A little less than two years ago, the people of the United Kingdom made an implicit deal with the people of the United States. They installed a government that committed itself to an austerity package as the best way to deal with the ongoing effects of the recession.
Rather than trying to boost demand with increased spending or lower taxes, the Conservative-led coalition government committed itself to an agenda of spending cuts and tax increases. The argument was that the financial markets would be impressed by the UK's commitment to reducing its budget deficit.
This would supposedly lead to lower interest rates which would help to boost investment, housing and consumption. Lower interest rates should also reduce the value of the pound relative to other currencies. That would make imports more expensive for people in the UK, leading to fewer imports. It would also make exports cheaper for people in other countries, thereby increasing exports. Fewer imports and more exports would provide a further boost to demand.
The commitment to deficit reduction was also supposed to instill confidence in business. They would see that the UK had a responsible government in power that would ensure that the debt would not get out of control. This would encourage them to invest, since they could be assured that the UK had a stable future and there was no reason to fear a Greek-style debt crisis.
We have now had almost two years to evaluate the effects of the UK's austerity policy, which is longer than most governments get to test the results of their policy experiments. After all, President Obama got his head handed to him in the November 2010 elections, which were just 20 months after the passage of his stimulus package.
It sure looks like the austerity critics won this one. While interest rates have remained low in the UK, this has been true of every wealthy country with its own currency, regardless of whether or not it was pursuing an austerity path.
Ten-year Treasury bond rates in the United States have averaged less than 2.0 percent in the last year, with rates in countries such as Denmark and Sweden being comparable. Japan, which has a debt-to-GDP-ratio of well over 200 percent and continues to run large deficits, pays less than 1.0 percent interest on its 10-year Treasury bonds. In short, austerity does not appear to have been necessary to keep interest rates low.
The UK economy does not appear to have done any better in terms of the rest of the picture. If austerity boosted business leaders' animal spirits, it is not showing up in the data. Nearly every component of the private sector has contracted over the past two quarters with construction leading the way, falling at a 0.8 percent annual rate in the fourth quarter of 2011 and a 12.0 percent rate in the first quarter of this year.
When taxes rise and government spending falls, and there is no offsetting boost from investment, our old friend Mr Arithmetic tells us that the economy contracts. And that is what is happening now in the UK. The economy shrank for the second consecutive quarter, pushing it back into recession. While the UK economy was growing rapidly at the time the Conservatives came to power in May of 2010, the economy is now smaller than it was in the summer of that year.
This is all very bad news for people living in the United Kingdom. There has been no job growth since the summer of 2010 and the unemployment rate has risen from 7.7 percent to 8.1 percent in the most recent data. It seems certain to rise more in the months ahead. If anything, the situation is likely to worsen over the course of the year as more of the spending cuts take effect.
But the bad news for the British people can be good news for the United States. Thanks to their generous offer to experiment with austerity, people in the United States can now see more clearly than ever that austerity does not work.
Of course we did have a lot of evidence on this topic already. We had our own experience in the Great Depression, where we saw that New Deal spending boosted the economy and shrank the unemployment rate, the drive to balance the budget in 1937 sent the economy plunging, and the huge spending associated with World War II eventually restored the economy to full employment.
In addition, we could witness the eurozone countries throwing themselves into recession at the behest of the European Central Bank and the International Monetary Fund. First Greece, and now Spain, Portugal and Italy seem all but certain to join the double-dip club. And there is also a considerable body of academic research, some of it old, but some of newly done, since the recession.
But there are many people in positions of power who want to push austerity for reasons that have nothing to do with economic growth -- and they are prepared to lie, cheat, and steal to advance this agenda. For this reason, however much we may sympathize with the people of the UK for their suffering, we should be thankful that they have given us such a beautiful example of how austerity wrecks an economy.
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