Which should come first: growth or austerity?
Debate is raging over whether government policy should favour short-term growth or short-term austerity. The British government has chosen austerity and the bond markets have rewarded it with low interest rates. But, a left-leaning think-tank claims to have the support of “100 leading economists” for its Plan B with higher public spending to boost the economy. Nevertheless, Britain should stick to its current path of cutting deficits.
Few would dispute that growth is needed – sooner or later – to pay off debt. If the economy is growing, young households can sensibly take on a large mortgage in the expectation that their incomes will grow over time to enable them to repay it. Countries can sensibly run budget deficits and build up debt during recessions because they anticipate reducing their debt through budget surpluses when growth rebounds. This is sound reasoning provided two conditions hold: that the debt-to-income ratio does not get too large, and that higher growth in the future is realistic without austerity now.
The eurozone crisis has cruelly exposed one of the key links between growth and debt. In the extreme case of Greece, being part of the eurozone enabled it to benefit from low interest rates that lulled it into delaying the politically difficult reforms that are necessary for it to become a competitive economy capable of sustained growth. Now there is no choice. The debt-to-gross domestic product ratio is above 100 per cent and accelerating as interest payments rise. Structural reforms such as better tax collection, fewer public sector workers and later state pension ages mean short-run austerity. But without them Greece cannot grow, even with a partial write-off of its debt. For Greece, with no exchange rate flexibility, austerity is a necessary condition for growth.
Outside the straitjacket of a currency union, the trade-off between growth and austerity is looser but still binding if debt is building. Both Britain and the US are in this camp. In both countries the budget deficit hovers around 10 per cent of GDP and the debt-to-GDP ratio is rising.
President Obama’s preferred policy is growth first, austerity later. During his first two years in office he pushed through two stimulus packages and has just send another bill to Congress which would extend and broaden some of the earlier measures. Some eminent economists have supported such additional stimulus on Keynesian grounds, but the acrimonious debate over raising the government’s debt ceiling showed how deeply divided public opinion is on this subject.
If debt is the underlying problem and two previous attempts at deficit spending failed to ignite a sustained recovery, why should more do so now? In effect, the public is demonstrating what economists call ‘Ricardian equivalence’, namely the rational expectation that government spending now will require higher taxes later. Taxpayers react by increasing their savings now, rather than their spending. Perhaps the sharp falls in business and consumer confidence surveys reflect this view. If so, further fiscal stimulus in the US will not ignite growth.
Britain’s trade-off is starker than America’s. Its currency is not the global monetary anchor, nor is sterling considered a safe haven in turbulent markets. The Chinese do not need to buy gilts. With a quarter of Britain’s debt held by foreigners, the country’s borrowing costs are directly determined by the confidence that the global bond market has in its policy. Last year 23 per cent of government spending was financed by borrowing. Entitlement programmes consume 29 per cent of the budget and represent the largest component of the structural deficit. Either these must be reduced or taxes will have to be raised. But already tax rates on individuals are among the highest among developed countries. These stark facts are the reason that the coalition government has wisely chosen to put austerity first in order to create the conditions for growth later. Economists may debate, but the markets will decide.
This commentary appeared in The A-list blog on FT.com on 1st November 2011