The single most contentious issue in economic policy at the moment is whether the government should abandon its fiscal plan and slow down the pace of fiscal consolidation. Rarely do we see views in economics expressed as strongly as those of the pro-growth camp. Former MPC member, and academic economist Danny Blanchflower for example, tweets almost hourly on the subject referring to the Chancellor as “Slasher” and insulting those on the other side of the argument in a most unacademic fashion.

While there are those on both sides of the issue who seem remarkably sure of their position, I personally have always felt uncomfortably torn on it. I don’t think the choice facing the incoming coalition in 2010 was particularly easy – they either had to plunge the economy into recession by cutting borrowing as they did or they had to carry on borrowing a fifth of their total spending for several years just as the bond markets were at their most frazzled. Neither option could have looked very pleasant.

Of course things have changed since 2010 and the data has not been kind to the pro-austerity side of the debate. The IMF and quite a few economists who had been sympathetic to the early fiscal consolidation are beginning to change their mind. So in case you are as confused by it all as I am, I thought I might put in writing, the state of the argument as I see it this summer outlining some points where there is agreement or not.

 
#1 Austerity lowers short term growth
Probably the clearest point of all is that austerity has reduced our national income in the short term. Some said that by cutting the deficit we would get an economic expansion. It didn’t happen and was probably never going to.

It wouldn’t be right to assume that UK recession is only down to the coalition’s fiscal policy of course. The huge surge in commodity prices in 2011 had a large effect too (it pushed up prices and acted rather like a tax on consumers); the weakness of the eurozone removed one pillar of a potential UK recovery; and the threat hanging over the whole banking system from the eurozone crisis has probably also restrained lending and exacerbated the downturn.

But true as all these excuses are, austerity has undoubtedly cost us some GDP. We don’t need to get into a debate over the exact figures; the story is there for all to see.

For many, that appears to be the end of the debate. If growth is good, then less growth is bad; austerity causes less growth so we should have less austerity. Simples.

That is the way the argument against the Chancellor is often written up. Alas, it is not quite that simple. Which brings me to proposition number 2.

 
#2 There is a trade-off between growth now and growth later
A defence of austerity – even if it is killing off growth this year – is that if we don’t have it now, we probably need to have it later. So while it is tempting to delay fiscal contraction to stimulate the economy this year and next, that comes at the cost of growth further down the line.

Some light has been thrown on this trade-off by some sensible projections (made by economists supportive of fiscal loosening) using the model of the National Institute for Economics and Social Research. (You will find the relevant paper here). They’ve looked at a scenario following the current government policy, and an alternative of waiting to 2014 to tighten fiscal policy. The paper suggests that if the government had waited, we could have avoided the double-dip recession, we would have enjoyed growth of 1.1 per cent this year and 2 per cent next year.

The cost of delaying the fiscal pain though, is that compared to George Osborne’s policy, you get lower growth rates from 2016 to 2021. By 2019, the George Osborne economy is actually bigger than the delayed-pain one, and it has a lower debt burden too on these projections.

Given that the idea of a short term pain versus long term pain trade-off is accepted by both sides in the debate, the question on which the whole issue hinges is not whether we lose growth now, it is whether we lose more growth now than we would in the future if we delayed. That is the issue that really matters.

 
#3 It all comes down to the fiscal multiplier
To make a judgement on whether short term pain is worse than long term pain or not, we can’t escape the concept of the fiscal multiplier. This is simply the amount of shrinkage you get (or growth) from a £1 cut in government borrowing (or increase).

There seems to be some acceptance on all sides that in normal times you might expect the fiscal multiplier to be about 0.5. Taking 1 per cent of national income off government borrowing, knocks half a per cent off growth.

If that fiscal multiplier was constant at all times, then it may not much matter when you do a fiscal consolidation – the cost will be the same in terms of lost national income.

The problem for George Osborne is that the evidence is stacking up that the multiplier is not constant at all times. It seems to be higher when the economy is depressed than it is in normal times. When the economy is in recession or depression, a cut appears to be more damaging than when it is plodding along comfortably. Logic would dictate that you should do the fiscal tightening when the impact is smallest – which would be during a recovery (or even better, during a boom if you can wait for one to come along) not during a recession.

I won’t go into detail on why the multiplier might change as the economy swings from recession to boom but there are several reasons. Monetary policy is weaker in a recessionary economy, and struggles to offset the depressing effect of fiscal contraction so can’t do its bit to ease the pain. At the same time, more households are constrained by an inability to borrow money in recession, so can’t maintain spending in face of the shock.

The study that is most horrific for the George Osborne side of the argument on this is a recent technical working paper from the IMF (which you can find here) which suggests that the loss of GDP from a fiscal contraction during a recession is much larger than that of a contraction in normal times. “Spending multipliers in recessions are
up to 10 times larger than spending multipliers when economies are expanding” it says.

The paper not only appears to contradict the IMF’s usual thinking on these matters, but it does so in two important ways – firstly it implies you wait for the good times to come before cutting borrowing. And secondly it also suggests that any consolidation that is imposed during a recession should come in the form of tax rises and benefit cuts rather than cuts in government services.

The economists who have made the specific projections for the UK that I referred to earlier, follow the thinking of that IMF paper (if not the numbers) and they come to the view that even though George Osborne gets more growth in the late part of the decade, and ends up with less debt and a bigger economy in 2021, the upfront pain is simply not worth it. They think that GDP over the whole current decade is about £239 billion smaller than it would be by delaying the austerity pain until 2014.

But it is that claim that is really at the centre of the argument on fiscal consolidation now or later. Do you believe the variable multiplier story? And how much weight do you put on those rosy future scenarios as opposed to the obvious damage being done to the economy now by austerity?

 
#4 Extra capital or infrastructure spending now may minimise the sacrifice later
For many of the economists lining up in favour of some kind of an alternative to the current strategy, the most popular option appears to be borrowing extra money now in order to invest it in new capital projects. You could for example, spend it on infrastructure or new houses, as opposed to borrowing for unsustainable tax cuts.

You can see why this might be attractive: capital spending appears to offer a route round the problem that getting extra growth now comes at the cost of growth later.

One reason for this is that infrastructure may have positive supply-side effects (it may offer us better transport, shorter journey times and a more competitive economy for example, allowing GDP to grow faster than otherwise).

A second reason is that infrastructure spending is generally reckoned to have a very high multiplier, so you get a lot of extra GDP from the extra spending you do.

And thirdly, capital spending creates assets as well as liabilities so a government would have something to show for its spending in future years, making any legacy debt far less problematic. If a government built houses for example, it might even improve its long term debt position by selling them at a profit, thus reducing the need for future austerity a little.

Given that there is a lot of useful infrastructure and housing to build in the UK, we are probably going to have spend money on it anyway and there is surely no better time to do so than when the economy is flat and construction workers have nothing else to do.

There are also tactical reasons for thinking this is a route to pursue. It is consistent with George Osborne’s most important fiscal target (that the cyclically adjusted current deficit should be eradicated); and it is politically attractive as it was not George Osborne that decided to halve the capital budget in the first place, but Chancellor Alistair Darling. In that respect, it represents less of a credibility-destroying U-turn than any other option.

One argument against infrastructure spending is that it takes a long time to turn the tap on. There are not that many shovel ready projects the builders cans tart on. This might be seen as a disadvantage, but it is worth warning that our economy might still be flatlining in two years time; who knows? It would be regrettable if we hadn’t made some preparations ahead of time.

Given that the arguments around extra capital spending are so different to those for extra current spending or tax cuts, it surprises me that the distinction isn’t drawn more clearly in the many words spoken about a fiscal boost.

I hope this romp through some of the arguments clarifies the issue. At least, it might explain why there is division on it.

For my own money, I worry that whatever policy we pursue, it is going to be tough for quite a few years. You can’t assume the economy will be in a strong recovery soon, either with or without a stimulus. The fear is that we face an unpleasant catch-22: that the economy won’t get sustainable growth until the government’s and households’ debts have come down, and that we won’t get those debts down until we have sustainable growth.