There is increasing evidence - see here and here - that austerity policies have been a failure in promoting an expansion of GDP as well as reducing high levels of government deficit and debt. These findings are buttressed by academic research - this blog by Simon Wren Lewis - that suggests that high government debt levels should be cut slowly.
The logic of this evidence is that a reversal of austerity policies, for a temporary period at least, should be introduced to encourage actual GDP to recover. Only, when GDP is expanding at trend or above and the economy is close to its NAIRU, or 'natural' rate of unemployment, should policies to reduce government's structural deficits and hence debt be introduced. Even then the speed of adjustment is still critical.
An objection to this approach reflects a fear that the financial markets would turn against the sovereign state that started to do this. The markets might refuse to buy its bonds or seek an ever greater risk premium. Hence, the fear that long-term bond yields would rise and the costs of financing government debt become punitive. But this view assumes that current low bond yields reflect financial market confidence in austerity policies. In fact, the evidence - see Jonathan Portes here - suggests that yields are low because the UK economy and the recovery is weak.
Moreover, financial markets also know that states that are monetary sovereigns i.e. have their own currency and a central bank able to print the currency, will not default on their debt unless by choice. This is one reason, at least, why the UK and the US are in a very different position from France and the periphery countries of the Eurozone.
Despite this, the concern about rising government debt levels has led many commentators to seek alternatives to debt financed fiscal expansion as the basis for their "Plan B".
Simon Wren Lewis makes clear here and here that in such a situation a balanced budget multiplier approach is an appropriate solution. Here a temporary increase in public spending is financed by an increase in taxes of equal amount. In simple economics, an increase in public spending of £1 raises demand by £1. Aggregate demand is raised because taxpayers draw some of their increased tax payments from savings as well as reduced consumption. The taxpayer pays more in taxes but this is offset by higher income. The balanced budget multiplier equals 1 and can be greater than one when interest rates are stuck at zero - as in current conjuncture. This is because any rise in expected inflation due to the demand stimulus will lower real interest rates and so stimulate activity further.
Indeed, as Simon further argues a stimulus effect can be secured without an increase in taxes as well as without further borrowing.
There is the option of tax and transfer switches, within a given tax burden, whereby taxes are cut/raised or transfers raised/cut for those groups with high/low marginal propensity to consume. Re-directing transfers in favour of the unemployed or those in receipt of benefits would be one possibility as I noted here. Simon also suggests ways in which a tax increase can be avoided: a debt financed stimulus can be reversed by lower public spending in the future and not by higher taxation.
A fiscal stimulus can also avoid higher taxes and increased borrowing by a monetary sovereign financing the temporary expansion through new money as Brad DeLong makes clear. I believe this would require legislation in the UK. But it seems to me that it would be a lot more effective than the current programme of quantitative easing (QE). The Bank of England could use sales of securities to lower the money supply once recovery was under way and the obstacle - to monetary policy - of the zero interest rate bound removed as rates rise.
At this point it seems appropriate to dismiss an "alternative" to austerity proposed by George Kerevan in the Scotsman on Friday. Kerevan notes that the Bank of England through its QE programme has built up large holdings of long-term UK government securities through secondary purchases from the private sector. He contends that
If the Treasury and the Bank of England agreed to cancel these bonds, the national debt would fall miraculously to a mere 41 per cent of GDP – very low by any standards. Plus government spending would be slashed by £18bn a year. That would cut this year's planned borrowing by 15 per cent. Alternatively, it could provide precisely the fiscal boost needed for growth – without adding to borrowing.
Unfortunately, it won't do anything of the sort. First, before QE, the interest payments of £18bn were being paid to the private sector, so redirecting them is not going to have that much expansionary impact unless it is along the lines of the tax/transfer switches noted above. Secondly, after QE, the £18bn interest or dividend payments are paid to the Asset Purchase Facility which is indemnified by the Treasury and is part of the public sector. The situation was clearly stated in the speech on QE by Charles' Bean, Deputy Governor of the Bank of England, in October 2009:
Any profits on the Asset Purchase Facility are passed to Her Majesty's Treasury, while any losses are also indemnified by the Exchequer. The accounts are therefore not consolidated with the Bank's own accounts, as the Bank has no economic interest in the fund.
.... gilts held in one part of the public sector, the Asset Purchase Facility, are just a liability of the rest of the public sector. In the accounts for the rest of the public sector, there must therefore be offsetting interest flows, as well as corresponding capital gains or losses,
.... whether the Treasury ends up with a profit or a loss from the Asset Purchase Facility represents only a small part of the picture. Gilt yields will be lower than they would otherwise have been during the period that they are held in the Asset Purchase Facility, so reducing the cost of financing a given budget deficit. This needs to be factored into any calculation of the implications for the public finances.
There are alternatives to austerity. There are alternatives to a debt financed stimulus and there are alternatives to tax financed stimuli. But there is no 'novel solution' to debt finance along the lines suggested by George Kerevan.