British Austerity: Is the Pain Worth the Gain?

Economists are arguing! That's not news but the argument is over Great Britain, the home of John Maynard Keynes, and that is interesting. One group of economists (the neoliberals) argue that (1) cuts to government expenditures (austerity) should being right away (here) and (2) since Britain has done just that, they are on the right path. Another group, the Keynesians (here) have argued that the math is unequivocal: Y = I + C + G + (X-M). If investment (I) and consumption (C) fall as a result of the subprime mortgage crisis and the balance of payments (X-M) is in balanced, national income (Y) will decrease unless government expenditure (G) fills the gap. The neoliberal argument is that austerity is necessary to restore confidence in the markets and in business. The Keynesian argument is that any decrease in national income is unlikely to instill any confidence.

Why should we care about the British experience and the arguments of economists? Some commentators (here, here, here and here) think that the British experience (positive or negative) provides a glimpse of the U.S. future.

My question is a little different: Was the British austerity experiment really necessary?

I can't answer the question of whether it was necessary to establish confidence since I can't directly measure confidence. But, I can determine whether British government expenditure was too large and whether it needed to be cut in the first place. The way I can do that is to use the WL20 model to establish the level of British government expenditure warranted by growth in the world economy. The red dashed line in the graphic above is the dynamic attractor for British government expenditure.

The black solid line in the graphic is actual British government expenditure. From 2000 to almost 2010, government expenditure was above the dynamic attractor. By 2010, however, expenditure was back on the warranted growth path. If you accept the model predictions, the Brits are fighting the last war. Yes, expenditure was too high. Do we need drastic cuts and austerity programs? No. We just need to allow the world economy to get back on course and not do anything stupid while we're waiting (the real lesson for the U.S.).

If you don't accept the predictions of the WL20 model, then I would ask to see the model you are using to decide that British government expenditure is too large. If the model is based on investor confidence rather than the path of the world economy, you have a pretty weak model.