Austerity in the UK
‘Expansionary fiscal contraction’ is the phrase du jour in economics these days. It has replaced the old buzz word ‘austerity’ with which it is synonymous. What it means is reducing government spending to make the economy grow. Expansionary fiscal contraction is voodoo economics. It doesn’t work.
This policy will reduce aggregate demand by reducing the government’s spending.
The question is what happens in the private sector. The financial sector balances sum to zero. Let’s assume we don’t see a huge fall in the dollar’s value that boosts exports more than the dollar value of imports. Then the adjustment falls to the private sector to make up for the reduction in the government sector’s deficit. A reduction in government spending could be met by a reduction in the private sector’s net surplus that fills the demand gap via business capital spending, consumer releveraging, etc. Or the private sector surplus remains about the same and the economy contracts. Remember, households have bloated balance sheets. If we assume that people are trying to draw down on their debt and increase their savings, it is reasonable to believe that the government’s reduction in spending will be met by a reduction in private sector spending.
People like Hugh Hendry get it. He is not advocating fiscal contraction because he believes it will immediately be expansionary. Instead, he argues there is no policy remedy for debt deflation. Rather than allow the government’s debt levels to climb and fill in the missing private sector demand as Richard Koo advocates, Hendry recommends just letting aggregate demand fall and starting anew. That leads to Depression of course.
This is risky advice. The dynamics of a world in depression are extremely volatile. This is an ideological question that has a lot to do with one’s view of the role of government. But, make no mistake, cutting government spending across a broad swathe of countries at the same time reduces spending in a way that increases short-to-medium term budget deficits and increases the likelihood of another banking panic.
The UK is a good example of what austerity means. In the wake of tax increases and budget cuts in the UK, retail sales in Britain have plunged by the most on record. I seriously doubt that the coalition government there will meet its deficit cutting goals with so many people still out of work. The good thing is that UK is but one country. Moreover, inflation played a key role in creating the mess there. And it is not clear yet that inflation will continue to be as much of a problem going forward. Nevertheless, when we get the same sorts of policies in the U.S., things will be different. The U.S. is a much bigger economy and the loss of that level of spending will have far-reaching consequences.