In my first triple crisis piece I wrote about John Quiggin's new book thesis concerning Zombie Economic ideas. Lead zombie of the moment is the idea of fiscal austerity as the way out of the crisis, despite oodles of evidence to the contrary. In short, we need to cut budgets to restore fiscal sanity, and we know that this is the way forward since small open economies in the 1980s (Ireland, Belgium, Denmark) that cut their budgets still grew. The economic (ir)rationale for this has been pointed out by Krugman, Stiglitz, and others. But for me the most interesting, and most tragic part of this story, are the distributional consequences of these policies, and the politics that they engender.
The first problem with such a policy is that if it works at all, it only works when everyone else is growing. If everyone else shrinks at the same time then what is individually rational becomes collectively disastrous, and viciously zero-sum. The second problem, the distributional one, is who pays for this debt crisis? The answer is 'not those who made the mess in the first place' – namely, finance. Instead, the double 'put' (quite literally) is on those who can afford it least, lower income taxpayers and consumers: once in the form of the bailouts, lost revenue, and lost growth, and now twice in the form of the fiscal consolidation (zombie-slashed public services) needed to pay back the debt generated from the bailout.
It is in this context that the much-anticipated budget cuts of the British government announced last week come to the fore. Britain has embarked upon a giant natural experiment to settle the stimulus versus austerity debate once and for all by plumping for austerity, and on a truly epic scale.
As Reinhardt and Rogoff remind us, approximately eighty percent of the time you have a banking crisis it will be followed by a sovereign debt crisis. As the public sector levers up to compensate for the fall in private spending, deficits are generated and new debt issues become a necessity. The UK economy was hit harder than many of its European peers when finance imploded because a full quarter of all British tax receipts came from the financial sector. This, plus the effect of the British economy's automatic stabilizers, resulted in a budget deficit of 10.1 percent of GDP by 2011, with British government debt issues rising to 58.5 percent of GDP to plug these gaps. This 'death spiral,' so the argument of the British government goes, has to be reversed since ever-increasing debts will lead to ever-increasing interest payments, eventually turning Britain into Greece. To avoid this the proposed sacrifice is a $128 billion reduction in public spending over four years, which it is hoped will reduce the budget deficit from 10.1 percent of GDP to 2.1 percent by 2014. Virtue, it seems, favors the bold.
Now let's put a human face on this explosion of virtue: 490,000 jobs. Those axed will find their benefits reduced, and now time-limited, in a weak economy with already high unemployment. As well as cuts there will be tax increases, but nothing too risky. Those at the top end of the income distribution will have their £1,000 per year child benefit stopped, and all will feel the pinch of an increase in value added tax (VAT). I say all, but as the most regressive tax the increase in VAT will mostly affect the poor. Consumers, in such a world, will now consume less, and with the private sector as a whole deleveraging (paying back debt) it is inevitable that national income will fall. The bet is that such a fall will be temporary, however, since virtue will be rewarded with lower interest rates as deficits are reduced and the recovery takes hold. That at least is the official story.
But how did the implosion of an elite-focused private sector composed of heavily leveraged financial companies writing deep out of the money options become a problem to be solved by those at the bottom of the income distribution? Part of the answer is the structural position of finance, especially in the UK. Too big to fail and too important for tax revenues, and the recovery (supposedly), those who made the mess are proving adept at avoiding paying for it. But part of this is also ideology. Rahm Emmanuel supposedly said, "You never want a serious crisis to go to waste," and then wasted it. The British Conservatives are making no such mistake.
Consider not just the asymmetry of who pays, but the targets themselves. Despite David Cameron's very public embrace of the UK's public health care system, the rest of the state is still fair game for the Conservatives, and this crisis really is too good an opportunity to waste. Although the details of these cuts are still vague, the broad outlines are already clear. Those thrown onto welfare will find that welfare much reduced. The universities, no friend of the Conservatives for many a year, are expecting massive reductions in their teaching budgets The recent Browne Review on higher education set 2011-12 English University teaching funding at £700 million, down from £3.9 billion, at a time when young people cannot get jobs. Taxes are only meaningfully raised regressively, and the government's new bank levy, the centerpiece of making the bankers pay, was noted by the Financial Times to be "too small to matter."
Finally, consider the overall macro-economic target of these policies. One lesson of the 1990s was that for countries joining the Euro through adherence to the highly restrictive Maastricht criteria (3 percent budget deficit, 60 percent debt to GDP ratio, inflation rate no more than 1.5 percent higher than the three lowest in the system) the costs in lost output, employment, and growth were oftentimes more than the benefits of joining. So why then is Britain deleveraging from a debt to GDP ratio lower than that of the Maastricht target (58.5 percent as opposed to 60 percent) and targeting a budget deficit lower still (2.1 as opposed to 3 percent)?
Well, one answer to that is the complement to who pays – who wins? And the answer to that depends upon what assets you hold over the next few years.
There are four ways out of a financial crisis. First, you can default. But with below-Maastricht debt levels and fear of the bond-market vigilante, the UK is nowhere near doing that. Devaluation is an option, and the Pound has lost value, but so have other currencies, notably the dollar, so there are limits there. So we are left with two choices: inflation or deflation.
If you hold real assets, inflation can be a free gift (consider all those folks with mortgages in the 1970s that saw half the cost of their houses disappear in the great inflation). So for those with debt (held as a debtor) inflation is a winner. For those with debt on the other side of the balance sheet – (debt held as a creditor) – it's a disaster. For these folks deflation, especially if it happens to someone else at the other end of the income distribution, is the preferred outcome.
Seen this way we get some clue as to why 'austerity' is the new 'there is no alternative' narrative. If inflation and default hit the powerful, and devaluation (exporting the costs of adjustment onto foreigners) has limits, then the only way forward is deflation. Those with 'real money balances' will have them restored, while those with real assets (or no assets) will take the pain. Meanwhile, a long held Conservative objective, the shrinking of the state, goes ahead in the name of pulling us back from the "brink of bankruptcy."
I used to think that John Quiggin's view of austerity, as a zombie economic idea was the right metaphor. After this week I think it's better to think of this whole episode as a Godzilla movie. Even if the policy fails, you will at least have slain the real monster – the state.