The UK is showing us why austerity is dangerous, but are we paying attention?
With the recent news that both the United Kingdom’s and United States’ economies contracted last quarter—the U.K. by a large 1.2 percent annualized rate and the U.S. by a much smaller 0.1 percent—it’s a good time to revisit the contrasting economic situations in the U.K. and the U.S. to show just how dangerous austerity is to economic growth. First off, both countries fell into recession by experiencing a similar housing market shock, and the central banks of both countries engaged in responses of similar magnitude. And between the second quarter of 2009 (the trough for both countries) and the third quarter of 2010, both countries grew at similar rates: 2.2 percent annualized real growth for the U.K., and 2.5 percent annualized for the U.S. (according to OECD data).
But in the summer of 2010, the newly-elected conservative-led coalition government of the U.K. passed and implemented an aggressive austerity budget. This budget was heavily weighted toward spending cuts—nearly 80 percent of the total fiscal consolidation—and included a 25 percent cut to non-health domestic departmental spending by 2014-15. Tax increases accounted for the remaining 20 percent, including increases in the value-added tax (essentially a sales tax). In total, this fiscal consolidation represented 2.2 percent of U.K. GDP by 2014-2015. Combined with the previous government’s planned austerity, the overall fiscal consolidation implemented totaled 6.3 percent of GDP.
This austerity package caused the British economy to stall and contract by an annualized 1.7 percent in the fourth quarter, which was predicted by textbook macroeconomics but totally contrary to those who claimed that simply announcing fiscal consolidation would boost the economy. Meanwhile, the U.S. sustained positive trend growth of 2.4 percent—inadequate to rapidly restore full employment but fast enough to prevent a slide into a deeper depression. Fast-forward to today: with the news that the U.K. economy contracted at an annualized 1.2 percent in the fourth quarter of 2012, this means that its economy has shrunk in five of the last nine quarters (since the third quarter of 2010), while the U.S. economy has grown in each of the last nine quarters except the most recent. In fact, over this time period the U.S. economy has grown over nine times as fast as the U.K. economy, which has for the most part totally flat-lined.
Ironically, the poor performance of the U.K. economy has also made it more difficult to address its fiscal issues. In fact, since mid-2010 public debt (excluding financial assets held by the government) as a share of the economy has risen, from 55 percent to 69 percent at the end of 2012.
The lesson here is two-fold. First, near-term deficit reduction can significantly harm economic growth. And second, as this approach drags on the economy, it will also exacerbate the deficit and debt. In other words, the U.K. austerity approach—which is intended to reduce the debt and boost the economy—actually does the opposite.
Generally speaking, the U.S. has so far avoided making the same mistake as the U.K. The phase-out of the Recovery Act, state and local government budget cuts, and the discretionary caps from the Budget Control Act are all forms of austerity that have dragged on the U.S. economy (one of the reasons that it performed better in the first five quarters of the recovery than the last nine), though this austerity has not been nearly as large as the U.K.’s.
But U.S. policymakers unfortunately continue to flirt with austerity. The U.S. economy’s contraction last quarter was largely driven by defense spending cuts, which are likely the result of the Department of Defense pre-emptively slowing down spending in anticipation of the January 1 sequester (which was eventually delayed until March 1). If the scheduled spending cuts in the sequester are fully repealed, then the delayed fourth-quarter spending will just be pushed to the first quarter of 2013, likely driving more economic growth in that quarter. But if the spending cuts in the sequester are allowed to remain in effect (causing a 0.7 percent drag on the economy through the rest of the year), and/or U.S. policymakers decide to engage in other forms of austerity, then the U.S. could likely end up on the path of the U.K.: an economy moving in the wrong direction with little end in sight.