, this is supposed to increase bank lending. The banks have more cash to lend out, causing them to lower their interest rates. As a result, more money is borrowed by businesses and households; the spending of the loans raises total spending, and therefore output, in the economy.

Early experience of QE showed that this was not happening: the banks were hoarding their cash, not lending it out. The architects of QE had underestimated the damage that banks had suffered as a result of the collapse of their assets in the crash, and therefore their desire to rebuild their reserves. What Osborne then did was to start subsidising bank lending. The Funding for Lending scheme, introduced in July 2012, was supposed to stimulate bank loans to businesses. It failed to do this – business lending is still well down from its pre-crash levels.

Desperate to get something in the economy going up, the Chancellor switched to Help to Buy in April and October 2013, which insured banks for a 15 per cent loss on 95 per cent mortgages. This has certainly contributed to the recent surge in house-buying and the rise in house prices.

It should be noticed, however, that both attempts to boost bank lending are fiscal policy by the back door, as the contingent subsidies are liabilities for the taxpayer.

Because of the disappointing results of bank lending, the Bank of England came to rely more on the second transmission channel, portfolio rebalancing, to stimulate the economy. Bond purchases by the Bank swell the cash deposits of the sellers, encouraging them to spend. Simultaneously, they reduce the supply of gilts in the market, which causes the price of gilts to rise and their yields to fall. The “search for yield” then induces investors to switch from gilts to stock-market securities and other assets, making it easier for businesses to raise capital. The increase in the price of these assets also expands the net wealth of the asset-holders, causing them to spend more. These various effects will result in growing GDP. Certainly the rise in stock-market and house prices has contributed to a “feel-good” factor, which is bolstering the current optimism about future prospects.

Set against these benefits are two costs. By encouraging excessive risk-taking, QE may reignite the pre-crash asset bubble, against which the new governor of the Bank of England, Mark Carney, has warned. The second is the increase in inequality. Of this, John Kay wrote in the Financial Times: “In the modern financial economy, the main effect of QE is to boost asset prices . . . the one certain outcome of QE is that those with assets benefit relative to those without . . . these policies may not benefit the non-financial economy much, but they are helpful to the financial services sector and those who work in it.”

The trouble with unorthodox monetary policy was that it is not unorthodox enough. Rather than try to increase private-sector cash balances, the Bank should have lent the money directly to the government to spend on public investment. We can be sure the government would not have hoarded the cash! But this operation would have blurred the line between monetary and fiscal policy, and thus the sacred ideological divide between the private and public sectors.

To put the matter crudely: a recovery based on stuffing the mouths of bankers with gold will be weaker and less durable than a recovery based on an upsurge of mass spending power. 

Conclusions

Wealth and income have been growing more unequal in Britain since the 1980s. George Osborne has not created the inequality; but he has exacerbated it by dragging out the slump and using lopsided means to bring about the recovery. Britain may well emerge from the recession with a problem of structural underconsumption. Investment is driven by consumption, so when consumption falls off, so does investment. A tendency to domestic underconsumption – unless offset by a buoyant demand for exports – will result in what economists such as Larry Summers have started to call “secular stagnation”. The chief symptom of this will be rising structural underemployment: a slackening of demand for labour which does not reverse itself with recovery.

This brings us back to the ideological fundament. It is the Chancellor’s firm belief that the government’s share of total spending should be reduced as much as possible. Spending financed by deficits is twice cursed, not just because government spending is wasteful, but because it enables governments to pass on the cost of waste to future generations. Hence Osborne’s pledge to eliminate the Budget deficit entirely. This is tantamount to saying that the government expects to pay out of taxes for all the schools, hospitals, housing and transport systems that it builds. Because all Conservative governments want to reduce taxes as well, this amounts to a vast programme to privatise virtually all public services.

At this point, the ideology destroys sane economics. A sensible view of public spending would distinguish between capital spending and current spending. It would enable one to say that deficits resulting from excessive current spending are bad because they do not generate any revenue and add to the national debt, but deficits that are incurred on capital spending can raise productivity, improving the country’s long-run potential. A sensible Osborne policy would have been to confine cuts to the current account and offset these fully by expanding public investment in green projects, transport infrastructure and social housing, as well as export-oriented small and medium-sized businesses (SMEs). The Business Secretary, Vince Cable, has been arguing this case inside the government; lip-service is paid to the principle, but public investment is still 35 per cent down from the pre-crash levels.

What George Osborne has done is to bring an ideological fervour to a defective theory of macroeconomic policy: the theory that additional government spending can, under no circumstances, move the economy to a better-equilibrium growth path. What may be rational to believe when the economy is fully employed is palpably wrong when resources stand idle.

Moreover, it is not Osborne and his friends and bankers and Top People who suffer. It is the ordinary people of this country, whose lives and prospects are wrecked or diminished. Four years of George Osborne have been four years too many.

Robert Skidelsky is a cross-bench peer and a leading biographer of J M Keynes. His most recent book is “Five Years of Economic Crisis” (Centre for Global Studies, £5)

This article first appeared in the 12 March 2014 issue of the New Statesman, 4 years of austerity

Ralph Steadman for the New Statesman.
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Tim Farron: Theresa May is "the prisoner of the Ukip wing of her party"

The Liberal Democrat leader on his faith, Blairism and his plan to replace Labour as the opposition. 

This is Tim Farron’s seventh general election. His first was in 1992, when his Tory opponent was a 36-year-old called Ther­esa May. He was just 21 and they were both unsuccessful candidates in the Labour fortress of North-West Durham. He recalls talking “to a bunch of ex-miners who weren’t best pleased to see either of us, some kid Liberal and some Tory”. Now he sees his former and current opponent as “the prisoner of the Ukip wing of her party . . . I think it has rendered Ukip almost pointless – she is Ukip now.”

May was elected to parliament in 1997, but it took Farron until 2005 to join her. She leads the dominant Conservatives while he heads a party of only nine Liberal Democrat MPs. Still, their reversal of fortunes gives him hope. “After the 1992 election, every­one said there’s no way for a non-Tory government, and it turned out there was. So let’s not assume it’s a given there’s a Tory government [for ever].”

In April, I accompanied Farron to Manchester Gorton, in the lead-up to a by-election that was cancelled by May’s decision to call a snap election on 8 June. Still, the 46-year-old’s party has been in campaign mode for months; Lib Dems spoke of using last December’s Richmond Park by-election to test their messaging. It clearly had an effect: the incumbent Conservative, Zac Goldsmith, lost to their candidate, Sarah Olney.

Brexit, to which the Liberal Democrats are vehemently opposed, will be a dominant theme of the election. Their party membership has just exceeded 100,000, close to an all-time high, and they have enjoyed much success in council by-elections, with more to come in the local elections of 4 May.

However, any feel-good factor swiftly evaporated when Farron appeared on Channel 4 News on 18 April. He was asked by the co-presenter Cathy Newman whether or not he believes that homosexuality is a sin, a question that he answered obliquely in 2015 by saying that Christianity started with acknowledging that “we’re all sinners”.

This time, he told Newman, he was “not in the position to make theological announcements over the next six weeks . . . as a Liberal, I’m passionate about equality”.

The Channel 4 interview divided opinion. One Liberal politician told me that Farron’s stance was “completely intolerable”. Stephen Pollard, the influential editor of the Jewish Chronicle, described it as
“a very liberal position: he holds certain personal views but does not wish to legislate around them”. Jennie Rigg, the acting chair of LGBT+ Liberal Democrats, said it was “as plain as the nose on my face that Tim Farron is no homophobe”.

Farron declined the chance to clarify his views with us in a follow-up phone call, but told the BBC on 25 April: “I don’t believe that gay sex is a sin,” adding, “On reflection, it makes sense to actually answer this direct question since it’s become an issue.”

For his critics, Farron’s faith and politics are intertwined. He sees it differently, as he told Christian Today in 2015: “. . . the danger is sometimes that as a Christian in politics you think your job is to impose your morality on other people. It absolutely isn’t.”

Tim Farron joined the then Liberal Party at the age of 16 but didn’t become a Christian until he was 18. Between completing his A-levels in Lancashire and going to Newcastle University to read politics, he read the apologetics, a body of Christian writing that provides reasoned arguments for the gospel story. “I came to the conclusion that it was true,” he told me. “It wasn’t just a feel-good story.”

In speeches, Farron now takes on the mannerisms of a preacher, but he had a largely non-religious upbringing in Preston, Lancashire. “I don’t think I’d been to church once other than Christmas or the odd wedding,” he says. “I went once with my dad when I was 11, for all the good that did me.”

When we meet, it is Theresa May’s religion that is in the spotlight. She has condemned the National Trust for scrubbing the word “Easter” from its Easter egg hunt, a row it later emerged had been largely invented by the right-wing press in response to a press release from a religious-themed chocolate company.

“It’s worth observing there’s no mention of chocolate or bunny rabbits in the Bible,” Farron reminds me. “When people get cross about, in inverted commas, ‘us losing our Christian heritage’ they mean things which are safe and comfortable and nostalgic.” He pauses. “But the Christian message at Easter is shocking, actually, and very radical.”

British politics is tolerant of atheists (such as Ed Miliband and Nick Clegg) alongside those who, like David Cameron, are culturally Christian but whose faith is “a bit like the reception for Magic FM in the Chilterns: it sort of comes and goes”. But the reaction to Farron’s equivocation on homosexuality prompted many to wonder if a politician who talks openly about his faith is now seen as alarming. Nebulous wishes of peace and love at Christmas, yes; sincere discussions of the literal truth of the Resurrection? Hmm.

Tim Farron’s beliefs matter because he has a mission: to replace not only Jeremy Corbyn as leader of the opposition but Theresa May in Downing Street. Over lassis at the MyLahore curry house in Manchester, he tells me that Britain is facing two calamities. “One is Brexit, indeed hard Brexit . . . and the other is a Tory government for 25 years. We have to present a genuine, progressive alternative that can not only replace Labour as an opposition, it can replace the Tories as a government.” This is ambitious talk for a party with nine MPs. “I understand the ridicule that will be thrown at me for saying those things: but if you don’t want to run the country, why are you in politics?” He pauses. “That’s a question I would ask most people leading the Labour Party at present.”

What does he think of May, his one-time opponent in North-West Durham? “She strikes me as being very professional, very straightforward, somebody who is very conservative in every sense of the word, in her thought processes, her politics, in her style.” He recalls her 2002 conference speech in which she warned Tory activists: “Our base is too narrow and so, occasionally, are our sympathies. You know what some people call us: the nasty party.”

“In many ways, she was the trailblazer for Cameron in being a softer-focused Tory,” he says. “It now looks like she’s been trapped by the very people she was berating as the nasty party all those years ago. I like to think that isn’t really her. But that means she isn’t really in control of the Conservative Party.”

Voters, however, seem to disagree. In recent polls, support for the Conservatives has hovered between 40 and 50 per cent. Isn’t a progressive alliance the only way to stop her: Labour, the Liberal Democrats, the Greens, the SNP and Plaid Cymru all working together to beat the Tories?

“Let’s be really blunt,” he says. “Had Jeremy Corbyn stood down for us in Richmond Park [where Labour stood Christian Wolmar], we would not have won. I could have written Zac Goldsmith’s leaflets for you: Corbyn-backed Liberal Democrats.

“I’m a pluralist,” he adds. “But any progressive alliance has got to be at least equal to the sum of its parts. At the moment, it would be less than the sum of its parts. The only way the Tories are losing their majority is us gaining seats in Hazel Grove –” he ticks them off with his fingers, “– in Cheadle, in the West Country and west London. There’s no chance of us gaining those seats if we have a kind of arrangement with the current Labour Party in its current form.”

What about the SNP? “Most sensible people would look at that SNP manifesto and agree with 99 per cent of it,” Farron says. “But it’s that one thing: they want to wreck the country! How can you do a deal with people who want to wreck the country?”

There’s no other alternative, he says. Someone needs to step up and offer “something that can appeal to progressive younger voters, pro-Europeans and, you know, moderate-thinking Middle England”. He wants to champion a market economy, strong public services, action on climate change, internationalism and free trade.

That sounds like Blairism. “I’m a liberal, and I don’t think Blair was a liberal,” he replies. “But I admire Blair because he was somebody who was able to win elections . . . Iraq aside, my criticisms of Blair are what he didn’t do, rather than what he did do.”

Turning around the Tory tide – let alone with just nine MPs, and from third place – is one hell of a job. But Farron takes heart from the Liberal Party in Canada, where Justin Trudeau did just that. “I’m not Trudeau,” he concedes, “He was better-looking, and his dad was prime minister.”

There is a reason for his optimism. “I use the analogy of being in a maze,” he says, “You can’t see a way out of it, for a progressive party to form a majority against the Tories. But in every maze, there is a way out. We just haven’t found it yet.” 

Stephen Bush is special correspondent at the New Statesman. His daily briefing, Morning Call, provides a quick and essential guide to British politics.

This article first appeared in the 27 April 2017 issue of the New Statesman, Cool Britannia 20 Years On

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