The tolerable cost of austerity

The Ernst & Young Item club reckon that, although the economy has escaped recession, it will grow by only 0.4% this year.

If this is right, it would mean that real GDP at the end of this year will be 4.4% less than the OBR forecast (pdf) in June 2010.

We can’t blame the euro crisis for this. For one thing, exports have held up relatively well, so far. And for another thing, one argument against austerity was and is that it gives us less “wiggle room” if the economy does suffer shocks.

Instead, the natural inference is that Osborne’s fiscal austerity has been more expensive than anticipated. One estimate of this extra cost is equivalent to £150 per month per household*.

This poses the question. If austerity has been significantly more costly than expected, why hasn’t it caused more public outrage, and more doubts about its efficacy amongst coalition supporters?

I suspect there are two reasons.

One is the status quo bias. Costs that are actually incurred by existing policies are often more tolerable than the same costs considered as potential effects of alternative policies. This bias causes people to tolerate policies which they might have rejected, had they known their actual costs. 

It’s not just UK austerity for which this is true. If you had told Spaniards and Greeks that joining the euro would cause a short-lived housing boom and then years of stagnation or worse, they might well have rejected the idea. But now these costs are being borne, people are (more or less) putting up with them.

A second reason lies in the “painting the target” effect. If you fire a bullet into a wall, you can paint the bullseye onto the wall, and then claim to have hit it. In this way, supporters of austerity point to low gilt yields and claim the policy has averted a debt crisis - oblivious to the fact that low gilt yields are largely a reflection of weak economic activity.

Again, there’s nothing unusual about today’s austerity here. A similar post hoc rationalization is often applied to the Thatcher recession of 1980-81. This was not supposed to happen. The hope was that monetary targets would lead to lower inflation expectations and hence to lower inflation without a serious recession; for this reason David Smith wrote that “by the end of 1981, Britain‘s monetarist experiment appeared to have been an unmitigated disaster.” (The Rise and Fall of Monetarism, p105) It is only with hindsight that we credit Thatcher with breaking workers‘ power, thus enabling a recovery in capitalists’ animal spirits and investment. But this is a “painting the target” syndrome.

These thoughts might seem mundane. But they have an important implication. If costs and benefits, once borne, are regarded very differently from how we’d regard them in anticipation, then what use is cost-benefit analysis?

* GDP in Q1 was probably 3% below the OBR’s June 2010 forecast. That’s around £11.8bn (money GDP in Q4 was £380.5bn.) There are 26.3m households in the UK, and £11.8bn divided by 26.3m gives us £448.67. Divide by three and we can call it £150. 

Comments

[Luis Enrique]

I'm not sure I understand your last point. I think you are arguing that policy choices have real implications (such as making us poorer, or not) but also that we tend to adjust to whatever we end up with. But you're not suggesting that this tolerance of the status-quo is so powerful that it obliterates the 'real implications' to the extent it doesn't matter what happens, we're equally happy in any event, are you?

In which case ex-ante cost-benefit analysis is still useful because the ex-post adjustment we make to the status quo applies in all case, yet we are still better off under some outcomes than others.

[Paolo]

Could it be that the costs of the austerity drive were unevenly spread, re. intergenerational inequality, so that perceptions that there hasn't been massive outrage is due to the fact that those protesting are usually given less weight when presenting a general view of the 'public opinion'. The recent outrage for the 'granny tax' suggest that pensioners are taken normally taken into consideration far more than, say, students....guess why?

[CharlesOJ]

"If austerity has been significantly more costly than expected, why hasn’t it caused more public outrage"

3rd possible reason: people are assuming the forecasts are routinely inaccurate, and we would be unwise to attribute lower growth (or higher growth) than expected to the alleged austerity.

Brown's forecasts were hopelessly inaccurate (all too optimistic):
http://dizzythinks.net/2010/03/shock-news-eu-says-pope-is-definitely.html

That's why, in my opinion, there's not much of a public reaction to the downgrade. They question the validity of the forecast data, rather than the validity of the policies.

[Bill le Breton]

The argument for austerity is based on a semi-religious antipathy towards debt in our society. If you can embed an argument within the instincts which support religious experience they are endorsed in the same way that superstitions are supported – somewhere there is a reflection of the organization of society requiring debt be ‘felt’ as both impure and dangerous. Those arguing for deficit reduction have this powerful magic on their side: it’s taboo.

[Ralph Musgrave]

There is also the Shi’a Muslim “lets whip ourselves with chains on the march to Karbala” factor. I.e. there is a semi religious tendency amongst human beings to believe that “if it hurts, it must be doing good”. Every society that ever existed has had a religion, and every religion involves sacrifice: at worst, human sacrifice.

[Dipper]

"The argument for austerity is based on a semi-religious antipathy towards debt in our society"

Yes. That's me, I don't like being in debt.

If borrowing more money will make things better, then surely borrowing absolutely enormous amounts of money will make everything fantastically better!

Surely nothing is more "religious" than the faith in the mystical properties of The Keynsian Multiplier to deliver wealth and happiness without us actually being good at anything?

And how is borrowing slightly less than we were previously "austerity", and not just being slightly less profligate than we were previously?

I think deep down this is an existential crisis on what kind of country the UK should be, what kind of economy we should have, and on how as a country we should pay our way. Pulling a few Keynsian levers just pushes the day of reckoning further down the road.

[Andrew]

CharlesOJ makes a key point, I think.

As for the "semi-religious antipathy towards debt in our society, Bill le Breton, that would explain the public+private debt running at the spiritually low level of 500% GDP.

[pablopatito]

Is David Smith's book worth reading or is it a bid dated now?

[Bill le Breton]

Dipper why should that statement make me a Keynesian? I could argue that MV=PY=AD therefore with insufficient AD we need the creation of more M (debt creates M, deleveraging destroys M.

For you and Andrew, I was trying to answer the question why the preposterous idea of expansionary deficit reduction should grip the minds of so many and why, nearly two years on, with economic recovery predicted by ITEM for year to be no more than 0.4%, there is not greater opposition to the policy.

Nor do I understand why considerable levels of debt in a society should invalidate the proposition that in our society there are taboos against debt which interfere with reasoned analysis.

Why cannot debt be seen as a secret pleasure, privately, and a scandalous violation, publically. Religion and hypocrisy are not exclusive.

The real issue is how we can bring our reason to bear on the problem of a balance sheet recession in the knowledge that one of the obvious ways of increasing the Debt:GDP ratio is to reduce GDP.

We have everything to fear from our superstitions.

[james higham]

If this is right, it would mean that real GDP at the end of this year will be 4.4% less than the OBR forecast (pdf) in June 2010.

A point they're hardly likely to over-emphasize.

[Blissex]

«If this is right, it would mean that real GDP at the end of this year will be 4.4% less than the OBR forecast»

That is probably a policy success seen from their point of view.

The UK economy has been artificially boosted 1985-2010 by oil exports and increasing debt levels, and both factors have come to an end for the foreseeable future.

This should lead to a significant cut in living standards across the UK, that is "austerity", to revert to trend without triggering a runaway collapse of the pounds due to surging oil and other imports that would be the consequence of attempting to maintain living standards without oil and debt production.

The big problems for the coalition are to do this in a gradual way and to ensure that most of the cut in living standards fall on the undeserving, parasitical lower classes, and not on the deserving, wealthcreating upper classes.

Mission largely accomplished.

[guthrie]

Actually, if you are talking about normal people, many simply don't understand what it is all about and therefore are not in a position to make much noise. Plus the goings on of high finance are less immediately important than whether or not their local hospital is being shut for example. Moreover there has been a large scale de-involvement of the public in politics anyway, which means that their opinions are no longer being informed by more politically astute individuals or roused by their unions.
Basically the project to reduce us to sheeple is well on track, despite the excitement about blogging.

[anonymous]

I’m sure everyone would agree that the majority of the public does not understand macroeconomics. So the significance of MV=PY=AD will probably be lost on them.

But this does not mean the public does not know how bad things are. The latest yougov gives the Coalition an approval rating of -37%, and a net -31% of people think they are managing the economy badly. Those suggest the public is not exactly frilled with the way things are going.

The fact that few journalists understand macroeconomics is more concerning.

The number of articles berating QE, as if it’s some sort of devilish plot to impoverish the country is astonishing. Especially given that economists and data analysts are in pretty much universal agreement that QE is the only thing keeping the economy from imploding, and on balance a higher inflation target (4-6%) would be beneficial.

Politicians of all stripes have been hugely dishonest about the causes and justification for the cuts. E.g. statements “There’s no money left” and “if we don’t do something quickly, we’ll turn into Greece”. It’s clear that the issues the country faced were long term, not short term. But many of the decisions made by the coalition have been extremely myopic, and they have ducked the long term problems due to the UK’s aging demographics.

It’s clear that the crisis started with the Bank of England bungling monetary policy in after Lehman Brothers 2008, they took six months to lower the base rate to zero, whereas the Fed took two. Then they kept monetary policy too tight after CPI increased because of the 2010 VAT increases, (constant tax CPI was below 2% for the whole of 2010.) Now the BoE is playing catch up, but they have focused on the process, “we will do X amount of QE”, rather than the destination, “we will keep employing QE until unemployment is below X or nominal GDP is back to trend”. Sir Mervyn King cannot be replaced soon enough.

It’s also clear that politicians have used the “crisis” to reallocate spending, (even in real terms total government spending is not falling). Politicians are simply reallocating spending from public services to fund pension promises they’ve made. At the last budget they raised the basic state pension by a record amount, which will cost a further £4-6bn this year. And the workers who pay taxes to fund these benefits on average got a 1.1% increase in the year to February, which equates to a 2.4% real terms pay cut.

You can tell a similar story in Spain, the first thing Rajoy, Spain’s new prime minster did after the election was to re-index state pensions to inflation. This is despite record public deficits and rising bond yields, and massive problems with youth unemployment.