Austerity 2.0 is Coming and It's Going to Hurt

By Anonymous Banker

I have a friend whose economic and financial analysis is always interesting because it is apolitical. He is a former City economist with decades of experience. I’ve always found his explanations and insights useful and I think you will as well. That’s why he’ll be contributing to my Substack from time to time as the Anonymous Banker.

You can read his first piece here.

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My last piece concluded with the gloomy prediction that Austerity 2.0, which is imminent, will be far worse than the austerity of the Cameron/Osborne era. In actual fact, a better way of framing this is that the austerity we are about to face will be real, unlike the faux austerity in the aftermath of the 2008 financial crisis.

What do I mean by this?

It is received wisdom that 2010 – 2019 was ‘a decade of austerity’ and ‘Tory cuts’. But was it?

Austerity means spending less than you earn. The UK has not spent less than it earned in tax revenue since 2001. To help you understand how long ago that was in political terms, Tony Blair was not only Prime Minister, he was also popular!

The perception is that the Cameron/Osborne era of austerity cut the debt and got us back onto a sounder fiscal footing post the 2008 financial crash. But that didn’t actually happen – they just borrowed less than before. Borrowing ‘less’ still adds to our total debt pile. Take a look at the charts below and see if you can spot the period where our borrowing was brought under control with massive spending cuts.

Source: ONS & OBR. Time series is Total Managed Expenditure.

These numbers are not inflation adjusted and supporters of Cameron and Osborne would justifiably argue that we should look at government spending as a percentage of GDP, which fell from 45.6% in 2010/11 to 40.7% in 2015/16, and that net debt/GDP essentially flatlined from 2014-17, oscillating around 80%.

Government spending under Cameron’s period in office grew by just 1.3% per annum on average. Inflation (CPI) averaged 2.2% over this period which implies a cut to spending of circa 0.9% in real terms.

However, the cold facts are that net debt/GDP was 68.8% in 2010/11 and had reached 79.1% by 2015/16 when Cameron stepped down. Meanwhile, the national debt grew from just under £1 trillion to £1.575 trillion over that period. Does this sound like the Tories getting Britain to live within its means?

By 2019, our last pre-Covid ‘normal’ year, we had reached 82.8% on a net debt/GDP basis.

To be clear, many sectors saw their funding cut (to allow for the ring-fencing of Health) and people suffered very real effects of these political decisions. This piece is not an argument for or against austerity. The point is that, despite public perception and misleading media reporting, we did not ‘tighten our belts’ or spend less than we earned.

Source: ONS & OBR

The media frequently use terms like ‘deficit’ and ‘debt’ somewhat interchangeably. This is misleading and worth clarifying. The debt is the accumulated pile of money we have borrowed which needs to be repaid. The deficit is the annual difference between government receipts (tax revenue) and expenditure. It is added to the debt pile each year.

Let’s look at the deficit under Osborne. You may recall the mantra of the Coalition years of ‘getting the deficit down’. This did indeed happen as you can see in the data below. However, the government still spent more than it earned in each year. This is why we didn’t see the national debt fall under the Tories despite ‘austerity’.

Source: ONS & OBR.

Think of the National Debt as your mortgage. The Deficit is your overdraft. So our total debt at any point (the sum of claims against us) is our mortgage and overdraft added together.

Let’s say we have a £100,000 mortgage. In Year 1 let’s assume we go overdrawn by £10,000. In total, we owe £110,000. In Year 2, we engage in Osborne style austerity and “only” go overdrawn by £5,000. We now owe £115,000 but we can say we have ‘cut’ the deficit. Yet the reality is we have raised our total debt burden.

UK net government debt is now around 100% of GDP¹. What does this mean? GDP is the size of our economy - it's similar to a company’s annual revenues. In personal terms, 100% debt/GDP is like saying your debts are equivalent to 100% of your annual salary – not a good place to be if you want to eat and pay the rent.

As of September 2022, the National Debt is £2.45 trillion which is 98% of GDP. The population of the UK reached 67.53m people in 2021, which means the debt of the nation stands at £36,280 per head. This is a truly sobering figure when one considers that the median annual salary in this country is less than that at £33,000.

There are important political implications of what happened recently for those on the left, as well as the beleaguered Tory government. The Modern Monetary Theory (MMT) crowd don’t like the idea of comparing UK Plc to a household, as they rightly point out that households can’t print money but a country can. However, what recent events illustrate very clearly is that other countries and investors have to value your money – they have to be prepared to accept it.

Over the last decade, MMT advocates have pushed the view that we can print money without consequence to solve our economic problems. We can’t and we never could. The consequences of money printing are consistent throughout history – see Germany in the 1920s, Zimbabwe or Venezuela more recently. Ask yourself this – if we can print as much money as we want without consequence why do you need to pay any tax at all?

Imagine a strange economy where we are in a house share with 4 housemates. There is one shop down the road. The shop will accept IOUs from us in the form of promises to give them something of value in return for food – let’s say it’s an hour’s labour stacking shelves, packing stock or working the till. Each time I shop, I do an hour’s labour and remain in balance with the shopkeeper. 2 of my flatmates do the same. The 4th loves his food and doesn’t like work. But his IOUs are as good as mine because they’re drawn on and honoured by our household as a whole. So, he writes as many as he likes. Eventually, the shopkeeper realizes there is so much work owed to pay off the IOUs he decides he doesn’t want to accept them anymore. We have created too many of them and now they don’t command the value they once did. Perhaps he can be persuaded to accept them if we raise the implied interest rate to 2 hours labour per IOU? [Incidentally, this house neatly describes the predicament of Germany, Italy and Greece, and hence why the EU has ‘rules’ about member state spending – watch the coming debate about whether the EU (Germany) will issue common debt to save the Euro.]

The market events post the Truss-Kwarteng mini-budget were the equivalent of the shopkeeper (i.e. the global bond markets) deciding they didn’t like our IOUs so much anymore.

Referring to the Cameron/Osborne era above, it is notable the inconsistency of many commentators on Trussenomics. For example, Economist and New York Times columnist Paul Krugman and the UK opposition have consistently argued austerity was a vicious policy mistake by an uncaring, ideological Tory government. Their argument was that instead of cutting, we should have been borrowing more to invest and thus generate growth (a larger economy) to create a larger tax base to pay off the debt. This clearly has a logic and we aren’t criticising their argument against austerity policies per se. However, at its heart, was Trussonomics not about borrowing more in a bold attempt to generate growth, and grow the pie, to solve our debt problems?

Those on the Krugman side of the argument were cynically derided in 2010 for trying to borrow their way out of debt by those on the right. But, there is actually a shared logic here between libertarian right and left wing statists in my view, even if Truss believed in free-market trickle down economics to grow the pie, whereas the anti-austerity crowd believed in government spending to grow the pie.

The key difference really is optics – Truss’ increased borrowing was seen to be to fund tax cuts for high earners by the media (when the reality was it was to fund the energy bailout). Its promises of jam tomorrow (in return for caviar for the rich today) were just too intangible and politically tone deaf in this environment. Especially when compared with borrowing to fund public investments. Both policies would amount to increased national debt but which you prefer likely rests on how you see the world politically.

The real driver behind the austerity of Cameron and Osborne was in fact the bond market. It was about signalling to international investors that the UK was serious about its fiscal responsibilities. The market wanted spending brought under control post 2008. That was the true subtext of austerity rather than an ideological desire to reduce the size of the state (though I would accept that it has the side benefit that it is consistent with traditional Tory thinking).  In reality, Cameron and Osborne limited the growth of the state for their time in office but they did not deal with our debt issue.

“I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” James Carville, Clinton Strategist.

What these recent events demonstrate is that an incoming Starmer government would not have the freedom many Labour voters are hoping for. The reaction of the markets to the UK looking to increase borrowing substantially under Truss’ proposals indicates that their tolerance for this profligacy within the G7 is coming to an end.

Public sector workers backing Starmer and expecting improved pay after the years of “Tory cuts” will find he has little room for manoeuvre. It is doubtful he will have an appetite for major spending cuts (though he will have little choice) so tax rises are clearly coming. However, he can’t be too aggressive on tax as this would potentially retard growth, which the markets would also take negatively. Therefore, whoever is PM faces an unenviable and delicate balancing act.

Truss pursued an aggressive strategy that was poorly communicated, with terrible political optics that spooked the markets. The political goodwill of being seen to take action on people’s rapidly rising energy bills was undone by tax cuts no one was expecting or clamouring for. The lack of clarity on how the hole in the finances would be solved by growth led the market to rightly focus on the open-ended commitment to pay energy bills and sell off UK bonds as a result.

Make no mistake though, whilst these events were about the UK, all the major nations are trying to square the same circle – massive debt, inflation and an energy crisis. Truss gambled ahead of others, putting the UK’s head above the parapet. The rest of the G7 will obviously heed the lesson. If you want a crumb of comfort – the UK can currently borrow for 10 years at 3.6%; the equivalent rate for the US government, in the privileged position of controlling the printing presses of the world’s reserve currency, is currently 4%.

What is clear from these events though is that it is not Starmer or Sunak who is in charge of our politics – it’s the bond market. And what does the bond market crave? Stability, clarity of intentions and action to balance the budget – either through increased taxation or spending cuts – (it’s agnostic which provided it is paid back) and that the Bank of England deals with inflation.

What this means for you and I is higher taxes, reduced government spending and higher interest rates on our mortgages and credit card debt, imposed by Sunak or Starmer, but at the behest of the global bond markets.

1. Per ONS:   Public sector net debt excluding public sector banks (PSND ex) was £2,450.2 billion at the end of September 2022, or around 98.0% of gross domestic product (GDP), which was an increase of £213.0 billion or 2.5 percentage points of gross domestic product (GDP) compared with September 2021. See: https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes/publicsectorfinance/bulletins/publicsectorfinances/september2022