Tue, Nov 09, 2010 - Page 9 News List

Britain’s fiscal consolidation should send a message to the US

We are still in the last stages of a bubble in government debt, and when that bubble collapses, it will hit not just the weaker countries, but also much stronger creditors

By Harold James

Illustration: Yusha

Britain’s policy of fiscal consolidation, recently announced by Chancellor of the Exchequer George Osborne, sent shock waves around the world.

Osborne argued that Britain was on the brink — that there was no alternative to his policy if the country was to avoid a massive crisis of confidence. Other countries, such as Greece, needed to have a full-blown crisis in order to prompt such adjustment measures, whereas Britain was acting prudently and pre-emptively.

If Britain, with a relatively low share of public debt to GDP (64.6 percent) is worried, the implication is that many other countries should be much more concerned, but drastic attempts at fiscal consolidation immediately evoke memories of the Great Depression.

Then-US Treasury secretary Andrew Mellon talked about liquidating workers, farmers, stocks and real estate in order “to purge the rottenness out of the system.” In Britain, Philip Snowden, a small man with a narrow, pinched face, who needed a cane to walk, seemed to want to remake the British economy in his physical image.

Given these historical analogies, a slew of heavyweight Keynesian critics are warning that the world is about to repeat all the disasters caused by bad fiscal policy in the 1930s, but this interpretation of the Great Depression, common though it is, is misguided.

In the first place, the critics get their history wrong. Then-US president Herbert Hoover’s administration did not initially respond to the depression by emphasizing the need for fiscal austerity. On the contrary, Hoover and other figures argued in a perfectly modern, Keynesian fashion that large-scale public works programs were needed to pull the economy out of the trough.

Moreover, today’s Keynesians ignore the urgency behind the depression-era concern with balanced budgets. When the Hoover administration did swing to fiscal tightening, it was responding to pressures from the capital and foreign exchange markets, which in turn were responding to the crises in Latin America and Central Europe, where public finances had been a major part of the problem.

Beginning in September 1931, the markets became nervous about the US, causing large outflows from banks — and therefore from the US dollar. The Great Depression had rendered capital markets incapable of absorbing large quantities of government (or, indeed, any other) debt. As a result, fiscal consolidation appeared to be the only way to restore confidence.

Britain in 1931 already grasped this logic. Snowden was worried that any attempt by the British government to borrow would fail, which would constitute an “admission of national bankruptcy.” That September, concerns about public debt and the British government’s ability to enforce austerity led to a run on the British pound. Rather than trying to mount a last-ditch defense of the fixed exchange rate, the government, at the suggestion of the Bank of England, agreed to abandon the gold standard and devalue the pound.

A third problem with the conventional Keynesian interpretation is that the balanced budget approach during the Great Depression did actually work. It calmed markets and Britain’s departure from the gold standard freed monetary policy from its previous constraints, allowing a monetary stabilization. The country was no longer subject to imported deflation via the fixed exchange rate.

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