The elections in UK have just delivered a verdict which surprised everyone. The Conservative Party, which was the major partner in the ruling coalition, has been returned with an absolute majority much against the predictions of all the pollsters. It amounts to a rejection of Keynesian orthodoxy and endorsement of old-style fiscal discipline.
British economic policy since 2010 has been a challenge to standard macroeconomics. In a deep recession which had struck in 2008 after the Lehmann Brothers collapse, conventional wisdom would have been that the fiscal policy should be expansionary. The government should borrow to stimulate the economy until recovery takes place. George Osborne who became Chancellor of Exchequer in 2010 took the view that the need was for a tight fiscal policy, reducing the deficit to zero within one Parliament. The debt-GDP ratio had long before exceeded 40% which is the norm for EU economies. Of course, while the deficit stayed positive, debt would go on rising.
Austerity was not popular. It meant cutting public spending steadily for five years. The biggest items of spending in the UK budget are welfare entitlements and health. The government promised to protect health spending as the National Health Service is central to most people’s lives and expectations. This meant cutting bureaucracy and benefits. There were many complaints about the hardships caused. When the government cut housing benefits, many families had to relocate out of metropolitan areas. The eligibility of drawing unemployment benefits was tightened as claimants had to show up for job interviews which they had been offered. If they failed to show up, their benefits were cut. This again caused a lot of distress. Public sector employment was cut, making many civil servants redundant .
But the UK labour markets are flexible. Many public sector workers found jobs in the private sector. But wage growth stopped though the level of unemployment did not rise. The shift from public to private sector in the labour force lowered the average wage. The real wage declined for the first four years while inflation, even while falling, remained above wage-growth.
The economy stagnated for the first three years with negative or very low growth. One reason was the collapse of growth in the Eurozone which is an export market for UK. But by the fourth year, it began to recover. UK regained its 2008 income-level and by the election time, the GDP was eight% above it. The latest growth data show the UK growing at around 2.5%, which is one of the highest in the developed world.
One criticism is that there was a large loss of income due to austerity. So the ‘gap’ is calculated as where the economy would be had the pre 2007 growth rate continued compared to the level of GDP today. But it is clear that the pre-crisis growth was fuelled by rising debts both for households and governments. By not factoring in the prospective repayment costs, income growth was being exaggerated. Finally, it proved unsustainable.
In standards macroeconomics, debt was seen as a distribution issue. The creditors—rentiers as Keynes called them—were owed money by the rest of the citizens. It was open to policy makers to squeeze the rentiers by cutting interest rates. Indeed, Keynes was so worried about over saving that he wanted the euthanasia—elimination—of rentiers. Now, we view debt as an inter-generational issue. This generation’s debt will have to be repaid by the next generation. We also have open flexible capital markets, in developed countries at least. Public debt is held by pension funds not just at home but abroad as well. National debt can be repudiated if the holders are just citizens. But if the debt is held by others, then the state has to behave like any other corporate borrower and honour its debts.
Demography in developed economies supports this altered perspective. Population is not growing very fast. People are living longer. Thus, the burden of pensions is higher on the shrinking total of working-age people relative to the retired. Thus, when there was the Baby Boom during the ‘Keynesian Golden Age ‘ of 1945-1975, the burden of pensions hardly mattered. Economists who lived through the Golden Age did not appreciate how dependent on good demographics the Keynesian policies were. There are no universal truths, regardless of the algebra used in economic models.
This lesson has now been learnt not just by governments but by citizens as well. It is clear from the UK election results that the voters chose the party which had said it would be tough on eliminating the deficit. Only half the deficit has been eliminated thus far. The public has now asked that party to finish the task of eliminating the deficit.
This shows that people understand that their interests are better served by a responsible fiscal policy rather than short run and unaffordable economic nostrums.
The author is a prominent economist and Labour peer