Tag Archives: austerity

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Of Reinhart & Rogoff & the Emperor’s New Clothes

The brutal smashing that Reinhart and Rogoff’s work has taken in the past 24 hours, was inevitable even without the catalogue of serious methodological errors in their paper.

Reinhart and Rogoff’s empirical result posited a clear threshold. Reinhart and Rogoff were clear that  debt-to-GDP ratio above 90% spelled doom for growth. The actual data is far less clear:

6a00e551f080038834017c38ae718e970b

There is some correlation, but that correlation was loose enough to suggest that this was just one factor of many, and it never said anything at all about whether high debt caused low growth, or low growth caused high debt, or whether some exogenous factor was causing both. The real questions are all about causation.

Far from being a magical no-growth threshold, the UK experienced some of its strongest growth at a public debt level above 90% of GDP, suggesting very strongly that there are many other factors in play. In general, I would tend to caution against the use of arbitrary thresholds to establish principles in economics, whether that is the debt level necessary to lower growth, or the leverage level necessary to trigger a bank run, etc. The evidence suggests these almost certainly vary on a case-by-case basis.

Of course, much of the pro-austerity case seems to have been built on Reinhart and Rogoff.

Olli Rehn of the European Commission defended austerity as follows:

[I]t is widely acknowledged, based on serious research, that when public debt levels rise about 90% they tend to have a negative economic dynamism, which translates into low growth for many years.

Paul Ryan defended austerity using the same criteria:

Economists who have studied sovereign debt tell us that letting total debt rise above 90 percent of GDP creates a drag on economic growth and intensifies the risk of a debt-fueled economic crisis.

Timothy Geithner too:

It’s an excellent study, although in some ways what you’ve summarized understates the risks.

Lord Lamont of Lerwick (an adviser to David Cameron) agreed:

[W]e would soon get to a situation in which a debt-to-GDP ratio would be 100%. As economists such as Reinhart and Rogoff have argued, that is the level at which the overall stock of debt becomes dangerous for the long-term growth of an economy. They would argue that that is why Japan has had such a bad time for such a long period. If deficits really solved long-term economic growth, Japan would not have been stranded in the situation in which it has been for such a long time.

Doug Holtz-Eakin, Chairman of the American Action Forum:

The debt hurts the economy already. The canonical work of Carmen Reinhart and Kenneth Rogoff and its successors carry a clear message: countries that have gross government debt in excess of 90% of Gross Domestic Product (GDP) are in the debt danger zone. Entering the zone means slower economic growth.

This all feels very much like a case of the Emperor’s New Clothes. Those shining robes that cloaked the austerian case for austerity now and at-all-costs were based on serious methodological errors — as opposed to more nuanced criteria for fiscal consolidation during the boomtime, when interest rates on government debt exceed the unemployment rate. All those serious people who praised Reinhart and Rogoff’s seriousness clearly didn’t read it very well, or study the underlying data. Much more like they formed an opinion on the necessity of austerity now, and looked around for whatever evidence they could find for their preconception, whether Reinhart and Rogoff, or Alessina and Ardagna.

The fact that Reinhart and Rogoff did not, and are still not prepared to issue some clarification to their study to prevent its abuse by austerity-obsessed policymakers is sad given the copious evidence that austerity under present conditions is self-defeating. The fact that their response has so far consisted of defending their very weak conclusions — in full knowledge of the political implications of their work, and how it has been used to justify harsh austerity in very slack economic conditions — is very sad indeed.

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When Is Austerity Necessary At The Treasury?

I have made clear in the past that I believe that the time for austerity at the Treasury is the boom, not the slump.

However this is a very general and non-specific definition. I want to be a little clearer and more specific.

First, I think it is important to define austerity. Government is a two-way street. It sucks in money through taxation, and it pushes out money into incomes through spending. Net government spending is the net of these two figures. Austerity in a technical sense happens when the change in net government spending turns negative either through spending cuts, or through tax hikes, or a combination of the two.

Second, I think it is important to specify that this is not a debate about the ideal size of government. This is a debate about the short-term government spending and taxation trajectory, which is a very different subject to one’s ideal size of government. It is possible to favour very small government in principle, but at times oppose austerity. It is also possible to favour large and expansive government, and at times support austerity.

Now, to be very clear: the time for austerity at the treasury is the time when government activity is crowding out the private sector. When does this occur? Well, the clearest example that I can think of are World War I and World War II. It is easy to imagine how government can smother the private sector in times of war; resources are centrally controlled and directed to the war effort, labour and capital are directed away from productive activities and toward fighting, toward building bombs and weapons to destroy things. There is little slack in the economy, as in total war the state commandeers as much of society as it possibly can toward the war effort. Notably, austerity programs that massively reduced the size of government following the two world wars were successful, and did not have a long-term downward impact on growth.

In peacetime, it is also possible for the government to crowd the private sector out of the economy, in a similar way. By commandeering large quantities of resources, labour and capital, governments can leave little for the private sector to use to create, build and invent.

The two most important parameters to determine whether a government is crowding out the private sector are labour markets and capital markets. In the broadest sense, the specific parameters are interest rates and the unemployment level. When the private sector is being crowded out in labour markets, unemployment falls to a low level, as the government is utilising all the slack. When the private sector is being crowded out in capital markets, interest rates rise to a high level, as the government is utilising all the slack.

Today, both in Britain and the United States unemployment is elevated (meaning labour is freely and readily available) and interest rates are very low (meaning capital is freely and readily available). First, Britain:

UKAusterityParameters

Second, the United States:

USAusterityParameters

What this means is that in a technical sense — and irrespective of one’s preconceived notions of the ideal size of government — government is not crowding out the private sector. There is plenty of slack in the economy in both labour and capital markets.

Yet in another sense — unrelated to spending — governments may be slowing private activity. By imposing high legal and regulatory barriers to entry, governments can slow business investment and prevent new businesses from forming, and the unemployed from becoming self-employed. Given the massive growth of legal and regulatory burdens in certain industries favouring only large and old competitors who can hire lots and lots of expensive lawyers, it is extremely likely the case that there are some negative effects. The OECD noted in 2006 that ”administrative simplification and reducing administrative burdens are a very high priority for OECD member countries”, and red tape levels have grown in both sides of the Atlantic since then. I have repeatedly suggested that in the current economic environment governments ease the regulatory and legal burden for small and new businesses in particular to foster competition and lower unemployment.

However cutting back on red tape is a totally separate matter to fiscal austerity, which in the current environment by definition takes an economy with significant capital and labour slack, and creates even more slack.

The time for fiscal austerity at the treasury is a time of high or rising interest rates and low or falling unemployment, and especially when interest rates are higher than the unemployment rate. The reality is that most of the Western world has the opposite of that right now.

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As Soon As The First Nation Leaves, A Trickle Will Turn To A Cascade…

If enacting a levy on Cypriot depositors was a call for a bank run, then saying that the actions in Cyprus are a “template” for future recapitalisations in other Eurozone countries — as the Dutch Euro Group President Jeroen Djisselbloem did yesterday —  was screaming it from the rooftops awash in a demented stupour, drunk on bullshitty Smets-Wouters DSGE and the ridiculous notion that the Euro is sustainable.

Dijsselbloem

This question, I think, needs answering:

Dijsselbloem is yet to respond to the question, other than to say that his claim that it was a “template” did not in fact mean that he meant that it was a template. 

Tyler Durden jokes that the only conceivable reason for this could be an insane pseudo-Keynesian conspiracy to trick people and businesses holding cash to go out and spend or invest it, thus raising aggregate demand and generating recovery:

Last week, when we commented on the absolutely idiotic Eurogroup proposal (now voted down and replaced by an equally idiotic “bank resolution” proposal which will see uninsured deposits virtually wiped out) to tax uninsured and insured deposits, we jokingly suggested that this may be merely the latest ploy by the legacy status quo to achieve one simple thing: force depositors across the continent (and soon, world) to pull their money out of a malevolent, hostile banking system and push that money into stocks, or simply to spend it.

Given the utter folly of the levy itself and the subsequent comments, this might as well be as good an explanation as any. The easiest and quickest way to destroy the fractional financial system is to convince depositors around Europe or the world that their deposits are under threat. The European policy elite has displayed a slavish tendency to protect bondholders from losses, but not depositors upon whom the banking system is utterly dependent. If bondholders do not buy bonds, then it becomes harder for governments to finance themselves (although it must be noted that around the world, interest rates are at all-time-lows in every developed country with its own currency, suggesting a run on bonds by bond vigilantes is a relatively small possibility). But if depositors withdraw their money en mass, the banking system collapses.

I believe that this slavish devotion to preventing losses is fundamentally unhealthy, as capitalism without the potential for loss is robbed of any internal stabilisation mechanism. If bondholders or depositors cannot lose their money, they have no incentive to be prudent with it. But with the danger of a Eurozone bank run looming putting bondholders ahead of depositors is unhealthier still. Protecting government borrowing at the expense of confidence in the banking system is a dire error.

And it is not like there is really a hard choice between the interests of bondholders and depositors. If the European policy elite would deal with the huge social upheaval that the Euro system has created — namely, very high unemployment, youth unemployment and slack resources following the burst housing bubble in the periphery — then both depositors and bondholders could sleep easier at night. All this would take is a firm, long-term commitment from domestic and supernational governments to lending, tax incentives and spending to support business growth. A Europe that is growing, producing additional goods, services, energy and resources that people want and need will be far more stable than one that is shrinking and weakened (in both supply and demand) by forced and centrally-planned fiscal consolidation imposed by the policy elite. People want jobs, contrary to the assumptions of certain neoclassical economists who believe that all unemployment is voluntary. People want business, not to be subject to humiliation and subjugation to meet an arbitrary debt target set by delusional central planners actively weakening economic activity. And, the only way for peripheral nations to get this is through leaving the Euro, which may very well soon start to happen. And once it does, a trickle will turn to a cascade as the leavers begin to quickly recover from their Merkel-inflicted wounds.

In the long run, 25% unemployment in Spain and Greece (as well as elevated unemployment throughout the periphery) will come back to hurt the core, whether that is through weak demand for core-produced goods and services, social unrest, Eurozone-rupture, etc. And Dijsellbloem may yet see how foolish his template was.

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Why Europe Is Still In Peril, In Two Charts

A lot of analysts, including myself, have given the European situation a rest since last year. There were certainly some signs that the ECB and IMF had slowed (if not stopped) the deterioration by providing liquidity backstops to the addled banking system. But perhaps that was just the calm before the storm.

In truth, things were still was probably just as perilous as ever up until yesterday when the ECB and IMF decided to start a banking panic by enforcing a haircut of up to 10% on bank depositors. That was literally the stupidest thing that anyone has done since the Euro crisis began, and while it may not lead to utter disaster, there is a significant chance that it will. Not only is it excruciatingly unjust (it’s theft!), it is also incredibly suicidal. Many, many Spaniards, Italians, Greeks and Portuguese will have looked at the Cyprus haircut in horror, and wondered “Am I next?” Some of those will withdraw their money from the bank and stuff it in a mattress or into tangible assets, furthering stressing the already-fragile and highly-leveraged European banking system. Even a 1% drop in European deposits would lead to over €100 billion of withdrawals.

The background to this is soaring European unemployment:

EuroUnemployment

The people running the European financial system and engineering the bailouts and austerity (ECB, EU, IMF, Germany) have ploughed on through with more and deeper austerity even as European countries (other, of course, than Germany) have run up to higher and higher unemployment levels. Spain and Greece are above 25%. Italy is above 10%, and Portugal above 15%. Hiking taxes and cutting spending is leading to more and more people in unemployment oblivion. That isn’t healthy. Let’s not forget what happened to Germany the last time when over 25% of its people found themselves unemployed:

Chart-German-Unemployment-and-Nazi-Links

If bank runs materialise across Europe next week, the unemployment situation is most likely to worsen even further. If that happens, expect more and more unemployed, underemployed and angry Europeans to start voting for increasingly radical political parties. This is suicidal. Europe needs to not only reverse the awful, stupid Cypriot haircut, but also to put fiscal consolidation on hold (it has, lest we forget, so far been counterproductive) and start worrying about unemployment levels.

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George Osborne Still Doesn’t Get It

In downgrading British debt from AAA to AA1, Moody’s was explicit enough to mention weak growth as the main problem. Now, I couldn’t in itself care less about what Moody’s thinks, because credit ratings agencies are themselves bastions of utter incompetence who continued to rate subprime junk mortgage-backed securities as AAA long after it became clear that they were dangerous default-ridden products. But Osborne himself made clear that Britain’s credit rating was the metric on which we should judge his performance. Yet although Moody’s mentioned weak growth as the problem, Osborne continues to talk about how reducing Britain’s debt-load is his main priority, something that he has completely failed to do:

That ultimately is the choice for Britain — either we can abandon our efforts to deal with our debt problems and make a difficult situation very much worse or we can redouble our efforts to overcome our debts and make sure this country can earn its way in the world.

Osborne is tackling this from the wrong end of the problem. Strong, sustainable economic growth is the way to tackle the debt problem in the long run. But Osborne’s fiscal austerity is not the way to strong sustainable economic growth, which means he is failing by on his own terms and by his own definition. In terms of growth, since 2007 Britain has done worse than comparable countries.

realgdppercapita

People like to talk of Japan’s problems with depressed growth, but since 2007 Britain has done worse than Japan.

And this lack of growth is the real reason why Britain’s debt load becomes ever more unsustainable, no matter how much austerity Osborne tries to implement.

So what’s Osborne’s plan to generate growth? Reduce regulation and taxes on small businesses and new businesses? Make it easier for construction companies to build new homes? Invest in infrastructure (ultra-fast broadband, improved roads and rail) and energy (solar, wind, hydroelectric, oil, natural gas)? Invest in science and basic research? Guarantee loans to unemployed people so they can become self-employed? Offer incentives to foreigners to invest in the UK?

Cutting spending (and yes — in real terms George Osborne is cutting spending) and raising taxes isn’t cutting it. It’s constricting growth. And at the next election if this depression continues, people will vote in droves for anyone but Cameron and Osborne.

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The Unending British Deleveraging Cycle

Current estimates of what is known in the UK as the M4 money supply — cash outside banks, plus private-sector retail bank and building society deposits, plus private-sector wholesale bank and building society deposits and certificates of deposit — show a serious contrast between Britain and the United States:

UKvsUSM4

Could this divergence explain the strong divergence between UK and US real GDP?

RealGDP

I doubt it. It’s a chicken and egg question — does a prolonged deleveraging cycle explain real GDP weakness, or does real GDP weakness explain the prolonged deleveraging cycle? It may in fact be a self-reinforcing spiral effect where the first leads to the second and the second leads to more of the first, and so on. But there are a lot of other factors all of which may be contributing to the worsening situation — protracted weakness in business confidence, tax hikes, spending cuts, weak growth in the Eurozone, elevated youth unemployment, and uncertainty. All these factors are probably contributing to some degree to the weak GDP growth, and the prolonged deleveraging, and thus Britain’s depressionary economic condition.

But we can say that the difference cannot be that Britain’s monetary policy has not been aggressive enough. Britain’s monetary policy has been far more aggressive than that of the United States:

CB assets

How can we break the cycle? Well, as the above graph shows, more quantitative easing is unlikely to have a beneficial effect. The transmission mechanism is broken. What good is new money if it’s just sitting unused on bank balance sheets? What new productive or useful output can be summoned simply by stuffing the banks full of money if they won’t lend it?

The sad truth is that a huge part of the financial sector has failed. Its inefficiencies and fragilities were exposed in 2008, as a default cascade washed it into a liquidity crisis. And yet we have bailed it out, stuffed it full of money in the hope that this will bring us a new prosperity, in the delusional hope that by repeating the mistakes of the past, we can have a prosperous future.

The sad truth is that the broken, sclerotic parts of the financial sector must fail or be dismantled before the banks will start lending again, start putting monies into the hands of people who can create, innovate and produce our way to growth.

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Britain’s Greatest Depression

This is just a disaster — and more prolonged than the depression of the 1930s:

GDP to January 2013

And even more of a disaster when we consider the impact this has had on youth unemployment, which has climbed far above the EU and OECD averages (although nothing like as badly as Spain or Portugal):

o-UK-YOUTH-UNEMPLOYMENT-570

This is not just a failure of government austerity, although that in itself has totally failed to ignite any kind of growth or recovery. The fiscal trajectory is important (not least for business expectations) — and trying to cut public spending and raise taxes during a severe depression in private activity has been shown repeatedly to just exacerbate the private slump — but it’s just one aspect of a greater problem — the failure to create a favourable business environment that can attract capital and growth to the UK.

Lending to UK business remains severely depressed:

LendingtoUKbusiness

Given that the British government owns the bailed-out commercial banks, it’s a shock that they haven’t leveraged this power to reignite lending to business, and particularly to business startups. So long as businesses are allowed to either succeed or fail on their own merits, it would not be a malinvestment of time, energy or capital to use publicly-owned bailed-out banks to break through the lending freeze.

It is something of a chicken-or-egg problem to say exactly how much of the problem is austerity, and how much of it is a weak business environment. But either way, we are on the wrong track. Business confidence levels are still deeply depressed — lower than they were when Cameron and Osborne came to power:

uk-pmi-services-buisness-confidence-feb-2013

We’re now half of the way to a Japanese-style lost decade. If we carry on on the same track, we may end up with exactly that.

If British businesses don’t have confidence in Cameron and Osborne’s policies, if their policies don’t lower unemployment, don’t create growth, don’t boost imports and exports, don’t result in recovery, and don’t even result in less borrowing  (their stated aim), why do they continue to pursue them?

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Latvia Is No Success

Anders Aslund of the Peterson Institute is fairly certain that austerity during depressions works:

After five years of financial crisis, the European record is in: Northern Europe is sound, thanks to austerity, while southern Europe is hurting because of half- hearted austerity or, worse, fiscal stimulus. The predominant Keynesian thinking has been tested, and it has failed spectacularly.

The starkest contrasts are Latvia and Greece, two small countries hit the worst by the crisis. They have pursued different policies, Latvia strict austerity, and Greece late and limited austerity. Latvia saw a sharp gross domestic product decline of 24 percent for two years, which was caused by an almost complete liquidity freeze in 2008. This necessitated the austerity that followed.

Yet Latvia’s economy grew by 5.5 percent in 2011, and in 2012 it probably expanded by 5.3 percent, the highest growth in Europe, with a budget deficit of only 1.5 percent of GDP. Meanwhile, Greece will suffer from at least seven meager years, having endured five years of recession already. So far, its GDP has fallen by 18 percent. In 2008 and 2009, the financial crisis actually looked far worse in Latvia than Greece, but then they chose opposite policies. The lessons are clear.

The notion that Latvia is somehow a success story is just absurd.  Latvia has shed some ten percent of its workforce during the economic turmoil — that would be like more than 20 million people emigrating out of the USA, or 4 million people emigrating from Britain. This is why the unemployment rate has fallen somewhat.  And Latvia’s economy is still deeply depressed, far, far below its pre-crisis peak. Would we be calling Britain and America success stories if millions and millions of people were leaving and output was still far, far, far below its pre-crisis peak?

This video from last year shreds the notion of Latvia as some kind of austerity-driven paradise:

The truth is that the binary choice between stimulus and austerity is false. The real decision is how best to produce productivity, creativity, entrepreneurship and growth. It is possible to do this without any debt-fuelled stimulus, and without any immediate fiscal contraction, by (for example) attracting more foreign investment, using bailed-out banks to provide business finance to the unemployed, and deregulating small businesses and entrepreneurs.

The fiscal trick is in learning to cut spending during the boom — something which very few governments have ever mastered, but which is necessary for long-term fiscal sustainability. In the United States during the mid-2000s, tax revenues were high, and growth was moderately strong. This gave the Bush administration a false sense of leeway that allowed them to embark on massive debt-fuelled spending at precisely the wrong time, starting two wars, and creating large-scale domestic spending programs like Medicare Part D and No Child Left Behind. If the Bush administration had cut spending during the boom, not only would it have offset some of the potential for bubbles in housing and stocks, but it would have left the American government in a much stronger financial position come the downturn.

Yesterday’s prosperity didn’t last forever (leaving us with collapsed tax revenues, and massive budget deficits) and today’s depression doesn’t have to last forever either, so long as we have the courage to create the environment for small business and entrepreneurs to thrive, and then to cut, cut, cut during the next boom. Trying to balance the budget in the way Anders Aslund seems to endorse is a road to deeper depression, extreme unemployment, and potentially to millions and millions of people leaving to look for work elsewhere.

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George Osborne Cuts His Own Welfare

George Osborne, the Chancellor of the Exchequer, a man whose salary totals £134,565 receives government welfare.

But he claims he is about to give up the dole in the interests of fiscal sanity.

In an Op Ed in the Daily Mail Osborne writes:

This week my family will not receive the child benefit we’ve been getting every week since our children were born. Any household where at least one member is earning more than £60,000 will be in a similar position.

They can either choose to stop receiving child benefit, as we have done, or they can have the equivalent sum taken away through the tax system later.

Those earning between £50,000 and £60,000 will lose a portion of that child benefit cash.

It’s not an easy decision we’ve taken as a Government – these days, there aren’t any easy decisions.

Osborne’s claim is that only through contracting spending can we reduce the deficit, and only be reducing the deficit can we have a brighter future. He couldn’t be more wrong.

While it is absurd that rich men like Osborne receive child benefit that they don’t need while severely ill and seriously disabled individuals are thrown off welfare and told they are have to find work (even though unemployment is already elevated, with eighteen people applying per vacancy in 2012, so just how disabled and sick people are supposed to find work in such a depressed economy is quite a conundrum) this is merely a side issue to the wider folly of Osborne’s economic policies.

Balancing a government budget is not simple arithmetic like balancing a household budget. The two policy tools typically discussed in dealing with deficits — cutting spending, and hiking taxes — have powerful hidden effects that often (paradoxically) make deficits bigger, as has happened in the case of the extreme austerity in Greece.

If spending on welfare is cut, then the income of those who would have received that spending is cut, in turn cutting the incomes of others — shops, manufacturers, service-providers — who could have otherwise sold things to them, cutting the incomes of their suppliers, and so on.  And the government will also lose any tax revenues that would have been paid, shrinking revenue and leading to bigger deficits.

If taxes are hiked, then not only does this shrink disposable income — leading to a similar contractionary effect as welfare cuts — but it also leads to Laffer-curve-style tax avoidance, as those subjected to higher tax rates move their income offshore, and use loopholes and creative accountancy to avoid paying taxes. This too can actually drink revenue and lead to bigger deficits.

The better option is to stop trying to balance the budget using contractionary budget cuts and tax hikes and instead focus on increasing output and decreasing unemployment by growing the economy. If the economy grows significantly, and government spending remains the same, then the budget deficit will by definition close itself (and the welfare bill will by definition shrink as more people find jobs). Although the capital markets are offering governments the ability to borrow at very low rates, there is really no straight binary choice between debt-fuelled stimulus and austerity. Policies that promote growth are possible without adding a penny of debt.

  1. Attract more foreign capital into Britain — there are trillions of dollars of foreign capital in emerging markets like the middle east, Russia and China. Britain could offer British citizenship and other incentives for citizens of foreign countries that invest in the UK. Foreign capital can be used to improve British infrastructure, like improving the road, rail and broadband networks, which will in turn provide new jobs.
  2. Increase entrepreneurship — use the bailed-out part-nationalised banks as a vehicle to offer business startup loans to unemployed people. There are millions of jobless people who want to work or a start a business, but cannot because of credit conditions and the weak job market.
  3. Deregulate small business — decrease the regulatory and tax burden for new businesses. Make it easier and simpler to achieve planning permission to build new homes.

Indeed, the current government has paid lip-service to some of the above, but with few tangible results. Britain’s difficult immigration laws continue to deter foreign investment. Four years after the bailouts and in spite plenty of promises from the government, the banking sector is still not lending to small business. The overwhelming thrust of the government’s policy has been contractionary austerity. And the overwhelming result has been weakness and contraction:

uk-vs-us-real-gdp-in-current-downturn

If Cameron and Osborne don’t change their strategy — move away from trying to cut absolute government spending, and move toward trying to boost the wider economy, and so cut government spending as a percentage of GDP, then the economy is highly likely to stay depressed.

And that would be a cut to everyone’s welfare.

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Are Cameron’s Economic Policies Working?

Britain has returned to growth:

But compared even to the USA — which has huge problems of its own — Britain is still mired in the depths of a depression:

An Olympic bounce does not constitute a recovery. As I noted in March, Britain is under-performing the United States — in GDP and in unemployment. Although Cameron and Osborne keep claiming that they are deficit hawks who want to cut the government deficit, the debt keeps climbing.

Defenders of Cameron’s policies might claim that we are going through a necessary structural adjustment, and that lowered GDP and elevated unemployment is necessary for a time. I agree that a structural adjustment was necessary after the financial crisis of 2008, but I see little evidence of such a thing. The over-leveraged and corrupt financial sector is still dominated by the same large players as it was before. True, many unsustainable high street firms have gone out of business, but the most unsustainable firms that had  to be bailed out — the banks and financial firms who have caused the financial crisis — have avoided liquidation. The real story here is not a structural adjustment but the slow bleeding out of the welfare state via deep and reaching cuts.

Britain has become welfare-dependent. Britain’s welfare expenditure is now over 25% of its total GDP. Multi-billion pound cuts in that figure are going to (and have) hurt GDP.

I believe countries are better with small governments and a larger private sector. The private sector consists of many, many individuals acting out their subjective economic preferences. This dynamic is largely experimental; businesses come and go, survive, thrive and die based upon their ability to stay liquid and retain a market, and this competition for demand forces innovation. The government sector is centrally directed. Governments do not have to behave like a business, they do not have to innovate or compete, as they have the power to tax and compel. (The exception to this is when governments become overrun by the representatives of private industries and corporations, who then leverage the machinations of the state to benefit corporations. When this occurs and markets become rigged in the favour of certain well-connected competitors, it matters little whether we call such industries “private sector” or “public sector”).

So I am sympathetic to the idea that Britain ought to have a smaller welfare state, and fewer transfer payments than it presently does. But the current and historical data shows very clearly that now is not the time to make such an adjustment. The time to reduce the size of the welfare state is when the economy is booming. This is the time that there is work for welfare claimants to go to. Cutting into a depressed economy might create a strong incentive for the jobless to work, but if there is little or no job creation for the jobless to go to, then what use are cuts? To reduce government deficits? If that’s the case, then why are British government deficits rising even though spending is being reduced? (The answer, of course, is falling tax revenues).

An alternative policy that would reduce unemployment and raise GDP without increasing the size of government is to force bailed-out banks sitting on huge hoards of cash to offer loans to the jobless to start their own private businesses. The money would be transferred to those who could be out working and creating wealth, but who cannot get credit through conventional channels, unlike the too-big-to-fail megabanks who are flush with credit but refuse to increase lending to the wider public. Even if the majority of these businesses were to fail, this would ensure a large boost in spending and incomes in the short run, and the few new businesses that succeed would provide employment and tax revenues for years to come. Once there is a real recovery and solid growth in GDP and in unemployment, then the government can act to decrease its size and slash its debt. Indeed, with growing tax revenues it is probable we would find that the deficit would end up decreasing itself.