The UK is getting caught in an austerity trap

The teenagers are once again in charge of UK fiscal policy. The teenagers are not the Chancellor and his team, but those who set the tone of the fiscal debate in the media and the financial markets.

The teenage scribbler is usually a young, pro-austerity banker, with no formal education in economics or economic history. The scribbler pretends that whatever happens is happening for the first time. The scribbler was still on the playground when the previous generation of scribblers talked their governments into austerity. That was not so long ago. The reasons why Italian voters have turned against centrist political parties for two elections in a row is precisely because the Italian establishment was in 2012 where the UK establishment is now – holding the belief that you need to start austerity the moment your country gets plunged into a recession.

The policy shift from Kwasi Kwarteng to Jeremy Hunt is more extreme than any shift from Conservative to Labour could ever be. They stand for the outer ends of the fiscal policy spectrum. Both are wrong. What you want to do with fiscal policy is to orient it long-term, address problems with productivity growth and debt sustainability through structural reforms, and provide counter-cyclical support during a recession.

The reasons the Conservatives are now embracing austerity is the fear that higher interest rates will kill house prices. This is mad.

One policy instrument governments do have at their disposal, and one they never use, is to have a go at the teenage scribblers themselves. You can tax profits from windfall financial profits on the bond markets. If a private sector company can speculate against the state, then it is only fair to demand a level playing field. There may be less crude ways for a government to extricate itself from the ire of the scribbler, but to follow their lead is probably the worst thing you can do.

A political commentator remarked yesterday that this financial statement was not quite Austerity 2.0, but almost. In pure numbers, with austerity savings as a percentage of GDP, that may well be true. But in terms of the likely dynamic effects it is not. The UK was not in recession, or about to fall into one, when George Osborne unleashed his policies. UK austerity was a mistake too in our view, but at least it was counter-cyclical. The austerity applied by the Monti administration in Italy was so catastrophic because it was pro-cyclical. The narrative at the time was that there was no alternative – the same narrative that is prevalent in the UK today. The markets would not have it any other way. This is clearly nonsense. Mario Draghi's programme of quantitative easing was, in a sense, an attempt to short the bond vigilantes, who had driven Italy’s debt yields to over 6 per cent. This is not to suggest that governments should do the same right now.

The right policy response to the situation the UK and other industrial nations are facing right now is to address stagflation with a mix of three policies: moderate loose fiscal policies, tighter monetary policies, and structural reforms. In the case of the UK, structural reforms should have included an opening up of immigration to address labour shortages. The problem is that the Tory party never agreed on whether the goal of Brexit is to drive immigration down to zero or to manage it according to the needs of the economy. These two goals are right now in conflict.

I have been critical on occasion of macroeconomic policy in EU countries. Very often in fact. But this time is really different. The Euro area is pursuing a much more level-headed policy. The US is a more resilient economy, and will come out of this mess in better shape than anybody else. This time, the UK is the problem. What has not changed is the reason: the spotless mind that favours austerity because it makes intuitive sense.