When David Cameron spoke about an ‘age of austerity’ he was describing the economic policy that would come to define his government. But ‘austerity’ is a misunderstood term. One way to think of it is in relation to the concept of a fiscal stimulus. In the standard Keynesian model, when consumption or investment are subdued, government spending or reduced taxation can ‘kick start’ the economy and boost output. In theory, governments can run a debt-financed budget deficit. Most stimulus plans will be a mixture of increases in government spending and reductions in taxes. But traditionally, stimulus advocates tend to focus on timely, temporary and targeted spending plans in line with the Keynesian belief that part of any tax cut will be saved.
Fiscal austerity is thought of as the opposite of a stimulus – that is, as the process of significantly reducing the budget deficit, predominantly through spending cuts rather than tax rises. We can immediately see two problems. The first is what we mean by ‘significant’. If the budget deficit falls from 9.1% of GDP to 8.9% of GDP, few would treat this as an austerity measure. The second problem is the definition of the term ‘predominant’. Few economists advise governments to increase taxes during a recession. This is also true of non-Keynesian economists who would cite supply-side reasons for not increasing taxes in a recession. But what proportion of the austerity package should be spending cuts? George Osborne's original plan was to reduce the deficit with around 75% coming from spending cuts and 25% from tax rises. This was an adaptation of the previous government's plans of 67% spending cuts and 33% tax rises. So the only difference between this government and the last government is the speed and composition of the austerity package, not whether there should be one.
But should we be using the word ‘austerity’ to describe this reduction in government borrowing at all? The term ‘austerity’ (which stems from the Greek for ‘harsh’ or ‘severe’) became popular after World War II, when government policy led to a reduction in the amount of luxury goods that people could consume. But the ‘luxuries’ that were being enjoyed prior to the financial crisis were bought with borrowed money and we could not afford them in the long term. Current government policy is an attempt to live within our means: it is a confrontation with reality and a correction of the previous largesse.
So, perhaps the word ‘austerity’ is inappropriate. But it is also important to look in more detail at the government's plans to understand their true characteristics. Firstly, not all government departments are being treated the same. The budgets for each department (known as ‘Department Expenditure Limits’) show that total spending is set to rise (from £322.5bn in 2011–12 to £330.2 in 2013–14), with more departments seeing an increase in budget than receiving a cut.
Secondly, ‘Total Managed Expenditure’ (TME) is also set to rise, from £696bn in 2011–12 to £756bn in 2016–17. Although it is the nominal levels that are supposed to matter in Keynesian theory, even in real terms there is little evidence of significant cuts.
Thirdly, the reason the budget deficit is expected to fall is mainly due to increases in tax. Tax receipts are expected to rise from £570bn in 2011–12 to £735bn in 2016–17, and there has been a whole host of tax increases announced over the last few years. So, what we have in reality is private sector, but not public sector, austerity (if austerity is the right word).
Finally, when looking at these figures as a proportion of GDP we rely on notoriously unreliable economic forecasts.
In Figure 1, the blue line shows the ratio of government spending to GDP which is set to peak in 2012 before falling until 2015. However any ratio is simply the product of the numerator (in this case government spending) and denominator (GDP). The ratio is falling, but only because GDP is expected by the government to rise more rapidly than government spending. If we replace the official GDP growth forecast with one at half the level we end up with a rising government spending to GDP ratio as shown by the red line.
There have been some instances where governments have significantly cut government spending and seen growth prospects improve – Canada in the 1990s and Estonia right now are good examples. But in the UK the picture is more nuanced and we can sum it up as follows:
- We are not following an ‘austerity’ path: if anything we are following a ‘fiscal stabilisation’ path.
- The government is not cutting its spending but cutting spending projections.
- So far, the main adjustment has fallen on the private sector as a result of increased taxes. There are adverse supply-side consequences of such tax hikes.
- Spending may fall as a proportion of national income, but only if national income grows rapidly.