When Osborne was appointed chancellor he immediately cemented his austerity programme by establishing the Office for Budget Responsibility. Uncomfortably Orwellian. His aim was to balance the Government’s books and counter what he calls “deficit denial.” At the moment he is trying to hoover up whatever reputation points he can from recently published economic performance data.
I have argued that austerity is hugely damaging a few times but mostly from a holistic perspective i.e. what effect it has on life in general. I thought it would be good to look at it from a more technical perspective. That is, try and figure out what austerity is as a mechanical process and how it can give rise to what we are seeing now.
The first most basic principal is what financial experts call financial identity. This is when two things are really inverse representations of the same thing. Any economy can be split, at the macroscopic level, into a government sector and a non-government sector. The net balance of these two sectors combined, as a matter of unavoidable financial maths, adds up to zero. This is a financially closed system . This means that for the non-government sector to save (run a surplus) the government sector must run a deficit. If the government runs a surplus, the non-government sector, necessarily, runs a deficit.
The government wants stuff done. So it imposes a tax liability, payable in it’s own currency and issues that currency. It can issue the currency lots of ways. Mostly, currency is issued either as a response to the non-government sector creating money or by buying things off the non-government sector (spending). Actually, really, both of these things are spending. One is buying financial assets of banks (as a response to banks needing reserves) and the other is buying real assets of the non-government sector. Neither of these things can be done just because the government says so. For example they can’t buy what the non-government sector doesn’t produce. It’s also forced to buy some things. This is why the idea that the government ‘creates’ money is flawed.
If the total tax bill is equal to the currency issued by the government, then the deficit is zero. This is interpreted as the government ‘funding’ it’s spending through taxation. Actually this is backward because the government has to issue the currency in order to tax it back. It’s more accurate to think that the government is pushing currency into the non-government sector at the rate it is sucking it back out again.
In this situation the non-government sector cannot possibly be saving . So, for the non-government sector to net save the government must run a deficit. Again, note that so far, this is all derived from that one unavoidable financial identity.
So what is the result of trying to reduce the deficit?
At first the non-government sector could absorb the deficit reduction by raiding it’s savings or saving less. This could give the impression of something miraculous, business as usual, giving the government some room for spin. Within the non-government sector different entities can play against each other. Some coming out better, others worse. But the net effect is that the sector as a whole will be subject to a lower rate of saving. If companies want to continue to save at the same rate then they will have to pay less in wages, so people will be forced to save less or cut spending. If they cut spending then some other non-government entity is going to lose an income, so they have moved the problem on to someone else in the sector .
The non-government sector has to meet it’s tax burden, but will do that by paying the lowest wage price it can. If we are lucky then everyone is employed. This would require the remarkable situation that the non-government sector needs to hire everyone in order to meet it’s tax burden. This situation can’t really continue for very long because firms are going to figure out ways to reduce costs. So it’s only a matter of time before they lay people off (assuming that full employment even happened in the first place). Unemployment will creep up or wages will creep down, or both.
How can the government react?
If the government is committed to a non-deficit there is pretty much nothing it can do. The situation will escalate. People without jobs need to eat. Fewer people working reduces tax receipts. The loop of currency begins to break down. Less and less currency circulates. The economy contracts financially, reducing wages and/or employment further. Sovereign currency becomes useless and inflation results. The government might be forced to issue more currency (as a reaction to inflation, which many will then interpret in reverse as causing the inflation) or stick to it’s austerity guns. An austere government could engage in some ’employability’ programs, but that can’t create jobs. And has to be funded. An austerity fixated administration would therefor feel it has to pay for those programs out of taxes. The tax burden would increase, giving the non-government sector stuff to do (the work to meet to higher tax burden)… but it also used those jobs to do the program.
The basic problem is that the economy needs to expand but can’t because the government has allowed no way for that to happen . Note that this situation is created and perpetuated for purely abstract reasons: the need for a number to be zero. The economy needs to expand but because 1+1=2 there isn’t enough currency to represent the extra work. It’s like saying we can’t build more roads because we have run out of miles. Absurd.
Look at it another way. How did all that money get into the system in the first place? The government issued it. So how can it grow without doing the same? It can’t.
The logic is clear: Unemployment means there is more ‘stuff to do’ than is being done. More stuff to do requires an expansion of the economy. An expansion of the economy is issuing currency.
 You might have instantly wondered where the rest of the world is. Actually the non-government sector can be split into two: the private sector and the foreign sector.
 Within the non-government sector individual entities can save, but only if some other entity in the non-government sector is running a deficit.
 You might be thinking “surely the non-government sector” is digging things out of the ground and getting better off as a result. Sure, but who are they selling it to? If they can find a buyer in the non-government sector then someone else has paid them for it. If they sell it to the government, and the government’s books balance, then whatever money they make will be paid back as tax.
 They could also manipulate perception of the facts. This situation is fairly static from a macro-economic perspective (ignoring uncontrollable things) but is likely a mess at the economic scale. Within the non-government sector entities will be doing each other over routinely, with terrible social effects. Labour will be getting turned over repeated. People getting fired at the drop of a hat. A spin doctor can select successes from this and give the impression there is progress happening.