Thursday, April 26, 2012

The Fools Running Britain--A Cautionary Tale

You know, there's a famous quote out there that says, "a smart man learns from his mistakesbut a truly wise man learns from the mistakes of others." Well, if there's anything to be gleaned from the utter disaster that is the current British economy, it's that the United States should not try to balance its budget right now. For those of you who don't know what's going on in Britain right now, a bit of history.


In the many months following the financial crisis, Gordon Brown's government steered Britain through the depths of the recession pretty well, and the stage was set for a fairly decent recovery. Then, the elections rolled around, and in mid-2010, the conservative David Cameron was elected Prime Minister. In his view, the biggest challenge facing Britain's economy was the amount of debt it had run up. In his view, Britain would go the way of Greece if it wasn't careful. So Cameron decided that a policy of austerity (budget-balancing by cutting spending/tax hikes) would be the best recipe for economic recovery. This, he argued, would inspire "confidence" in businesses and investors and make them want to start hiring more. So the government started down the road to austerity, in spite of the warnings of many economists. What was the result, you might ask? Well, here's a graph from Joe Weisenthal comparing the real GDP of the UK, US, and the Eurozone:




You'll note that Britain's GDP flatlined and even started falling in 2010-2012. In fact, Britain's growth has been negative for two straight quarters, so technically it's in a double-dip recession. The Eurozone, too, looks pretty similar, for much the same reasons. The difference is that the austerity Britain imposed upon itself wasn't even necessary! The IMF and ECB didn't impose their budgetary demands on Britain like they did on Greece. Britain's 10-year borrowing rates prior to Cameron entering office were around 3.75%. By comparison, U.S. bond yields around the same time were roughly 3.5%. Neither country was anywhere close to being in a debt crisis. Just to make my point abundantly clear, here's a graph (via Krugman) charting Britain's recovery from the Great Depression versus the current recovery:


The numbers on the bottom are quarters since the start of the recession.
So Cameron, as Krugman says, has the remarkable achievement of making Britain's recovery the worst ever. Could it be possible that Britain's slowdown in the numbers was caused by multiple factors? I'm sure that it was. Economics is, as you all know, an inexact science, but the fact is that austerity policies certainly didn't help matters. As if this wasn't bad enough, the initial goal of austerity--to balance the budget--is revealing itself to be self-defeating.

The real lesson that we all ought to take away from this is the one that smart people have been warning us about from the very start: contractionary policies are contractionary. Any economics textbook would tell you that. The IMF did a great study in which it analyzed the effects of fiscal consolidation on various measures of economic growth under a wide variety of conditions. According to them, if multiple countries undergo fiscal consolidation (a la the Eurozone plus Britain) while interest rates are at the zero-bound (as is the case in Britain and nearly the case in Europe), the effect of austerity is dramatically increased (pages 17-18 of the study). This study was published in October 2010, before the full effects of austerity were felt in either Britain or the Eurozone. So the story that the IMF told us would unfold under these conditions seems to have come true. Now, if you want to argue that the BoE could have done more to offset the fiscal contraction, you definitely can. But to my knowledge, what they've done hasn't been enough. NGDP targeting, anyone? 


All of this brings my point home to the United States. You'll notice on the first graph that our recovery, while still not great, looks better than Britain's or the Eurozone's. This, in my view, stems largely from the fact that we have not undertaken substantial austerity measures. Yes, the U.S. has a long-term debt problem, but that won't be the case in the short-run. So the next time you hear allegedly "serious" people like Paul Ryan advocating near-term budget cuts and saying things like, "The overarching threat to our whole society today is the exploding federal debt," you should remember Britain's experience. This recovery has been slow enough, and the last thing we want to do is party like it's 1937.