Misunderstandings around austerity economics

After the 2008/9 recession the coalition government famously adopted a set of contractionary fiscal policies with the aim to reduce national debt. Elements of this austerity programme included significant cuts to government spending, public sector job reductions, and changes to welfare programs. Various Keynesian economists claimed that such policies would be detrimental to the British economy, including Nobel prize winners Paul Krugman, and Joseph Stiglitz. 

In some sense they were right, but for all the wrong reasons. 

Austerity in the UK was harmful due to the impact which it had on total expenditure. The reduction in government expenditure caused a reduction in public sector employment, which had a knock on effect in the private sector as lower total spending in the economy led firms to layoff workers. Primarily through these mechanisms austerity policy led to rising unemployment, and a general reduction in standards of living. 

However, this is not inevitable. Following the recession the US adopted a very similar set of austerity policies to the UK, if anything they were slightly more radical. Just as economists did in the UK, a letter signed by 350 Keynesian economists suggested that this might push the US economy into recession. The US budget deficit was then reduced from roughly $1,050 billion in 2012 to $550 billion in 2013. Despite this, there was never an equivalent ‘double dip’ recession, as was experienced in the UK and EU.

This is because the Federal Reserve adopted sufficiently expansionary monetary policy to offset the impact of the reduction in government expenditure on NGDP (total expenditure). While government expenditure fell, this was negated by the increase in private sector expenditure, meaning there was no significant increase in unemployment. Had the Bank of England adopted similar monetary policy, the country undoubtedly would have fared far better during the austerity period. 

Austerity in the UK was not harmful because government expenditure fell, as many will often suggest, but instead because inappropriate monetary policy allowed total expenditure to fall.