The Paradox of Austerity

Martin Wolf of the Finanical Times, spoke on BBC’s Newsnight last night of the UK’s Paradox of Thrift. This was first phrased by Keynes and it basically means that when consumers decide to save money in  a recession and deleverage, aggregate demand falls and total savings of the population also falls.

In times of economic woe, where unemployment is higher and, for those with jobs, the risk of losing their jobs is higher, saving for an uncertain future is a defensive natural reaction. Furthermore, for those consumers with debts it makes sense to pay off these liabilities to improve personal balance sheets for potential future shocks.

However, if everyone cuts spending, total consumption in the economy will weaken, leading to falling incomes and, therefore, less total saving.

Now, Keynes advocated an increase in government spending to replace the fall in consumer spending at times like this to boost aggregate demand but Chancellor George Osborne is currently thinking like an individual consumer rather than the social planner that he is.

The deficit reduction plan by the government is important but mistimed. It may have had a chance of success if the Euro-Zone and US economies were not also suffering from a slump but given the aggressive austerity packages taking place in the Euro Zone, demand from our biggest trading partner is also be subdued.

It is important to note the words of US Fed Chairman, Ben Bernanke, at his testimony to Congress this week who inferred the difference between long-term fiscal sustainability and the short-term needs of the economy by warning against fiscal policies that impede long-term economic growth.

Whatever critics say, the UK is not Greece, and because the UK lies outside the Euro Zone, the government has a freer hand to steer the country through the economic storm. Raising government spending through targeted policies aimed at boosting aggregate demand now can give the UK a much needed boost. Governments have the luxury of being able to spend now and pay later through future taxes and spending cuts. Although this may sound like heaping more liabilities on an ever growing debt mountain, it is less painful to pay for austerity when the economy recovers, confidence is rejuvenated and growth is back on an upward trajectory than to strangle growth in the short term, potentially leading to a rerun of the Japanese deflation.

When consumer savings have been boosted and private debts paid off, there will be greater demand from the private sector and the strings to the government’s purse can be tightened.

The good news is that Osborne appears to be leaning towards introducing policies aimed at boosting demand such as credit easing announced at this week’s Conservative Party conference but more needs to be done.

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This entry was posted in Austerity, Bailout, Bank of England, BOE, Cameron, Conservatives, Debt, Economics, Euro Zone, Osborne, Recession, Tax, UK, Unemployment and tagged , , , , , , , . Bookmark the permalink.

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