Does the recent experience of the U.K., which is mired in a painful economic slump, debunk the idea that austerity is the way out of the developed world’s ills? This question is on the minds of economists and elected officials the world over, and the answer could provide one of the most important economic guideposts of our time.
In his Jan. 29 New York Times column, economist Paul Krugman uses the example of Britain to indict what he calls “expansionary austerity.” The phrase refers to the idea, popular among U.S. conservatives and some European officials, that slashing government spending to reduce budget deficits will trigger a confidence-driven recovery.
On that narrow point, Krugman is right. Since Conservative Prime Minister David Cameron came to power in May 2010 and began to put in place deficit-cutting measures, Britain’s economy has decidedly not boomed. Economic output shrank in the fourth quarter of last year, and by at least one measure -- cumulative change in real gross domestic product since the last peak -- Britain is in worse shape than it was in the wake of the Great Depression.
But that’s only part of the story. There’s a more important question, and one with a higher burden of proof: Would Britain be better off if it hadn’t embarked on an austerity program? What if the U.K. had instead engaged in more fiscal stimulus, and with it, more deficit spending? The jury is still out on that one, but the available evidence suggests that Britain chose the correct course.
Consider Britain’s predicament in 2010. After bailing out a banking system whose total assets dwarfed national annual economic output, the country faced a battle to demonstrate that it wasn’t the next Iceland. The British pound had lost about a quarter of its value against the dollar since mid-2008, and the government had recently suffered a failed bond auction. With budget deficits gaping, and gross government debt forecast to exceed 90 percent of GDP by 2013, Britain needed to do something fast or risk a market rout.
The resulting combination of spending cuts and tax increases, some of which began before Cameron, aims to reduce the U.K. deficit by about 8 percent of GDP by 2016 -- a magnitude similar to what the U.S. must achieve to get its budget in long-term balance. It has had some success in restoring -- or at least maintaining -- investor confidence, in sharp contrast to the fate of European governments (think Greece, Portugal and Spain) that didn’t attempt similarly ambitious austerity measures in time.
The cost of default insurance on U.K. government debt, for example, currently stands at about 80 basis points (meaning 80,000 pounds a year to insure 10 million pounds of government debt for five years). That’s roughly where it was when Cameron took power. In the same period, the cost of insuring French government debt has more than doubled, to about 165 basis points from 80.
Postponing deficit cuts hasn’t put Italy and France in a better position. Higher borrowing costs have pushed them into a period of market-imposed austerity, with all the economic pain that entails. Forecasters tracked by Bloomberg currently expect no growth in France this year, and a contraction of more than 1 percent in Italy. The forecast for Britain is a 0.5 percent gain.
The broader lesson isn’t that stimulus is a bad idea in the U.S., or that austerity is the sole answer to Europe’s problems. Rather, experience suggests that any country’s borrowing will ultimately run into market constraints, and that governments are better off getting their finances in order before that happens.
Leeway for Stimulus
The U.S. has so far been lucky. Thanks to the global role of the dollar and investors’ continued willingness to buy U.S. Treasuries at extremely low yields, the government still has some leeway to use fiscal stimulus to create jobs in the short term. It’s a shame policy makers aren’t taking advantage of that luxury.
But if the U.S. wants to avoid a predicament similar to -- or possibly much worse than -- the euro area’s sovereign-debt crisis, it must come up with a credible plan to get budget deficits and debt under control in the longer term. Britain’s experience demonstrates that such austerity won’t be easy. It’s also the only way to avoid paying a steeper price down the road.
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