The Austerity Fairy
25/01/2012 14 Comments
Today I’ve been playing with the greatest toy ever created. It’s not a Sony Playstation and it’s not a Pokemon. It’s a Rubik’s Cube.
The Problem
One of the things that makes a Rubik’s Cube so great is that the problem you are trying to solve is very easy to understand. From the time you first picked one up, you understood exactly what you had to do – arrange it such that each face of the cube was the same colour.
The Solution
The very best people in the world have solved it in under 10 seconds, putting through around 5 moves per second.
I’ve just tried making 5 moves per second and I couldn’t even get close.
Let’s imagine taking someone who could move the cube this fast but didn’t know what they were aiming at, that is they know there is a single arrangement of the cube they are aiming for but don’t know what it is so they need to try every possible permutation. I done a sum and by my reckoning, assuming they were able to go at 5 moves per second and were able to keep track of every permutation they had tried so that they never hit the same one twice, it would take them around 274 billion years to get through them all and be sure to have hit the solution.
6 seconds vs 274 billion years – the importance of understanding the problem you are trying to solve.
So anyway, the economy is shrinking again – down 0.2% in the final quarter of 2011 😦
George Osborne was not worried though:
We have the right plan and we’re going to stick with it!
In fairness to him he was half-right. We are going to stick with it.
George thinks the problem is spending. He thinks that as long as we spend less, at some stage the Austerity Fairy will show up and magic the economy back to health.
He blamed firstly, the reckless spending of the Labour government. Let’s get this one out of the way quickly with the IMF data I’ve put on here before. Between 1997 when Labour came to power and 2007, the year before financial meltdown, the UK’s debt as a proportion of its GDP was the lowest in the G7. In every single year:
Government debt as a percentage of GDP (Source IMF)
Yes, the UK is the orange line at the bottom.
Next he blamed Europe. Wait a moment – is that the same Europe who are also awaiting the arrival of the Austerity Fairy? How’s that working out for them? Oh.
Much as George would like it, it’s actually not all everyone else’s fault. The reason George has not solved the problem is because, like the poor bugger spending eternity on a Rubik’s Cube he doesn’t understand the problem he is trying to solve.
The problem isn’t that we currently have too much spending. The problem is a lack of growth and high unemployment. Let me explain further.
In normal economic times when employment is high, if the economy starts looking a little shaky the Bank of England can cut interest rates. Lower interest rates make people want to save less money and spend more. When people spend more the economy picks up. Even Robert Peston knows that.
We are not in normal economic times though. Interest rates have been at an all time low for almost three years and you know what? No one is spending. For the rising number of unemployed this is understandable but for the people who kept their jobs why would they be saving more and spending less with such low interest rates?
It’s fairly simple. In an economic depression, even those people with jobs are scared that they might not have jobs at some time in the not so distant future. What would happen if they were made unemployed? Probably they wouldn’t walk straight into another job so they save. Even with crappy interest rates they save.
We have reduced interest rates pretty much as far as they can go but have still not got people spending again and we have therefore become stuck in something that economists call a liquidity trap. We have nowhere to go with interest rates so as long as the economy is weak no one will spend and as long as no one will spend, the economy will be weak.
This is the problem. Understand that much and the solution is a bit easier to grasp – you plug the gap with government spending until employment goes back up to healthy levels and people are spending again. When people are spending again, then you reduce it.
Even if George were able to grasp the economic problem, it would lead immediately him to a political one. How would he possibly explain to the public that for the past 20 months he had pursued exactly the opposite strategy of the one he should have? It would be political suicide. He’s not going to do that.
Better to take David by the hand and skip off together down the road to nowhere in search of the Austerity Fairy.
RedEaredRabbit
About RedEaredRabbit
RedEaredRabbit 
My understanding is that the problem is not the Government debt – which, as a share of GDP, is, as you say, low by international and historical standards (although it started rising as a share of GDP in 2007-8) – but two problems: net private and public debt, and the budget deficit.
Total private and public sector debt is apparently around 500% of GDP gross (up from around 220% in 1990) and 280% net (since bank debt tends to be offset by matching assets) – this net figure is apparently higher than any other major economy’s (except Japan’s). It reflects a heavily indebted population – low interest rates are designed to reduce this debt burden.
The deficit – the difference between what the government spends and what it raises in taxes is apparently very high – at around 12% of GDP. The previous recent high was about 8% in 1995 but the budget was in balance in 1997 and ran a small surplus until 2001/2.
Then the deficit started to increase again – running at around 3-4% for six years (during a period of growth – when J.M. Keynes would have suggested running a surplus) before the crash of 2008, which saw it shoot up.
No one is talking of paying off the government’s National Debt – the scary £1trn headlines are just nonsense. No one is even talking about reducing the debt (it is projected to rise over the next five years – and would have done regardless of which party was in power).
Both the coalition and Labour have consistently said they would bring spending (the deficit) under control – the coalition plans are not that different from the previous government’s announced on the eve of the general election. (The too far too fast debate is semantics – neither route would have been anything less than painful.)
If the deficit does not come down – the government’s borrowing costs might rise – that would increase the national debt. The issue with that is not so much the total size of the debt but the share of GDP that has to be diverted to pay the interest on outstanding debt.
The question that has to be answered is: how sustainable is a Deficit (not debt) of 12% of GDP – if it is not sustainable (few suggest it is) then how do you reduce it (combination of tax increase and spending cuts) that’s where the hard bargaining comes in.
Kind regards
H
Correction of sorts – while no one is talking about reducing the national debt – there is, as part of the deficit debate, an argument about how to reduce the rate of increase in the national debt.
Although Government debt as a share of GDP is currently still relatively low by comparison with other countries (64% of GDP), it is rising.
The Deficit is not sustainable at 12% of GDP because the national debt, as a share of GDP, would rise at an accelerating rate. This would increase debt repayments as a share of GDP – which would make the deficit worse, which would further accelerate the growth in the debt – creating a vicious circle.
My understanding is that even if the Deficit is reduced the National Debt will increase to some 70% of GDP by the time of the next election.
So – debt/deficit dynamics currently not good – but might be slowly improving.
Question: How do you, at the very least, prevent a further collapse in GDP (we are still some 3% below trend following the crash of 2008) – and possibly stimulate some growth without increasing the deficit without making the debt dynamics worse?
A: I don’t know – but long term investment in strategic infrastructure strikes me as one essential element, since it increases the long term growth potential in the economy. Faster roads (particularly on national east-west routes) and faster broadband would be a start.
My final point: the size of the debt in cash terms (the nominal figure in £) is irrelevant (except to foaming-mouthed readers of certain tabloids) – as is the deficit in cash terms – since the amount tells you nothing – there is no context.
You must always consider both in terms of their ratio to GDP (since that gives you some idea of our ability to finance them). More importantly you have to know the trajectory and rate of change. Is it going up or down and how fast. That is where the debate lies – not in the cash sums.
Someone with £10k of debt may well be worse of than someone with £100k of debt. If the first only earns £20k a year and is paying interest of 20% they will have difficulty just meeting the interest payments and little chance of paying off the principal (pretty much the situation in Greece and Portugal at the moment).
The second may have secured an interest rate of say 3% and have earnings of £1m a year – they can comfortably pay the interest and repay the principle in time (Sweden perhaps).
The UK is somewhere in between – interest payments are manageable – but we aren’t paying back the principle (some might argue that we are simply aiming to reduce its value through a mix of inflation and growth).
The trouble is, the debt is increasing because of the recent sharp increase in the deficit. That rate of increase in the debt might accelerate, particularly if interest rates rise, unless the deficit is stabilised and, in time, reduced.
However, if the plan to control the deficit does not appear credible, markets (your pension funds) might demand higher interest rates sooner – this would further increase the deficit (because it would increase the interest we pay on our debt as a share of GDP) – unless further reductions to spending are made elsewhere. So you see this can become a vicious circle.
What ever any politician tells you bare in mind three things: there are no perfect answers, any answer involves some very tricky balancing, whatever path you choose will be quite painful.
Kind regards
Huw
@HuwSayer
Darn! “…worse off..”
I should probably start by thanking you for taking the time to write all of that. Also you make a lot of very good points and I will try to address the main ones at least.
I agree private debt in the UK is extremely high. This is I think a large factor in why our economy faired worse than many others when the financial crisis hit in 2008 (also we were more reliant on our financial sector than some other economies). It also helps to explain why even with very low interest rates people are not spending. They are in save/pay off debt mode even though interest rates have never been so low for so long and we have run out of room to cut interest rates any further.
I also agree that the deficit is certainly high by historical standards and I agree it is not sustainable over a long period. However if you look at the proposed government cuts they are not nearly enough on their own to get rid of it by the end of this parliament (this was their target.) This wasn’t because they did their sums wrong, it was because in their model they required economic growth as well as spending cuts to eliminate the deficit.
I am not advocating sustaining the deficit indefinitely, just proposing that since all models to reduce it require economic growth, pursuing policies that prevent economic growth is counterproductive. An alternative, of which I am in favour, would be to stimulate the economy now to bring unemployment back down and then reduce spending and raise taxes (mainly on higher earners) when the economy has recovered.
All other things being equal it makes little difference whether we start reducing the deficit now or in a couple of years time. All other things are not equal though, and attempting to reduce it when the economy is shrinking, I believe, has prevented economic growth and raised unemployment unnecessarily. If we had a healthy private sector to step in and snaffle up all of the unemployed people then fine but we don’t, so spending cuts = unemployment and unemployment is hugely expensive for the economy. (Not to mention fairly horrible for the people who are living with it.)
It is very cheap for us to borrow at the moment and unlike the Eurozone countries our debt is in a currency that we have control over printing so we are nowhere near being considered a default risk.
As you mention, UK GDP is still way below its 2007 peak and while we have a large interest cost, we also have an implicit cost due our GDP being kept down by austerity. The former problem, as you mention is going to be around for an awfully long time, but the latter could be addressed in the short term by an economic stimulus. The government at the moment seems to be intent on making both long term problems.
This paper is good, although quite mathsy. http://www.princeton.edu/~pkrugman/optimalg.pdf
Anyway, thanks again for taking the time to read and comment.
RER
@HuwSayer – very good comments, which I applaud.
I’d also like to add that the post doesn’t consider the long game – while things are in the doldrums now, I believe that is because people are in “batten down the hatch” mode and are paying off personal debt or simply saving\investing. Once people have a comfortable level of personal debt again, they will start spending and the economy will start moving.
I Am Not An Economist, but I would see this happening in around two to three years, purely because of the way my coffee grounds lay this morning when I emptied the сafetière..
I agree I was a bit brief on the long game. The short game was stimulate the economy to get employment back to a healthy level and the long game would be to reduce spending and increase taxes once everyone had a job – whilst ensuring economic growth and employment was maintained.
This would likely mean that after returning to employment and growth we had a long period of slow growth but that seems to be the best outcome we can expect.
Thank you FO and RE for your replies.
Broadly I agree with you that policies that hinder economic growth are counter productive. I also think part of the problem is a lack of confidence on the part of consumers and business.
Unemployment as you say is hugely costly to the economy, society and those personally affected – in many ways it is as damaging to the economy as high borrowing. We therefore need to do more to bring this under control (perhaps we need an ’employer of last resort’ as much as the banks need a ‘lender of last resort’).
A long period of slow growth might be the best we can hope for but as yet we don’t even look close to achieving that. Sadly, the policies of the mainstream parties fail to convincingly say how they will balance the need to control the deficit, boost growth and keep interest rates low.
As you say, RE, we should use the current very low interest rates to fund very long term investment in infrastructure that supports growth. Sadly the one big project, HS2, seem like the wrong thing, in the wrong place for all the wrong reasons.
Roads deliver a far higher return on investment than rail – and increase workforce flexibility. My suggestions are here http://huwsayer.wordpress.com/2012/01/27/infrastructure-ideas-for-long-term-growth-just-dreaming/ and here http://huwsayer.wordpress.com/2011/11/13/keep-on-dualling-to-keep-the-economy-trucking/.
Thank you for the Krugman link – will study later.
Best wishes
Huw
@HuwSayer
Completely agree that HS2 looks very suspect for several reasons. I don’t know an awful lot about roads vs rail but would very much like to see investment in renewable energy. We have to move in that direction anyway, so why not use this as an opportunity?
Thanks for the reply, Rabbit. Your reply to Huw was good, so you needn’t have bothered with me over in the peanut gallery.
You suggest we should borrow, as we’re good for a buck or two at the moment.
I feel that would be a mistake. The reason (IMO) we have cheap rates is because we aren’t borrowing (in an investment sense). We have a perverse situation where if we used that cheap money, it suddenly wouldnt be cheap.
To me it’s an economic Weisz marshmallow test – if we can leave it alone, the reward will be better.
Despite my suggestions above – I fear FO you may well be right about the illusion of cheap money – at same time we need to avoid prolonged slump on the scale of those in Greece, Spain and Portugal – hoping free floating sovereign currency might just be our lucky penny.
It’s less that it’s our lucky penny, more that it’s their millstone.
I don’t see why all the people falling over themselves to lend us money would suddenly disappear if we took some of it.
All the government rhetoric is about our country being bankrupt but it isn’t and the market clearly understands we are not a default risk and are nowhere near becoming one.
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