Prosperity, austerity and the national debt

28 January 2015

By Sue Konzelmann and Frank Wilkinson.

Osborne argues that the economy is on the road to recovery. Cameron claims that the government is well on the way to reducing the national debt. So how come most people still feel under-paid, over-charged and living on the edge? In the second of a series of blog pieces, Frank Wilkinson and Sue Konzelman expose the fiction behind the government’s financial arguments. Analysing the UK’s history of economic performance, they conclude that austerity doesn’t work. It hasn’t in the past and it won’t in the future.

“Necessity is the mother of invention” is an English proverb meaning that difficult or impossible scenarios prompt inventions aimed at reducing the difficulty. So it was that the UK Chancellor of the Exchequer George Osborne contended in his 2010 Mais Lecture, that ‘[a]s Rogoff and Reinhart demonstrate convincingly, all financial crises ultimately have their origins in one thing’ – high levels of public debt.

So that the Tory party, backed by the Liberal Democrats, embarked on a programme of austerity aimed at cutting the national debt. However, only four years later, not only has Rogoff and Reinhart’s contention been comprehensively discredited, the Uk’s public debt has rapidly increased – from 58% of GDP in 2009 to over 80% in 2014.

The reason for this increase is clear when you look at shifts in the national debt over time – along with the events and policies associated with them.

As evident in Figure 1, which covers the period from 1929 to 2014, the UK’s public debt stood at 166% of GDP in 1929. By 1933, following the Great Depression, it had increased to 187%. But with rapid economic growth after 1933 it fell to 151% by 1938. Borrowing to finance the Second.World War, caused it to increase again – to 259% by 1946. But from that point onward, apart from an upward blip during the stagflationary crises of the 1970s, the UK’s national debt continued to fall, reaching a low of 28% of GDP by 1991. After that, it followed a slightly rising trend, reaching 37% in 2006, on the eve of the credit crunch.

The effect of the credit crunch of 2007 – including bank bailouts – abruptly lifted the UK’s public debt to 68% of GDP in 2009; and by 2014, after a dose of austerity, designed to achieve quite the opposite effect, it had risen again to more than 80%.

Clues to factors determining changes in public dept are provided in Table I, which divides the period into episodes when public debt decreased and when it increased. The first post-war period shows how remarkably successful Keynesian policies were in reducing the national debt: between 1946 and 1973 it fell by 205 percentage points. Not only were Keynesian inspired governments (both Labour and Conservative) able to fund the new Welfare State and pay off the Second World War debt, they also reduced the UK’s public debt to 36% of what it had been in 1938.

This debt reduction process slowed during the 1970s with the switch from Keynesianism to Neo-liberalism, beginning rather tentatively by the Labour Party under James Callaghan in 1976, then whole-heartedly by the Conservatives under Margaret Thatcher and continued by the opportunistically¹ New Labour duo Blair and Brown when they came to power in 1997.

Among the effects of this reversal in policy has been the slowing of real GDP growth – from an average annual rate of 2.72% during the 27 years between 1946 and 1973, to 2.24% during the 34 years after that – and an increase in average annual unemployment from 2.88% to 6.24% during the two periods. Meanwhile, reduction of the UK’s national debt slowed from an annual average of 6.24 percentage points before 1973 to 0.59 percentage points thereafter.

The existence of a direct link between the pace and direction of public debt retirement and economic performance is clearly illustrated by Table 1, which relates the change in UK national debt to changes in economic growth and unemployment. With the exception of the Second World War, changes in the size of the UK’s public debt are directly related to the rate of economic growth and inversely related to the level of unemployment.

The explanation for this is simple enough to be understandable – even by Cameron, Clegg and Miliband as well as other would-be national leaders. When the productive economy is growing and unemployment is falling the taxable base of the economy is expanding, causing public revenues to increase and the cost to the state of unemployment and poverty to fall. This provides the opportunity to pay down debt and to save on interest payments. By contrast, when economic growth slows and unemployment is growing this “virtuous circle” is reversed as tax revenues fall and the cost of unemployment and poverty rise, pushing up the budget deficit and the national debt. In these latter circumstances, attempts to balance the budget by cutting unemployment-related social costs and reducing anti-poverty expenditure can only be counter-productive by further reducing aggregate demand, deepening the recession and adding to unemployment and poverty.

To avoid the “vicious cycle” of falling revenue and increasing expenditure, it makes perfect sense for the government to borrow when growth is low and unemployment is high, and to pay back the debt when improving economic conditions and the growing fiscal surplus provide the opportunity, especially with interest rates at a historical low.
Current austerity policies are ultimately based on a series of myths.

Firstly, it is ludicrous to suppose that national finances are analogous to those of a household. Few of us – however much we might like to – can set our own interest rates or indulge in a bit of quantitative easing.

Secondly, it is equally inane to suppose that national debt can be reduced simply by cutting expenditure. Government spending is an important part of aggregate demand, creating jobs, generating taxable income, and the wherewithal to repay debt. Therefore, judicially used, public expenditure is the cure rather than the disease.

Thus, it makes no sense at all for a government to think that it can cure austerity by adding to it. This is akin to the pre-scientific medical practice of blood-letting: bleeding the sick, observing them getting sicker as their life blood ebbs away, bleeding some more – and then, surprised by the resulting death, putting it down to an act of God.

This is the second in an ongoing blog series by Sue Konzelmann and Frank Wilkinson, looking back at the UK’s economic performance. Part 1 can be found here.

^{1. Defined as “self seeking with guile”↩}