JUNE 22, 2012
THE LAST FOUR YEARS have created what economists call a “natural experiment” in economic policy. As a consequence of deregulation and globalization, Britain and the United States experienced the financial crisis of 2008 in much the same way. Large parts of the banking system collapsed and had to be rescued; the real economy went into a nosedive and had to be stimulated. But after 2010, the United States continued to stimulate its economy, while Britain chose the stonier path of austerity.
The British are no more wedded to the idea of fiscal austerity than are the Americans. The Victorian aim of an annual budgetary surplus (in order to allow for the repayment of debt) has long since vanished. Both countries experienced only occasional surpluses in the postwar years associated with exceptional booms. The divergence of the two countries lies not in underlying attitudes but in political and institutional circumstances.
First, the British entered the crisis with a largely discredited Labour government; the Americans with a largely discredited Republican administration. The political swing gave power to the traditional spenders in the United States and the traditional budget-cutters in Britain. Second, despite their small-government rhetoric, Republicans have actually always accepted, and indeed promoted, large deficits in the name of national security. Third, whereas the U.S. Treasury is simply an agency of government, the British Treasury has always assumed that it should control, not facilitate, government spending. Finally, Britain, with European examples in mind, was concerned that foreign bondholders would take fright at the growth of the national debt—at least, this became the grand rationalization of austerity policy after the Greek crisis flared up in 2010.
These factors help explain the differing fortunes of John Maynard Keynes in the two countries. Homegrown in Britain, Keynesian policy was enthusiastically embraced by British governments immediately after the war. In the United States, full-blooded Keynesianism started only with John F. Kennedy and Lyndon Johnson in the 1960s. The United States under Ronald Reagan and Britain under Margaret Thatcher abandoned official Keynesianism in the 1980s, but the taxcutting, defense-boosting commitments of the Republican Party kept unofficial Keynesianism alive in the United States long after it had been relinquished in Keynes’s own country. When George W. Bush, in announcing his stimulus measures of 2001, declared that budget deficits were justified by war, a recession, or a national emergency, Milton Friedman deplored the fact that “crude Keynesianism has risen from the dead.” Paradoxically, Keynesianism, unacknowledged and often reviled, chimed in with some constants in U.S. political life better than it did in Britain, where it is still customary to pay homage to the master while ignoring his teaching.
SO WHAT DOES the experiment in economic policy tell us? At the start of the crisis, leading economic indicators in the United States and Britain were broadly similar: a government deficit of around 2.7 percent of gross domestic
product (GDP), inflation of around 2.5 percent, and unemployment around 5 percent. The greatest differences were in GDP growth, with Britain growing at 3.5 percent in 2007 and the United States at 1.9 percent, and in the debt-to-GDP ratio, with Britain at 38 percent and the United States at 48 percent. In the autumn of 2008, both countries saw their financial and real economies rapidly contract. By the third quarter 2009, GDP had fallen by 5 percent in the United States and 5.9 percent in Britain, with unemployment rising sharply.
Both the Bush and Obama administrations and the British Labour Government subscribed to a Keynesian “savings-glut” interpretation of the crisis. According to this view, excessive saving in East Asia led to current account surpluses and created global deflationary pressure. Cheap money and expansionary fiscal policy in the West in the runup to the crisis were necessary responses. The resulting asset bubbles were not the fault of expansionary policy, but due to the fact that the money was channeled into speculation rather than investment. Once the bubble burst, savings rose and aggregate demand collapsed.
It followed that recovery required a boost to demand. As President Barack Obama put it: “It is expected that we are going to lose about a trillion dollars worth of [private] demand this year [and] a trillion dollars of demand next year because of the contraction in the economy. So the reason that this [stimulus package] has to be big is to try to fill some of that lost demand.” Britain’s Labour government agreed. In 2008–2009, Prime Minister Gordon Brown pumped an extra $41 billion into the British economy; in February of 2009, Obama signed into law a $787 billion fiscal stimulus package. Insolvent banks were bailed out and the central banks of both countries started “quantitative easing”—effectively, printing money—in an effort to expand the supply of credit by forcing down bank lending rates.
The activist policies had an immediate impact in both countries. A year after the onset of the crisis, GDP growth started to pick up. However, while stimulus measures prevented another Great Depression, they helped expand government debt. In 2007, both the British and U.S. government deficits were 2.7 percent of GDP; in 2010, the figures were 9.9 percent and 10.5 percent, respectively.
Chicago economist Robert Lucas has ruefully remarked that “everyone is a Keynesian in a foxhole.” But once stimulus policies removed the danger of prolonged depression, ideological conservatism reasserted itself. The fact that the bond markets started betting against highly indebted governments gave fiscal hawks an excuse to cut state spending under the guise of restoring “credibility” and “sustainability”; in Britain, these ostensible virtues became the basis of official policy after the general election of 2010. Britain’s Conservative spin doctors fueled the debt aversion with images from the streets of Athens and analogies between the private and public purse. Unless the state learned to live within its means, Britain would become “another Greece.” Austerity, not stimulus, was the road to recovery.
AS AUSTERITY POLICIES took hold in most of Europe, a Hayekian “money-glut” analysis of the origins of the slump replaced the Keynesian “savings-glut” one. According to Friedrich Hayek, slumps result from overly loose monetary policy. Excessive money-creation by the central bank makes it possible for banks to lend more than the public wants to save. Hayek called the creditfinanced investment that results from this “mal-investment.” Malinvestment manifested itself mainly in rapidly rising housing and asset prices. These prices were unsustainable, because they were based on debt, not genuine saving. Once the default rates on mortgages went up, the banks found that their AAArated assets had become junk. So they stopped lending.
The collapse of the financial economy led to a sharp contraction of the real economy. In this view of things, the main requirement for recovery was to increase saving and liquidate the malinvestments. Fiscal stimulus would only delay a genuine recovery.
While the Obama administration continued to stimulate the U.S. economy—through the Recovery and Reinvestment Act of 2009—George Osborne, the new British Conservative chancellor, pursued a modified Hayekian experiment. The government set out to slash public expenditure by £99 billion—or 7 percent of GDP—per year by the 2015–2016 fiscal year and increase taxes by another £29 billion per year.
Two years later, the score card is in. Since May 2010, when U.S. and British fiscal policy diverged, the U.S. economy has grown—albeit slowly. The British economy is currently contracting. Unemployment in the United States has gone down by 1.4 percentage points; in Britain, it has gone up by 0.2 percentage points. And despite keeping up stimulus measures, the Obama administration has been more successful in reducing the government deficit—by 2.5 percentage points compared with Osborne’s 1.9 percentage points.
Earlier this year, Paul Krugman wrote that “Britain . . . was supposed to be a showcase for ‘expansionary austerity,’ the notion that instead of increasing government spending to fight recessions, you should slash spending instead—and that this would lead to faster economic growth.” But, as Krugman wrote, “it turns out that . . . Britain is doing worse this time than it did during the Great Depression.”
For Keynesians, this is not surprising: By cutting its spending, the government is also cutting its income. Austerity policies have plunged most European economies (including Britain’s) into double-dip recessions. At last, opinion is starting to shift—but too slowly and too late to save the world from years of stagnation.
Robert Skidelsky is John Maynard Keynes’s biographer and a member of the British House of Lords. His latest book, co-authored with his son Edward, is How Much Is Enough? Money and the Good Life.
This article appeared in the July 12, 2012 issue of the magazine.