The 2008 global financial crisis provided a rare test-bed for macroeconomics — an opportunity to sort out some old controversies. One issue dominated the debate during the recovery phase: with national budgets and official debt pushed up by the crisis, should budget austerity be imposed as a matter of priority to reduce debt levels?

In this debate, the UK was seen as the clearest test-case — described by one observer as a 'laboratory rat.' The latest UK budget provides an opportunity to evaluate the test, and ask whether it is relevant here in Australia.

Some of the deficit and debt growth in the crisis-affected countries came from the need to bail out collapsing financial sectors. But the larger and more persistent factor was the sudden and sharp fall in GDP, followed by a lacklustre recovery.

In 2009, in the immediate aftermath of the shock, global policy-makers were unanimous in agreeing that automatic stabilisers (the budget components which automatically respond to soften the effects of the cycle, such as higher unemployment benefits and lower tax takings) should be allowed to take budgets into larger deficit. The G20 gave its seal of approval. So far so good.

Then, around the end of 2009, the Greek debt crisis arrived.

Policy incompetence in a country smaller than the state of Victoria set off a market panic in the European periphery that focused global policy attention on official debt levels everywhere. Fears of Greek insolvency were translated into global insolvency concerns. The three most influential global financial institutions – the IMF, OECD and Bank for International Settlements – all strongly urged budget austerity focused on getting government debt down.

Some academics argued that if debt tipped over a critical trigger level (just a bit higher than where many countries found themselves), economic growth and recovery would collapse. Others revived an arcane view that budget austerity would actually be expansionary, with austerity boosting confidence so effectively that private sector expansion would outweigh the budget contraction. Economist-blogger Paul Krugman dubbed this the 'confidence fairy' effect.

Indisputably, the European periphery (Greece, Spain, Portugal and Ireland) was in such deep trouble that severe budget austerity was necessary, no matter how painful. But everyone joined in. Abruptly and universally, budgetary policy switched from supportive to contractionary.

The UK was the prime test-case for this new wisdom.

The newly-installed chancellor of the exchequer, George Osborne, endorsed the 'expansionary austerity' mantra. Certainly, the budget deficit was alarmingly high, temporarily inflated by the cost of bailing out the UK's bloated global banks. Undoubtedly, there was fat in the budget which would, at some stage, have to be trimmed. The critical question, however, was the pace of budgetary reform. Was it better to go 'cold turkey' (including raising the VAT — the equivalent of our GST — and cancelling infrastructure projects), or support the recovery while committing to make structural reforms in more favourable times? 

We can now judge this experiment. The taut austerity was maintained for 2010 and 2011, in which time the UK economy stagnated in the trough of the cycle. A good recovery started in 2013, but it was only at the end of 2014 that UK GDP returned to where it had been in 2007, before the crisis. The current budget has set off a strident argument over whether living standards have in fact returned to pre-crisis levels

This belated recovery has been taken by some (not least the Chancellor) as a vindication of austerity. But what about the seven years of lost potential output? Even with the strong recovery, GDP is 16% below the medium-term growth trend. Unemployment is down, but productivity (the source of rising living standards) has stagnated. Was this the best that could be done? 

More damaging for the 'expansionary austerity' theory, the UK had already departed from its planned path of budget austerity by 2012, pushing back the target for budget balance. The latest budget pushes it back even further; three or four years later than originally planned. The structural budget balance has hardly changed in the past two years.

The recovery should be linked to this easing of fiscal austerity, rather than be seen as a vindication of the initial harshness. Nevertheless, the Chancellor's hair-shirt rhetoric remains unchanged even in the current budget. To do otherwise would raise the question of whether the initial pain was really necessary after all.

Budget austerity has also seriously distorted monetary policy.

The initial hope for UK growth was that fiscal austerity could be balanced by abnormally accommodative monetary policy – near-zero interest rates and huge quantitative easing. But monetary policy is a weaker instrument than fiscal policy, and couldn't offset the budget contraction. The long period of low interest rates has eroded pension incomes and given misleading price signals to investment. Quantitative easing has distorted bank balance sheets, weighing them down with unwanted excess liquidity. Macro policy has been seriously out of balance. Yet in international discussions, some hold up the UK experience as an enviable model. Even here in Australia the new Treasury Secretary, John Fraser, called the UK austerity policy a 'clear success'.

The UK experience seems to confirm some old lessons: when you tighten the budget, the economy slows; the 'confidence fairy' is still imaginary; and there is no painless schedule for structural budget reform.

Photo courtesy of Flickr user Number 10.