Austerity drives can unleash confidence By Guy Monson and Subitha Subramaniam

Published: July 27 2010 11:23 | Last updated: July 27 2010 11:23

Britain’s politicians appear to thrive on habitual experimentation. In the early days of the financial crisis, the UK was the first to offer the banking system unconditional support. It then went on to become the first country to embrace “zero” interest rates and quantitative easing. Now, just two years on, the new coalition government looks set to do another first by abandoning the spirit of Keynesian interventionism that prevailed during the dark days of the crisis.

The Con-Lib volte-face on state spending is to be lauded; as the facts changed, the coalition changed its mind. The ever-expanding state was no longer the solution to economic lethargy, but the cause for endemic underperformance, and unless the state itself was “right-sized”, the economy would struggle to achieve its potential. Such flexibility of thinking or opportunistic policymaking is remarkable; Keynesian interventionism worked to resuscitate animal spirits in the dark days of financial panic, but with markets now more rational and the costs of interventionism rising to 40 per cent of gross domestic product, does it not then make sense for policymakers to throw out the Keynesian rule book?

To begin with, Keynesians argue that government spending has a positive multiplier effect on the economy, with every pound of government spending increasing GDP by roughly £1.70 (the “multiplier”). Keynesians therefore believe that periods of weakness in private demand should be offset by increases in government spending.

But perhaps this is too simple – there are limits to Keynesian interventionism. As the state gets larger and larger, the multiplier benefits of government spending become smaller and smaller, and taxing the working many to support the non-working few eventually leads to a system of the working few supporting the non-working many.

There is also the question of affordability; when debt loads are light, it is easy to be guided by Keynesian interventionism. However, with the Treasury’s purse exhausted, and the debt-to-GDP ratio set to climb to 70 per cent by 2012, further intervention needs funding. At the extreme, debt monetisation, or the explicit purchase of the Treasury’s deficit bonds by the central bank, could resolve funding needs. But there is no free lunch for the government – debt monetisation will eventually lead to a loss of investor confidence, with bond vigilantes demanding higher interest payments which would gobble up scarce government resources.

Perhaps the biggest fallacy of today’s interventionists is to ignore the role of private sector expectations. Government spending does not exist in isolation, pumping up demand in bad times and pumping down demand in good times. Government policies usually trigger a strong feedback loop from the private sector, as households, investors and corporations all start to adjust their spending and investing decisions.

There has been no better champion for the importance of the private sector’s reaction to government policy than David Ricardo, a classical economist from the 18th century. In Ricardo’s world, there is an “equivalence” of public and private spending that essentially renders the fiscal pump irrelevant. The private sector understands that there is no free lunch for the government and anticipates that government splurges will be followed by tax increases. Periods of government expansion are therefore offset by increased private savings, and periods of fiscal frugality offset by private spending. For Ricardo, the fiscal multiplier is essentially zero and government spending has no impact on economic growth.

In recent years, classical economists have taken Ricardo’s “equivalence” a step further by arguing that the fiscal multiplier on government spending is actually negative. In other words, spending splurges reduce growth and austerity drives raise growth. This is because government behaviour not only impacts the private sector’s expectations but also confidence. A smaller government improves confidence as the private sector expects lower future taxes and lower interest rates. Both these work to lower savings and boost asset values, which become the engine for a sustainable expansion. In sharp contrast to the Keynesians’, these classical economists believe that austerity drives can unleash “expansionary fiscal contractions”.

Though seemingly a paradox, expansionary fiscal contractions are not a figment of economists’ imagination. They have occurred in recent history, with Denmark and Ireland in the 1980s being the most successful examples. In both cases, there were three key ingredients for success.

First, the public sector made a clear commitment to embark upon large-scale restructuring aimed at improving the flexibility of the market and the economy. Fiscal consolidation targeted structural reforms that aimed to improve the competitiveness of the labour market. Second, the fiscal consolidation plans were credible, permanent and broad-based. Only when the public believed that the government would not backtrack, did they change their savings and consumption behaviour positively. Third, fiscal consolidation triggered a powerful decline in interest rates and interest rate expectations, which boosted asset values and consumption.

The economic reality is that the role of the government can be either a Keynesian positive or a classical negative, depending upon how fiscal plans are executed. If consolidation plans tackle structural reform and are permanent and credible, then there is every chance that growth can resume even as the government makes cuts. However, if fiscal consolidation measures are temporary and not targeted at reform, then there is every chance that growth suffers as the government recedes.

The new government has little choice but to play the hand it has been dealt, and this is a hand of grim fiscal realities. Its decision to execute a large, permanent and credible fiscal consolidation programme is an active choice to shift the government “multiplier” in its favour. It is seeking to improve confidence and growth even as austerity reigns – and its foresight should be lauded. Better to create a smaller and more nimble government that steers the economy through tomorrow’s world of austerity, than passively to stay the course and hope for a better tomorrow.

Guy Monson is chief investment officer and managing partner at fund manager Sarasin & Partners. Subitha Subramaniam is Sarasin’s chief economist