Austerity v Growth: A False Dichotomy

Politicians’ commentary on the state of the UK economy remains frustratingly tendentious and unsophisticated. The rhetoric of both the “austerity”  and “growth” camps is overly simplified and needlessly polarized. Action is needed to stimulate growth. However, this fact doesn’t necessitate adding to the debt burden. The economics of the fiscal multiplier implies greater concern should be given to the composition of spending cuts and tax rises. By designing our austerity strategy to reallocate resources to “high multiplier” activities, growth can be initiated during fiscal consolidation. Elucidating this common ground between the camps is required to move the debate forward and set the stage for the development of a credible and equitable austerity strategy.

Recession? Depression?

More than two years since the UK entered recession, the much anticipated recovery is yet to make its appearance. This week the ONS confirmed that the economy contracted by 0.2% in the last quarter of 2011, a consequence of chronically weak business investment and manufacturing. GDP remains almost 4% below pre-crisis peak. Comparing the current recovery to those following past recessions is chilling. The graph below, taken from Jonathan Portes’ blog, shows that output has already been depressed for longer than that experienced during the Great Depression, and looks set to remain so for the foreseeable future.

The current malaise is the product of weak demand, causing the economy to operate approximately 3% below its potential, and of reduced potential supply. Households and the government are set on consolidating their balance sheets and the Eurozone crisis has effectively foreclosed an export led recovery. There is thus little incentive for investment. The latest negative growth figures therefore come as no surprise.

Ongoing weak demand and reductions in supply capacity are linked, a phenomenon economists call “hysteresis”. If demand for a firm’s output is depressed for a prolonged period, machinery is scrapped and planned investments go unimplemented. Workplace skills and the likelihood of returning to work altogether decline in the length of an unemployment spell, reducing the stock of “human capital” in the economy. Not only has unemployment continued to rise in the UK, but it is increasingly long term and concentrated among the young. Youth unemployment has especially pernicious consequences, affecting the individual and economy for far longer than the spell of joblessness itself. Those experiencing spells of unemployment while young face significant wage penalties and a higher risk of future joblessness compared to their peers for decades, even after controlling for a wide array of individual and family characteristics (see, for example, Gregg and Tominey (2005) and Mroz and Savage (2006)). Thus, the fact that 18% of 16-24year olds are ‘NEETs’ (Not in Employment, Education or Training) should be sending alarm bells ringing through Whitehall. Their current idleness is not just an awful waste of their talents at this particular moment but makes it more likely for them to become trapped in dead-end areas of the labour market for much of their adult life. This is unfair, they did not choose to be born at a time dictating they join the workforce during the worst post-war recession, as well as being highly damaging to the wider economy.

Poor growth prospects ultimately make it harder to finance those dreaded debts. Low economic activity implies lower tax revenues, acting to undermine the UK’s fiscal credibility. In November, the OBR announced that £15bn of tightening is required in addition to what was initially anticipated to meet the deficit reduction targets. Moody’s, the rating agency, put the UK’s AAA credit rating on negative outlook, citing weak growth prospects and Eurozone exposure as justification.

Austerity v. Growth: A False Dichotomy

It seems like an impossible situation. Low growth undermines our fiscal credibility but, so we are told, raising government spending is off the cards as it will add to the national debt, spooking the markets, creating financial turmoil. With both austerity and growth strategies, it seems to be a case of damned if we do, damned if we don’t.

However, all is not lost. First, the downside risks of slowing the pace of fiscal consolidation are overblown and small relative to the costs of continued deficient demand but, leaving this to one side, the situation is not as hopeless as presented. We are not, in fact, faced with the choice of austerity or growth. This dichotomy is false and damaging. Rather than seeing this as a one-or-the-other problem, we should focus on the design of austerity strategy and how fiscal consolidation can be achieved with the lowest impact on growth and demand. It isn’t just a case of “tighten or not” but also “how to tighten”. By reallocating government resources to activities with a high fiscal multiplier, growth can be supported while the budget deficit is reduced. Enacting this principle also implies equitable policy reforms, dictating a transfer of resources from the richest to the poorest in society.

The Fiscal Multiplier

The fiscal multiplier gives the impact that changes in government spending have on overall demand in the economy. With a multiplier of 1, an extra pound of government spending raises total demand in the economy just by a pound. However, we generally expect the size of the multiplier to be greater than 1. Imagine government spending is increased by 1. This additional £1 then represents income which is spent. Let households spend a fraction c of their income. c is defined as the “marginal propensity to consume”. This extra c of spending then represents income for someone else…..who spends c of it….and so on. Thus, one can think of the total increase in demand leading from the £1 of government spending as

1 + c + c2 + c3 + …

Therefore, there can be a more than proportionate increase in demand with increase in government spending.

The actual size of fiscal multipliers is difficult to measure but a moment’s thought suggests they will vary across government activities. Resources should be shifted to high multiplier activities and the burden of cuts should be disproportionately concentrated on those with low propensities to consume. Imagine a balanced budget policy, taking income from one group and transferring it to another. Although fiscally neutral, the policy will boost growth if spending rises by more among the recipients than it falls among the funders. This will be the case if the marginal propensity to consume is higher among the recipients. By redesigning our austerity strategy to shift resources to high multiplier groups and activities, growth can be stimulated without a need to increase the debt burden.

What could this look like?

The analysis above suggests that cuts should be targeted at those with a low marginal propensity to consume, while those with higher MPCs should be protected. We shall also see that enacting this thinking implies equitable policy changes, dictating transfers of wealth to low income groups in society.

Exploiting variation in fiscal multipliers lies behind the Social Market Foundation’s suggestion of cutting high rate income tax relief on pension savings and capping ISA contributions. Such a policy would extract more tax revenue from those in a relatively secure financial position, who are better able to smooth the impact of cuts and tax rises, thereby minimising the impact of consolidation on overall demand. The SMF calculates that halving higher rate tax relief on pension contributions would save £6.7bn annually, while an ISA cap of £15,000 would generate an additional £1bn each year. Tightening should also be done through greater targeting of benefits rather than a reduction in their general level. Families at the bottom of the income distribution, without a savings safety net, are likely to have much higher marginal propensities to consume. Their income levels should thus be protected as far as possible on efficiency, as well as equity, grounds. Therefore, greater means testing of benefits should be enacted. Making child benefit and subsidies such as winter fuel payments and bus passes only available to the most disadvantaged in society will save huge sums but protect those who need it most.

Funds from savings created by efficient, equitable redesigns of the welfare system should be used to instigate a public works programme to facilitate a transition to a new industrial economy and restore the productive capacity of the economy. There are plenty of private sector projects in the pipeline that could be quickly undertaken given government funding. For example, as mentioned by Gerald Holtham, there is a private consortium willing to build the Severn barrage, a multi-billion pound scheme to supply 5 per cent of the UK’s electricity needs, given some guarantee on electricity prices. Investment spending could be rapidly deployed on schemes such as toll roads, that produce a revenue stream, and to support the UK’s broken housing market. We face a chronic shortage of housing in this country. The number of people waiting for social housing rose by 4.5% in 2010/2011, with 1.84million on the list in April 2011. Supporting investment in the housing stock would have huge social value and give a boost to the construction industry.

Further, funds could provide an initial capital injection to a small business bank or increase the scale of the coalition’s green investment bank. A new small business bank could make use of existing agencies to allocate and dispense the loans, offering them to small businesses at low rates, potentially concentrating funds in areas of especially afflicted by unemployment. The focus on small businesses should prove especially affective at job creation given research funded by the Kauffman Foundation showing that all net new private-sector jobs in America were created by companies less than five years old.

A middle ground exists

We need to move beyond the unnecessarily polarised austerity-growth debate. Casting these aims as mutually exclusive is misleading and unhelpful, contributing to policy inertia and unnecessarily limiting debate on how we achieve fiscal consolidation. Action must be taken to improve the UK’s growth prospects. The fact that we simultaneously want to get the public finances under control does not imply nothing can be done. The government’s hands are not fully tied, it must use them.

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