The Common Sense of Austerity and GDP growth

The anti-austerity protest which is getting under way on 20th June, is not just a politically motivated objection to a policy of the governing Party. It is a protest with deep foundations in both theory and common sense.

For successive governments GDP growth has been the holy-grail. Despite misgivings over its validity (, it is accepted that balancing a budget with a growing GDP is a whole lot easier than doing so in recession. But imposing austerity on the economy only stifles GDP growth. So why do governments of both main Parties – assuming Labour takes the suicidal Blairite route – accept austerity as the necessary medicine for our economic ills?

The economy is a complex of many different sectors, public and private, that relate to each other in all sorts of different ways, and it is continually on the move with some sectors growing and some shrinking, some dying off altogether and new ones emerging. That dynamic is the result of millions of people striving to make progress. Politicians don’t control the economy; the best they can aim for is to do the people no harm.

In 1911, Irving Fisher came up with an equation which defined the economy in terms of money: MV=PT where M is the amount of money, V the velocity of its circulation, P prices and T the number of transactions. Like most equations in economics it was obviously unmeasurable in the real world, but was nevertheless much quoted in support of policies which achieved little of value.

The MV quantity did, however, provide some insight. Injecting an additional £100 into an economy will not have any economic impact if its recipient just sticks it under their matress, ie velocity of circulation zero. If, on the other hand, it is spent on real goods and services it will have an impact, growing the economy by £100. If it is spent again by those who received it first, it will have a double impact. In that way, the £100 injected could be re-spent, say, every month, thereby having the economic effect of £1200 over the year. The velocity of circulation is clearly important in determining GDP growth.

As a proxy for GDP, the MV measure suggests two possible ways of increasing economic activity: increasing the amount of money in the economy or increasing its velocity of circulation.

Friedman was the lead economist associated with the misuse and policy failure of the quantity theory of money. Even he acknowledged, late in his life, that its results were ‘disappointing’. Nevertheless, post 2008, politicians have persisted with repeated rounds of quantitative easing (QE), money paid to the banks in the professed hope they would invest it in the real economy. QE in the UK has so far totalled an eye-popping (to quote the Financial Times) £375 billion. The banks have used the money to rebuild their balance sheets, placing the funds in the care of professional traders and fund managers.

The reason why QE has failed to impact the real economy has been reported many times over, including on this blog (eg J K Galbraith referred to it as ‘trying to push the economy with a piece of string.

Prior to the 1986 ‘big bang’ stock market computerisation and financial sector deregulation, money was mostly invested in real economy enterprises, in the absence of more lucrative alternatives, with the result that real jobs were created and the whole economy gained. Since 1986, a virtual economy has grown up which is drawing investment away from the real economy of manufacture and non-financial services, to betting on deliberately opaque composite securities. According to the International Swaps and Derivatives Association, that virtual market is now worth many times the world’s investment in stocks and shares of real firms.

Instead of increasing the quantity of money by QE, common sense suggests increasing its velocity of circulation would be more effective. To make sure that injections to the economy circulated fast they would need to be made available to those who would spend them quickest. That would, of course, be those in greatest need, who wouldn’t have any option but to spend immediately. That would seem to maximise the economic impact of the injection.

The policy of austerity has exactly the opposite effect on GDP growth, reducing the spending power of those who would spend fastest. The combination of austerity with QE, multiplies the adverse impact, ensuring growth is focused on the virtual economy where investment is for speculative gain.

That is where the application of Friedman’s theory inevitably leads. The common sense response was provided more than eight decades ago by Roosevelt’s New Deal which invested directly in the real economy to provide employment among those who would spend fastest and therefore stimulate the economy most. That was before the publication of Keynes’ General Theory which provided an explanation of why it worked so well.

But that’s where economics being politics comes in. There are so many layers of political loyalties which cling to fragile economic theory for their justification. It surely isn’t the Osborne-Cameron aim to screw the poor for the benefit of the rich. But that is their effect. If they were to apply common sense to the situation, rather than clinging to a half-baked economic theory, they would pursue the Roosevelt line and invest to create jobs. There are no lack of investment opportunities for governments prepared to think beyond the next quarter’s results. The world is not just demanding, but screaming out for, the development of new sustainable technologies which, as of today, only the Green Party is fighting for.

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