Don’t blame austerity for the crumbling concrete, Osborne salvaged Britain’s deficit

If only the Conservatives had loosened the purse strings on public spending in the 2010s, the story now goes, all the decrepit buildings could have been fixed. “Austerity” has, of course, become the catch-all word describing the David Cameron and George Osborne policy of restrictions on public spending to control Britain’s financial deficit.

This misperception is particularly surprising given the consequences of the massive increase in the deficit which was planned by the short-lived Truss government. As is only too well known, the markets took fright, the interest rate on government bonds skyrocketed and the government performed a dramatic 180.

But the critics of austerity never seem to recognise that the same effect could apply if the government reduced spending to cut the deficit. The crucial difference would be that it would be exactly the reverse: the rate of interest on bonds would be lower rather than higher.

In this way, policy which at first sight seems to be contractionary can in fact be expansionary. Reductions in public spending which appear to reduce overall demand can in principle increase it through the indirect effects of lower interest rates.

This point was understood by Keynes, the economist whose name is invoked all the time by those who want more public spending. In his magnum opus, he championed the idea that extra government spending (which he preferred to tax cuts ) could help keep an economy out of recession.

But he qualified this with two key points. When government deficits rise as a result of increased spending, Keynes wrote that “The method of financing the policy may have the effect of increasing the rate of interest”. He went on to suggest that there might be a separate, adverse psychological effect on “confidence”.

Keynes himself did not draw the conclusion that these arguments can be applied in reverse to cuts in spending. But they clearly can be.

Of course much depends upon psychology, on the unpredictable reaction of businesses and markets. But there are several episodes in post-war British economy history which suggest that fiscal restraint boosts the economy.

In the years immediately before the 1951 general election, the then Labour government ran huge public sector surpluses, amounting to £90bn a year in today’s prices. Far from causing a recession, they laid the foundation for the sustained economic boom of the 1950s.

In early 1981, the UK economy had moved into a deep recession, comparable in size to 2008. In the budget of March of that year, the then-chancellor, Geoffrey Howe, cut the financial deficit by 1.5 per cent of GDP, or some £20bn in today’s prices. The economy promptly began to recover during 1981, and posted a healthy growth rate of 2.2 per cent in 1982, followed by a boom rate of 3.9 per cent in 1983.

From 1994, the then chancellor Kenneth Clark carried out substantial fiscal tightening, continued by Gordon Brown until 2000. Over this period, the UK economy grew rapidly.

Austerity worked. Without it, the economy would have been smaller today, with even less tax receipts available to meet the myriad demands currently being placed on them.

As published in City AM Wednesday 13th September 2023
Image: Wikimedia
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