The case for cuts: why the austerity argument held on

Paul Krugman, the Nobel-winning economist who writes a column for the New York Times, has published a long essay in the Guardian this week under a headline calling the case for cuts a lie. His argument is that the doctrine behind the turn to austerity in 2010 has been abandoned almost everywhere in the rich world except Britain, where both main parties are still campaigning on it. One need not share his tone to take the question seriously. With a week to go before polling day, it is worth setting out what the official evidence now says, and why so little of it has reached the debate.

How the turn happened

In the spring of 2010 the UK was borrowing on a scale not seen since the Second World War. Public sector net borrowing peaked in 2009-10 at £153 billion, 10.2 per cent of national income. The coalition that took office in May set out to close most of that gap within a single parliament, mainly through spending cuts, with a rise in VAT to 20 per cent on top.

Three ideas carried the case. The first was Greece. Its borrowing costs had soared in the months before the British election, and ministers argued that a country with a deficit like Britain’s could suffer the same loss of market confidence unless it acted quickly. The second was the claim, associated with the Harvard economist Alberto Alesina, that cutting spending could itself boost growth by restoring the confidence of businesses and households. The third was a 2010 paper by the economists Carmen Reinhart and Kenneth Rogoff, which appeared to show that growth fell away sharply once public debt passed 90 per cent of GDP.

Each of these has since been weakened. Britain borrows in its own currency through its own central bank, and interest rates on its debt have stayed low throughout, as have those of other countries in the same position, whether they cut hard or not. The confidence effect proved hard to find outside a few special cases, such as small open economies that could cut interest rates or devalue at the same time. And in April 2013 three economists at the University of Massachusetts Amherst, Thomas Herndon, Michael Ash and Robert Pollin, found a spreadsheet error and some questionable weighting in the Reinhart and Rogoff data. Once corrected, the cliff at 90 per cent disappeared, leaving a much milder link between debt and growth whose direction of cause remained open.

What the multipliers said

The technical heart of the argument is the fiscal multiplier: how much national output falls for each pound of spending cut or tax raised. When the Office for Budget Responsibility assessed the coalition’s first budget in June 2010, it used multipliers that ranged from 1.0 for cuts to capital spending, through 0.6 for welfare and day-to-day departmental spending, down to 0.3 for income tax and National Insurance. On those assumptions the damage from austerity would be real but modest.

Growth did not follow the forecast. In its forecast evaluation report of October 2012, the OBR worked through what had gone wrong. It estimated that Labour’s last budget and the coalition’s first between them tightened fiscal policy by about 3.3 per cent of GDP over 2010-11 and 2011-12. Taken at face value, its own multipliers implied that this would leave GDP in 2011-12 about 1.4 per cent lower than it would otherwise have been. But growth in 2011-12 came in at 0.5 per cent against a forecast of 2.4 per cent, and the OBR calculated that the multipliers would have had to average 1.3, more than double its estimate, to explain the whole shortfall. It was careful to point to other causes too, including high inflation squeezing household spending and the crisis in the euro area.

The International Monetary Fund went further. In its World Economic Outlook of October 2012, and then in a working paper in January 2013 by its chief economist, Olivier Blanchard, and his colleague Daniel Leigh, it compared growth forecasts with outcomes across European economies. Countries that had planned bigger consolidations had consistently done worse than forecast. The authors concluded that the multipliers built into the forecasts, around 0.5 on average, had been too low by roughly one, which means that each pound of consolidation had cost more than a pound of output in the early years of the crisis, rather than the fifty pence or so that forecasters had assumed. The IMF had itself backed the British plan when it was announced.

Why growth came back

Growth returned in 2013, and by 2014 Britain was among the fastest growing economies in the G7. Supporters of the government took this as vindication. Critics, Krugman among them, answered that most of the tightening was concentrated in the first two years of the coalition, that the pace of consolidation slowed sharply after 2012 as targets were pushed back, and that an economy is expected to recover once the drag is removed. On that reading, the recovery was delayed by austerity rather than produced by it.

The OBR’s figures for March 2015 support at least part of this. Borrowing in 2014-15 is estimated at £90.2 billion, or 5.0 per cent of GDP, about half the peak as a share of national income. The original plan had aimed to close the structural current deficit by 2014-15. Instead, about half of the total reduction planned for 2009-10 to 2019-20 has been done, and the rest has been rolled into the next parliament. The March 2015 Economic and Fiscal Outlook shows the government’s spending plans reaching a small surplus in 2018-19, which would require deep further cuts to departments outside the protected areas.

Economists have largely drawn their conclusion. When the Centre for Macroeconomics asked its panel of UK economists this month whether the coalition’s austerity had a positive effect on output and employment, 15 per cent agreed and 66 per cent disagreed, with the rest undecided. That is not unanimity, but it is a clear verdict.

Why the argument held on

If the economics has moved, why has the politics not? Krugman offers several answers, and some of them stand without his sharper edges.

One is the household analogy. Most voters think about the national budget the way they think about their own: when money is short, you cut back. The fact that a government cutting its spending in a slump also cuts the incomes of the people who would pay its taxes is harder to fit into a sentence. Politicians of every party use the family budget comparison because it works on the doorstep.

Another is that Labour never mounted a sustained challenge to the premise. Having been in office when the crisis struck, the party accepted the story that its spending had been the problem, even though the deficit before 2008 was modest by historical standards and the explosion in borrowing followed the banking collapse. Its manifesto for this election opens with what it calls a Budget Responsibility Lock, a promise to cut the deficit every year. The argument between the parties is now about the pace of cuts and their mix, not about whether they are needed.

Talk of deficits has also served a purpose of its own. Ministers have said openly that they want a smaller state for its own sake, and that is a legitimate position to argue for. It is a different argument from the claim that the bond markets left no choice, and conflating the two has made both harder to examine.

For the organisations this site writes about, the distinction matters. Community groups, advice services and social enterprises that deliver public services have spent five years absorbing cuts to council budgets and grant funding, and the plans on offer promise more. Whether those cuts are needed to stave off a debt crisis, or chosen because a smaller state is preferred, is a question voters are entitled to have answered plainly. Krugman’s essay insists on that distinction, and the official evidence from the OBR and the IMF gives it firm ground.

Since then, the general election of 7 May 2015 returned a Conservative majority government, and the programme of further spending cuts went ahead.