Tory Hypocrisy and the Brexit Silver Lining

by George Hatjoullis

The Autumn Statement basically abandoned the Tory commitment to austerity. The excuse is Brexit. But this does not really wash. If fiscal deficits are an unsuitable way of boosting the economy, which was the Osborne/Cameron position, then this still holds. If infrastructure investment is a good idea today then it was on June 22. This is just the usual political expediency repackaged as virtue. Those Tory voters that bought the austerity argument based on extrapolating from personal financial prudence to macro financial prudence must be very confused. I am pleased because this extrapolation is nonsensical and I am happy to see distressed Tory voters.

I went to some lengths to explain why it makes no sense to extrapolate personal finance to macro fiscal policy in my Economics series (review 1-5 for a refresh). Macro economics is not simply personal economics at the state level. The UK government can borrow for a negative real yield of around 1.5% for 50 years at the moment. How many potential infrastructure projects do not meet this hurdle rate? The government has had a perfect opportunity to rebuild the infrastructure of this country for some years but it eschewed it in pursuit of some ideological golden chalice of fiscal prudence. Not only was it cheap to borrow in real terms but the economy was experiencing deflationary pressures so fiscal spending would have not been in any way risky.

Instead the government repeated the insane mantra of balanced budgets under all circumstances (there are circumstances in which a balanced budget makes sense of course) and has missed the opportunity. This forced the BoE to pursue easy money to the point that it has become counter-productive and has possibly resulted in an asset price bubble. Economists are taught to think in terms of the optimal money/fiscal policy mix. The objective is maximum output subject to price stability. If one fixes the fiscal position under all circumstances then the mix is always sub-optimal except by coincidence. The new position of the UK government allows a better approximation to an optimal policy mix. This is the silver lining.

The problem is that the switch to more flexible fiscal policy has come at a less propitious time. The collapse of sterling has given the economy a huge inflation shock. It remains to be seen whether this will be damped or amplified but, with looser fiscal policy, the risk of amplification is greater. The UK economy is moving from free trade with 500m wealthy people to bilateral trade with whomever it can manage. Other things being equal, this will boost inflationary tendencies. This could mean a much more rapid tightening of monetary policy than is being signalled by the BoE. The optimal policy mix with looser fiscal in this more inflationary context inevitably involves tighter monetary conditions.

Those following my blog consistently (and understanding and remembering, so probably no one) will be aware that austerity as an ideology has been complicit in the road to Brexit. The eurozone crisis was made deeper and more savage by the Germans not allowing any fiscal leeway to countries in need of finance. The result was a surge in unemployment and a strong flow of job seekers towards the UK from other EU states. The UK was affected by the eurozone crisis despite not being a member because of its EU connection. The Brexit vote is more complicated but this was a contributing factor and one that initially provided the main impetus to the UKip campaign to leave. It is thus ironic that the Brexit outcome is now being used as an excuse for the UK to abandon the austerity mantra. One wonders if this lesson might not also be learned by the eurozone.