Easy on the austerity George

Nightfall

Tomorrow George Osborne unveils his emergency budget. Amid calls for him to cut, come what may, I’d like to put forward an alternative view.

Isaac Asimov, a writer most famous for his science fiction, but who wrote about almost everything, a child prodigy who raced through the educational system devouring subjects like the cards in a football trading game, could not understand economics. I’m not surprised. Asimov was a scientist who also loved the humanities, but economics sits uneasily between them, neither a science nor an art, but a confusing mish-mash of variables and possibilities.

Like Asimov, I struggle with economics, but I follow the economists. One in particular is frightening me.

Paul Krugman is both a serious economist, and a polemicist. He’s been a consistent advocate of economic stimulus since the financial crisis started, a policy that seems to have worked, and he regards with accelerating alarm recent austere pronouncements by the European Central bank and governments including ours.

Responding to a G20 communiqué calling for cuts in government spending, Krugman argues that cutting while unemployment is rising and economies are growing weakly or contracting is both expensive and ineffective in reducing future debt. The cost in terms of jobs and reduced taxes outweighs the lower cost of debt repayments.

The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered — specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity.

Later, in other words, when they are growing strongly and they can lower interest rates to stimulate more growth, over-extended governments can cut. Now, with interest rates so close to zero, they shouldn’t, unless they have no choice like the poor Greeks. Here in the UK, and in the US, governments can still borrow at low interest rates, so they should.

Some people reading this will be thinking if we keep borrowing more, we’ll end up like Greece. At some point we would, but if Krugman’s right that point isn’t now, so in the topsy-turvy world created in the financial crisis the right policy is to spend, even though it is spending that got us into trouble.

George Soros likens this to controlling a skid (pdf). Your inclination is to turn away from the skid (cut spending), but to regain control you must turn into it (spend). Then you try to restore balance.

Paging through Krugman’s blog and others, you’ll find examples of when austerity allegedly brought about a recovery but actually impeded it. The most pertinent, because the coalition government has drawn inspiration from it, is Canada in the 1990’s. In the USA in 1937 an attempt to balance the budget choked off a recovery that might have ended the Great Depression, and in Japan premature austerity stymied recoveries throughout that country’s two lost decades according to The Bank of England’s Adam Posen (pdf). Krugman, also a student of Japan, believes premature austerity would presage a lost decade in the US and UK too.

Although I struggle with economics, I think I understand the stock market better. Investors are divided. Some assume financial markets are governed by the rational expectations of individual investors and others think sometimes markets are driven by ‘animal spirits’, investors are subject to bouts of enthusiasm and panic and generally, at these times, overreact. The term ‘animal spirits’ was coined by an economist and investor, John Maynard Keynes, and that is the reason I follow Krugman, who pays homage to Keynes.

As an investor who is all too aware of animal spirits, I think it’s likely  politicians and economists overreact too. To preach austerity, ‘savage cuts’, is tough, virtuous, even cathartic now we know we’ve been naughty.

But I don’t think playground psychology should apply to economies, however good it feels. So I hope the government is playing a craftier game and in its emergency budget and subsequent spending review Osborne goes easier on immediate austerity than we expect. Instead he might use the political capital the government has engineered in bracing us for tough times to begin to tackle the problems that will drag us down, not this year, or next year, but in ten years time; public sector pensions, say, the cost of the health service, and the lack of alternative sources of energy. The Office of Budgetary Responsibility and a commitment to transparency looks like a good start.

One of Asimov’s famous short stories is Nightfall. Every few thousand years the inhabitants of a planet near the centre of the galaxy experience collective madness when there’s an eclipse. All knowledge is lost as people burn down their cities in desperation for light, but eventually a new civilisation flourishes and the cycle repeats.

Krugman, who was inspired to be an economist by Asimov, thinks our lust for austerity is collective madness brought on by the economic cycle, when (Keynesian) economic knowledge is forgotten and animal spirits take over.

Perhaps ours is an economic tale Asimov would have understood.

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