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 returned with an absolute
majority, much against the predictions of all the pollsters.
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 Budget should be in deficit. 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. But it was still worth cutting the deficit which had reached 10% of the GDP, almost the same size as Greece, which was then having difficulty borrowing.
The norm until then had been to rely on growth and increase government spending in line with the growth of GDP. For a while, even during the years of prosperity, government spending had been rising faster than GDP. Now there was no growth of GDP and government spending had to be reduced. This went totally against the Keynesian orthodoxy which is what most politicians of a certain age group have been brought up on.
Austerity was not popular. It meant cutting public spending steadily for five years. The biggest
items of spending in developed economies’ budgets are Welfare entitlements and health. The government’s promise 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. But by the fourth year it began to recover. UK regained its 2008 income level and by the election time the GDP was eight percent above it. The latest growth data show the UK growing at around 2.5%, which is one of the highest in the developed world.
UK has thus gone through a sort of pre-Keynesian policy experiment. What do we learn from this? The first point is that in standard macro models of the IS-LM type, we concentrate on flows of income and expenditure. Stocks are ignored. UK like many other economies was piling up income growth but with debt accumulation. This was the case not just with the government but households as well. Thus there was a stock dis-equilibrium. Income growth was being exaggerated because the repayment of debt sooner or later was not being factored in. This stock- flow mismatch meant that the income growth of the years before the crisis was unsustainable.
In standards macroeconomics, debt was seen as a distribution issue. The creditors – renters as Keynes called them – were owed money by the rest of the citizens. It was open to policy makers to squeeze the renters 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.
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 bribes.
When Keynesian macroeconomics was challenged by the New Classical paradigm, the absence of stocks persisted. New classical theory does not admit deficit financing nor does it believe multipliers are high. But even so the stock- flow equilibrium is ignored by New Classical theory as well. What we now know is that the debt repayment issue is one which governments cannot easily ignore. But economic theories will also have to be revised to accommodate this question.