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Lessons from a decade of failed austerity

Getting it right this time
Report type
Research and reports
Issue date
Chapter 7: Policy recommendations
The chapter reviews practical issues around setting an expansionary fiscal policy. Government should increase current, capital and social security expenditures; the spending should be loan financed.

The mantra after the financial crisis was that the public – households and government – had been living beyond their means. The reality is that the economy is operating beyond the means of workers. Rather than reduce the means of the economy, the solution is to increase the means of workers. The situation, and the associated hardships, successes and setbacks, rationalise two centuries of trade union policy.

The remedies operate in two directions, first by securing trade union rights, widespread use of collective bargaining and decent conditions at work to help drive up pay and conditions. This report is concerned with macroeconomic policies that operate in the second direction. In the present context, several issues need to be addressed.

A changed perspective on the economy

As we set out above, at present action is contained by the overriding judgement that we are living beyond our means. Beyond a little flexibility in the early years of the crisis, these have translated to a view that for the past five years the economy has been operating at capacity. Alternatively, the output gap is judged to be closed. This view is doubly wrong. Shortfalls in outcomes under austerity have been wrongly attributed solely to the supply-side of the economy. This is compounded by wrong judgements about the likely size of the output gap at start of the crisis.

MPC members have recently recognised uncertainties in this area. Silvana Tenreyro points at low core inflation for services as a potential indicator of a negative output gap.[1] In a discussion of David Blanchflower’s new book, Gertjan Vlieghe addressed the relation between demand and productivity:

“I thought he would perhaps argue that, if only there was more demand stimulus, higher productivity growth might return, i.e. that some part of the lost productivity is cyclical and reflects lower intensity of factor utilisation, not structural developments. I would have some sympathy with that idea.” [2]

The problem is confounded by underestimates of multiplier effects. Therefore a more realistic estimate of the behaviour of the output gap since the crisis will require a more realistic estimate of multipliers. The IMF are among the sources cited by the OBR for their multiplier estimates. Yet the OBR did not react when the IMF very quickly reviewed their position given the experience of austerity across countries. The IMF’s revised estimate of between 0.9 and 1.7 provides a sound way forward.

The same goes for the NAIRU. Always a contentious idea for trade unions, doubts about relevance are now widespread. Above all, Jay Powell, the Chairman of the Federal Reserve, has acknowledged “the relationship between the slack in the economy or unemployment and inflation was a strong one 50 years ago … and has gone away”.[3] In practice the NAIRU has been reduced retrospectively, in the light of benign inflation outcomes. A more positive approach would be to operate policy according to a lower NAIRU, perhaps shifting down one percentage point at a time.

Overall policymakers have throughout mistaken a situation of excess supply with one of excess demand. As Figure 22 sows, inflation has corresponded to the former situation throughout. The present trajectory of ‘potential’ is wrongheaded and effectively imposes stagnation. At a global level, the likely danger is of deflation not inflation.

Spending: current and capital

Given a wider output gap, policy needs to operate on demand.

Operating on demand will strengthen economic activity, current expenditures on public sector wages, public services and welfare are not only desperately needed but an economic necessity. As Vleighe speculated, they will result in higher growth, increased employment and reduced underemployment, wages and productivity.

But plainly there is a wider need to begin to reconstruct the UK economy, to revitalise the manufacturing industry, address severe regional imbalances and address other social priories – not least climate change. As a starting point public investment should be raised to the OECD average of 3.5 per cent of GDP. Investment spending is doubly advantaged as it operates on both demand and supply, but current spending – especially a fully-funded pay increase – is easier to get up and running as purchasing power catches up with production. Wage dynamics over the past decade are a symptom of austerity; expansionary fiscal policy will mean expanding wages across the economy and a virtuous cycle of increased expenditure and stronger growth.  

Fiscal constraint

The public debate on austerity has been gravely misleading. The past decade has showed cutting spending to be counterproductive: the private sector was not ‘crowded out’ by government spending. The correct approach is an expansion of public spending to ‘crowd in’ private sector spending.

Likewise, austerity did not improve the public sector debt. Slower than expected GDP growth meant weaker government revenues[4] and greatly slower than planned deficit reduction, taking roughly ten rather than five years.[5] Reduced pace deficit reduction has not been adequate to reduce debt. Before the Coalition Government’s austerity policies, the debt ratio was expected to peak at 70 per cent of GDP in 2013-14; the ratio has now (probably) peaked in 2018-19 at 86.5 per cent of GDP; it is not expected to fall to 70 per cent of GDP at any point in the future. and so higher public debt.

Increasing government expenditure will strengthen the economy and the consequent gains in revenues and reductions in welfare spending will improve the public sector finances and public debt ratio.

Financing of spending

Aspects of the fiscal policy debate have become bogged down in calls for the central banks to aim money creation more directly at good causes, for example ‘green quantitative easing’.[6] Carney’s (2017) analysis shows just how important this mechanism already is. But the real point is that government expenditure should be self-financing through leading to increased economic growth. In 1932 the Danish economist Jens Warming observed “If a bank promises credit for an investment it really disposes of something belonging to the future: the coming saving”.[7] Keynes called for ‘loan-financed public works expenditures’, with the approach to loan financing a function of his wider initiatives around debt management.[8] But equally he was distancing himself from raising taxes to fund public services as putting the cart before the horse. Tax revenues should rise automatically as GDP expands; the repositioning of the tax system is a separate matter.

The constraints on action by government in post-crisis economies are self-inflicted. The logic needs to be turned upside down. A focus directly on jobs and the quality of work will make economic conditions right.

Plainly any such initiatives should not stand alone, but be part of wider (and related) strategies for industry, energy, regions, skills and the environment. Finally, as part of broader action to support private productive activity, there is a need for a more deliberate action on investment banks, reform of the domestic banking system as well as wider issues related to globalised finance. These are outside the scope of the present discussion.[9]

[1] ‘The elusive supply potential: monetary policy in times of uncertainty’, 7 March 2019.

[2] ‘Not Working - Where Have All the Good Jobs Gone?’ - David Blanchflower in conversation about his latest book with Dr Gertjan Vlieghe. In the same discussion John Llewelyn (consultant) argued productivity might be endogenous rather than exogenous, and Jagjit Chada (director of NIESR) spoke of wages adjusting in respect of a given total amount of demand.

[3] ‘Powell seeks a cure for the ‘disease’ of low inflation’, Financial Times, 22 July 2019.

[4] For example the OBR showed a shortfall of £85bn for financial year 2015-16 (Forecast evaluation report, October 2016).

[5] See ‘TUC Budget Statement: Undoing the Damage’. November 2018.

[6] ‘Green quantitative easing: paying for the economy we need’, Colin Hines and Richard Murphy.

[7] Jens Warming (1932) ‘International Difficulties Arising Out of the Financing of Public Works During Depression’, Economic Journal, Vol. 42, No. 166, Jun., pp. 211-224.

[8] These were aimed at ensuring interest rates did not rise; fundamental to this was allowing the public (and markets) to choose how to borrow rather than the Treasury dictating preferred instruments. The relevant procedures were set out in a 1945 Treasury Report of the National Debt Enquiry; one such process was the introduction of Treasury deposit receipts which obliged retail banks to lend directly to government. See Tily (2010) Keynes Betrayed, Basingstoke Palgrave Macmillan, Chapter 7 and annex.

[9] However, see: GFC Economics, ‘Financing Investment – Final Report’:;

and Christine Berry and Laurie MacFarlane, ‘A new public banking ecosystem’:

Frances O’Grady (2016) ‘No Worker Left Behind’ IMF FINANCE & DEVELOPMENT, December 2016, Vol. 53, No. 4.