The Austerity Fallacy

If you’ve been on a long-haul aeroplane ride in recent years you will no doubt be familiar with the fantastic invention of noise-cancelling headphones. Noise-cancelling headphones use a microphone to measure background noise and then cancel it out by transmitting the “opposite” noise through the headphones.

I use the word “opposite” a bit clumsily here. I don’t mean that if there is a “woof” in the background then the headphones transmit a “meow”. I mean that if there is a sound wave that looks like this:

Background noise

Background noise

Then the noise-cancelling headphone produces a sound that looks like this:

Noise-cancelling effect

Noise-cancelling effect

Note that the peaks of the background wave line up with the troughs of the noise-cancelling wave and vice versa, so when we add them together they offset one another. The noise-cancelling wave probably won’t be perfect and remove the sound completely but it will get rid of most of it resulting in a smaller version of the original background noise (the green line below):

Noise-cancelling wave

Noise-cancelling wave

Essentially it works the opposite way round to a hearing aid. A hearing aid also has a microphone but instead of transmitting the “opposite” noise through the earpiece, it transmits the same noise – i.e. the peaks and troughs all line up. This time, rather than cancelling each other out, the waves combines to produce a bigger version of the original wave:

Amplifying Wave

Amplifying Wave

Now you might wonder what all of this has to do with austerity. I’m coming to that but before I do let’s remember an important economic principal that I have mentioned many times before:

In the economy, my spending is your income and your spending is my income.

What I mean by this is that everyone’s income is a result of someone else spending money. If I buy a new pair of shoes then that gives income to the people who work in the shoe shop, people who work in the factory that produces the shoes, people who produce the raw materials such as leather, rubber, cotton, plastics etc that go to the factory, people who drive the lorries etc that deliver the raw materials to the factory, etc etc etc.

How did I get the money to buy the shoes? Someone else spent some money on the good or services that I help provide in my job. The point I am making here is that in the economy, spending and income are two sides of the same coin – you can’t have one without the other. Although this is the case, it is far easier to find a politician who says that we should all reduce our spending than it is to find a politician who says that we should all reduce our income. Politicians are a funny sort though. Anyway let’s talk about spending.

In the economy, at the highest level, we have two classes of spending – private spending and government spending. Private spending covers things like household spending, (such as the pair of shoes I bought) and the spending of companies. Government spending covers things like the NHS, state education, the armed forces, council budgets, roads – well, anything the government might want to spend money on.

The sum of private spending and government spending represent the total spending that is going on in the economy and therefore the total income. In order to maintain a healthy economy a healthy level of spending needs to be maintained but unfortunately the private sector is very unreliable in this respect.

The economy is sometimes good and sometimes not so good. When the economy is good the private sector wants to spend money – companies have lots of demand for their goods and services so they increase supply to meet the demand. This means employing more people opening new shops or offices or buying more raw materials from suppliers etc. When the economy is bad and demand for their goods and services is low they respond by reducing spending – making redundancies, closing shops, buying less raw material from suppliers etc.

So private spending over time might look a bit like this:

Private Spending

Private Spending

Those peaks are nice but those troughs are a problem. During those troughs, other things being equal, the economy as a whole is going to suffer from a lack of spending and a lack of income. Other things do not have to be equal though.

When the economy weakens, the government usually responds by cutting interest rates. This helps by making saving less attractive and borrowing and spending more attractive. More often than not this is enough to get the economy heading back in the right direction. In the case of the current financial crisis though it has not been enough to get things back on track. Interest rates were cut to near zero over three and a half years ago but the economy is still not recovering. Even with extremely low rates people would still rather save and pay down debt than borrow and spend.

So what are we left with? Remember that total spending is made up of private spending and government spending. We know that the private sector isn’t spending so we’re left with government spending. If the government keeps their own spending constant then overall spending will drop by the same amount that the private sector cuts spending. That doesn’t help.

The government could act as noise cancelling headphones though – increasing spending when private spending drops and cutting it when private spending rises. This might look like this:

Sensible Government Spending

Sensible Government Spending

You notice that when the government spends like this it helps to fill in the troughs and helps to stop overall spending (and therefore income) plunging by as much as it would if left to the private sector. (Note – we’re not asking the government to spend more overall – we’re asking the government to spend more when the private sector is not spending and less when the private sector is spending.) When interest rates can’t help then this is a very sensible fiscal policy – spending and income is to a large extend maintained.

Let’s look for a moment though at the opposite fiscal policy – what would happen if the government chose to cut spending at the same time as the private sector? (Essentially fitting a hearing aid when noise-cancelling earphones were required.) Now the government actually amplifies the effect of the private sector downturn:

Daft Government Spending

Daft Government Spending

Bizarre as it might seem, this was the choice of the UK coalition government. Rather than act to offset the spending cuts of the private sector they chose to amplify them and instead of smoothing over the cracks they have opened them up.

This is the Austerity Fallacy – the widely held belief that cutting government spending when private spending is depressed will create economic growth. But your spending is my income and my spending is your income. The government has intentionally engineered a situation where no one in the economy is spending which bizarrely they expected to create growth.

Just in case I get the usual arguments in the comments on this post, I’ll address them now in a pre-emptive strike:

But government spending is what got us into this mess in the first place!

No it isn’t, I already covered that.

But if we don’t slash spending then the rates at which the UK government can borrow will become unaffordable!

No they won’t, I already covered that too.

Damn you! But we can’t spend more than our income forever! (Ha! I have you this time!)

You have not read this post properly. I do not say the government should increase spending forever. When the private sector is weak and unemployment is high then there are lots of spare resources in the economy that increased government spending can utilise. When the private sector is strong then the government can reduce spending safe in the knowledge that there are plenty of jobs being created in the private sector for people to move to.

I am definitely not advocating high government spending when the private sector recovers – quite the opposite in fact. We have long-term problems in the shape of the government’s commitments to pensions. With an ageing population our pension liability is increasing far quicker than our motivation to address it. I agree that we need to get on top of these things but to decide to try to do it in the middle of a depression is frankly very stupid.

When the economy is not working our government has an immediate obligation to fix it. When it is fixed we can go about tackling the long-term things but attempting to tackle them when the economy is depressed is self-defeating – both in theory and (thanks to the government) we can now see, in practice.

The government’s policy of choosing to amplify the downturn is not just a mistake, it is entirely negligent and is not just causing unnecessary hardship and unemployment today, it is creating problems that will negatively affect the economy and the lives of many for years to come. Middle-aged people who have worked all their lives are now amongst the long-term unemployed, their savings spent and the prospects for the second half of their careers in tatters. University students are graduating into an economy that has no use for them. Rather than take the skilled jobs for which they have trained they are forced to choose whatever is available and this will affect their prospects and their incomes and their spending and everyone else’s incomes for their whole lives.

Whatever we do now, the effects of Cameron’s and Obsorne’s austerity experiment will be felt far into the future and the Chancellor’s new policy of further cuts to welfare in order to pay for the backfiring of this experiment is almost beyond belief.

Every model of the current depression says that we will eventually recover. Even with the current government’s policy of amplifying the downturn, all models suggest we’ll get back to a sustainable economy eventually. But why didn’t we do something that would have brought us to that conclusion two years ago? Or failing that why don’t we do it today?

The government won’t do it though because it would be political suicide to admit that they had got things so wrong. Too late for that – better to plough ahead and hope they can convince the public to swallow The Austerity Fallacy for another two and a half years.

RedEaredRabbit

*In the UK The Bank of England were made independent in 1997 so it is now they who set interest rates rather than the government. If only we could find someone to take over fiscal policy too…

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About RedEaredRabbit
My name is RedEaredRabbit, King of Kings. Look on my works ye Mighty and despair.

12 Responses to The Austerity Fallacy

  1. Daniel Ripley says:

    Hi

    My knowledge of economics is poor, so I don’t know how best to address Britain’s fiscal woes. However, I’ve heard this argument that increasing government spending is the answer, many times.

    If this is the best approach, then why would our government choose to do the opposite? Regardless of what one thinks of the people in government, isn’t it safe to assume that some of them have studied economics and learnt from the mistakes of their predecessors?

    It just baffles me why a government would deliberately choose the wrong course of action, one which is likely to see them lose at the next election.

    I’d be grateful for your opinion on this. I’d also be interested to know about your economics experience.

    Thanks,

    Dan

    • Hi Dan,

      It’s certainly a good question! I can’t say for sure but can offer an opinion about why the government is continuing to pursue the wrong policy even though it has continually failed to deliver the growth that they promised.

      It certainly does look odd if we consider it purely an economic problem but perhaps less so if we look at it also as a political one.

      Firstly different parties hold different political ideals, which means that they might do different things when presented with the same situation. Parties on the left often tend to favour a larger public sector and parties on the right often tend to favour a smaller one.

      Many of the policies that the coalition is pursuing would be those that you might expect a Conservative led government to pursue anyway. Cuts to welfare, cuts to the top rate of income tax, cuts to education, local councils, police etc

      When they came to power the economy had actually been growing unspectacularly for a year and they probably thought that it would recover on its own without the need to pursue an expansionary fiscal policy. And that wasn’t necessarily a terrible point of view. There was a lot of disagreement within the economic community about whether such a policy was needed or the economy would just recover on its own – after all, in every recession since the Second World War the economy basically sorted itself out before too long.

      So although in hindsight it’s easy to look back and say they made the wrong choice it is understandable how it happened. What is harder to forgive though is their behaviour since then. A sensible way of taking that policy forward would be something like:

      – we believe that the economy will recover without the need to further expansionary fiscal policy
      – we cannot be sure though so we will closely monitor the situation and be prepared to adapt our policy based on how things go

      There is a strong political problem with the second point though because we live in a society that does not accept politicians who say they need to change their policy because it didn’t deliver the results they said it would. We say they’re making a u-turn and they can’t be trusted etc. Because we do this, we effectively force politicians to stick with whatever policy they started with. Cameron has a much better chance of reelection by sticking with his policy and misleading the public about the alternatives than he does by changing his policy.

      It’s mad when you think about it. In my job if I was pursuing a particular strategy and it was clearly not working then I would adapt it and that would be seen as a good thing. In fact if I pursued a strategy that delivered the opposite of what I said it would for several years then it would be looked on very badly.

      While I don’t consider the economic problem particularly tricky to solve I have no idea what to do about the political one.

    • L says:

      Daniel: I’m no economist either. But my understanding is that the Tories have an ideological hatred towards the welfare or ‘nanny’ state, to national services (trains, health, post, water, power, etc etc), and have a complete evangelical belief in the private sector. They know that they may only have 5 years in power (they’re only in power because the LibDems propped up their numbers), and for them to change the structure of society to fit their ideological ideals, they have to do it in that small window of opportunity, regardless of the economic situation. This is what they are doing.

      When people say the cuts are ideological, that is what they’re referring to – that the cuts aren’t ‘necessary’ to fix ‘the mess inherited from the previous government’, they’re necessary to break apart public services and sell them to the private sector, and shrink the welfare state. And this isn’t just because they believe that the public sector is bad for the country (I don’t even know if they do actually think that), it’s because they know that the private sector is better for them. They are protecting their own futures, and their own investments. The rich know how to stay rich, and when they’re in power, they will manipulate the system to enable it.

      So not only are these cuts unnecessarily ruining the lives of people worse off than them, they are breaking apart public systems irreversibly. Companies they are affiliated with will then start to profit, and siphon more money out of the economy (because they don’t spend like the public spend), where previously the money was in the public realm. With the current tax avoidance of both corporations and many millionaires (see: Gideon Osborne’s offshore £4million; using taxpayer’s money to pay for his paddock, at a cost of £450,000, which he sold for a £450,000 profit; etc etc etc etc), this will see more money being sucked from the common pool which we all have a right to.

      So unless someone corrects me: the reason they are doing the exact opposite of what they should be doing is not because they’re stupid or uninformed. Quite the opposite, they’re very clever and very educated. They’re doing it, simply, because they are greedy, irresponsible thieves.

      • L says:

        RedEaredRabbit – as I realise I said what you said, but far worse (I’d not seen your reply), feel free to not publish my post as it isn’t exactly analytical and did get a bit, um, emotive.

        But I certainly believe that the reason they’re doing this is because that was always their dream, and agree that they probably thought it’d sort itself out. Because, as I said, their trust in the private sector is unshakeable.

        Thanks for a brilliant article, as always.

      • I think we were saying the same thing – essentially it’s a political problem rather than an economic one.

    • Ben says:

      A point worth making is thar the people who are (nominally) in charge of various government departments do NOT necessarily understand their briefs. George Osborne is the Chancellor, & studied history at university, and has only ever really worked in politics. Jeremy Hunt is in charge of Health, and studied PPE and has taught English in Japan, and worked in PR

  2. Very interesting as always, and it seems to make logical sense. It would be interesting to have some rough figures to understand how much increased/decreased govt spending could possibly affect overall spending – I have no idea if govt spending is 0.1% or 49% of overall spending, and that’s quite important to the argument. (Saddling ourselves with a huge debt to increase overall spending by 0.1% might not really help in any practical way, even if the debt were not a big problem, as you suggest.)

    My question (again) is why nobody else holds this view, or if they do, why their view is not slapped all over the front of The Times. There are many examples of verifiably bad government decisions which are also not widely covered by the press (e.g. badger culling) but this one seems a bit big to ignore.

    Just to be clear, I am absolutely not saying they are doing the right thing. I have no political allegiance. I’m just interested in the evidence. (Important: “Their theory is wrong” does not prove “My theory is right”.)

    • Hi,

      Well a lot of people hold this view. Much as I would love to be breaking new ground with economic theory, I would describe my blog more as attempting to put a fresh perspective on explaining existing ones.

      Lots of people have written about this stuff before – try Martin Wolf at the FT, Jonathan Portes at NIESR, Brad Delong or Nobel Laureates Paul Krugman or Joseph Stiglitz.

      As to why it’s on the opinion pages rather than front page news, well that’s up to the newspapers. If I had one I’d put it on the front page. Still front pages tend to be about a single current event rather than a policy that has just delivered the opposite of what was claimed it would do for two and a half years.

      Still Martin Wolf does write very well about this kind of thing in the FT quite often.

  3. Nick says:

    Such an informative post. I wish everyone would read this. We are being swindled by a government we didn’t vote for!
    I have a question; the government is pressing ahead with its cuts and justifying it by saying that our national debt is shrinking. Having read your articles I am sure that its reduction is not down to austerity measures, but what is it down to and would it shrink quicker if we were spending our way out of this?

  4. Madra Rua says:

    Hi Rabbit,

    While I agree with a lot of the theory that is in this piece I am confused about how some of it would make sense in real world situations. For example I am in Ireland, (and if there is a need for useful economics anywhere, it is here), when times were good the economy boomed. By your analysis we should have reined in government spending. The problem with that is, as employmnet increased, population increased. That has the knock on effect of requiring more government spending to provide schools, hospitals roads and other utilities- a need which didn’t exist in leaner times.

    Even if you could justify to an electorate an increased public building schemes for schools etc. when there isn’t a need for it I am not sure it would be responsible to do so as they may be redundant, misplaced or unsuitable if the time came to use them. I say if because while I do believe in economic cycles I do not think that they are symmetrical and that our needs today willnot necessarily mirror our needs in the future. Costly infastructure which made perfect sense in the 80’s during our last big recession would have been useless in the recent boom times. We had moved on from the telecommunications which existed then, the large multinationals which had been located towards the centre of cities and towns moved outside of the cities to business parks an depots. This has an effect upon population with people wanting to be near jobs and on where the most efficient roads should be buit.

    I do like the simple ideas contained in this piece, I am just worried that it is human nature to have an irrational herd mentality and this will continue to produce booms and busts and bubbles in everything from property to shares. When prices rise people take confidence in this as a sign of strength and buy/pay more. When prices fall the opposite. I’m not sure economics never mind the government can ever temper this.

    Thanks,

    Madra Rua

    • Hi Madra,

      Thanks for the comment – there’s quite a lot in there but I’ll do my best to reply to each point.

      Ireland’s population has been increasing at a fairly constant rates for past fifty years. With that does come an increased need for certain types of government spending irrespective of the state of the economy. However, during the good times this population increase meant that there were more people in work so this also meant higher tax revenues for the government. So while they might not cut spending in absolute terms they might still reduce it so that it were less than their tax revenue and run a surplus.

      Regarding what the government spends money on there’s two ways to approach this. The basic economic view says that to stimulate the economy it doesn’t really matter what you spend the money on. The government could employ 250,000 people to dig holes and 250,000 other people to fill them in again. This would stimulate the economy but clearly there are better ways to spend it. Renewable energy would seem like a good option but either way – I’m sure the limitation is not that we can’t think of something to spend the money on.

      Economic cycles are not symmetrical at all – you’re right. This was just a simplification in order to make it visually clearer on the graph. It doesn’t change the underlying argument though.

      Lastly, regarding booms and busts, I agree that nothing has been done to prevent the private sector causing them in the future. I expect them to continue to happen – that’s precisely why I want our governments to be prepared for them and to meet them with responsible fiscal policy.

      RedEaredRabbit

  5. Pingback: The Worst Speech Ever Made | RedEaredRabbit

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