I've talked before about the follies of trying to balance the budget during recessions. Here's a new and compelling example from an intriguing and instructive piece from Martin Wolf.
The UK emerged from the first world war with public debt of 140 per cent of gross domestic product and prices more than double the prewar level. The government resolved both to return to the gold standard at the prewar parity, which it did in 1925, and to pay off the public debt, to preserve creditworthiness. Here was a country fit for the Tea Party.
To achieve its objectives, the UK implemented tight fiscal and monetary policies. The primary fiscal surplus (before interest payments) was kept near 7 per cent of GDP throughout the 1920s. This was, in turn, accomplished by the “Geddes Axe”, after a commission chaired by Sir Eric Geddes. This recommended slashing government spending in precisely the way today’s believers in “expansionary austerity” recommend. Meanwhile, the Bank of England raised interest rates to 7 per cent in 1920. The aim of this was to support the return to the prewar parity. Coupled with the consequent deflation, the result was extraordinarily high real interest rates. This, then, was how the self-righteous fools in the British establishment greeted the hapless survivors of the hellish war.
So how did this commitment to fiscal famine and monetary necrophilia work? Badly. In 1938, real output was hardly above the level of 1918, with growth averaging 0.5 per cent a year. This was not just because of the Depression. Real output in 1928 was also lower than in 1918. Exports were persistently weak and unemployment persistently elevated. High unemployment was the mechanism for driving nominal and real wages down. But wages are never just another price. The aim was to break organised labour. These policies resulted in the general strike of 1926. They spread a bitterness that lasted decades after the second world war.
Quite apart from their huge economic and social costs, these policies failed in their own terms. The country went off gold, for good, in 1931. Worse, public debt did not fall. By 1930, debt had reached 170 per cent of GDP. By 1933, it had reached 190 per cent of GDP. (These numbers put the panic over today’s far lower ratios in perspective.) In fact, the UK did not return to its pre-first world war debt ratios until 1990. Why was the UK unsuccessful in lowering the ratio of debt to GDP? Briefly, growth was too low and interest rates too high. As a result, even a huge primary fiscal surplus could not constrain the debt ratio.
The consequences of this folly were devastating. As a result of economic weakness, Britain lost its place in the world order, going from being the greatest superpower to a has-been. It was left with an enduring class hatred, which embittered politics and slowed economic growth for two generations. And how much of the appeasement of the 30s came from the absence of money to pay for rearmament?
There are obvious lessons here not just for the Tea Party numpties but also the the austerity ghouls in Europe. The West risks negligible growth for two decades while the rest of the world powers ahead, pointlessly since the austerity is unlikely to cut government debt. The parallels with the US are frightening Read the whole piece, it's really worth it.
Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. These days I'm retired, and I can't by law give you advice. I do make mistakes, but I try hard to do my analysis thoroughly, and to make sure my data are correct. Remember: the unexpected sometimes happens. The expected does too, but all too often it takes longer than you thought it would.
The Goddess of Markets punishes (eventually) greed, folly, laziness and arrogance. No matter how many years you've served Her. Take care. Be humble. And don't blame me.
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