Flatlining Britain needs a short, sharp shock

Austerity hasn't had a great press in the last few months. Half the eurozone is stuck in unending recession. The Greek economy is fast disappearing down the plug-hole, and now the Portuguese economy is going the same way. Britain may well be heading for a triple-dip recession as the lid is kept on government spending and the other engines of growth fail to spark to life.

In this country, the Labour Party is inevitably calling for an end to George Osborne's austerity programme. The shadow chancellor, Ed Balls, has yet to meet a problem to which borrowing more money was not the answer.

But it is not just the usual suspects centre-left politicians and public-sector trade unions who are opposed to the slowdown in spending. Employers' organisations and many firms are now starting to argue that we need to ease up on austerity and try to grow the economy out of trouble.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Yet there are signs that austerity can work so long as it's tough enough. Ireland and Latvia have already proved this point.

Ireland was one of the most prosperous countries in the world until it got caught up in the wider eurozone crisis and saw its over-stretched banking system collapse. In 2010, the costs of bailing out the banks overwhelmed the government and it was forced to ask for a bail-out from the rest of the eurozone. Ever since then it has had to tap its partners for money rather than borrowing on its own terms.

But now it has issued its first ten-year bond since the collapse. It managed to get them away at an interest rate of just over 4% more than Britain, France or Germany pay, but far less than other crisis-struck euro nations. And demand was healthy. It was a key milestone on the country's path towards financial rehabilitation.

Latvia too is on the road back to stability. The Baltic state has seen its bond rating upgraded by Moody's. The agency cited the solidity of public finances now heading back into surplus, and the strength of the country's exports.

But back in 2008 it had to be bailed out by the International Monetary Fund and the EU after going broke. It is a spectacular turnaround matched only by its close neighbour Estonia, which this year managed to join the euro after collapsing in 2008.

What do Ireland and Latvia have in common, apart from being quite small, and relatively cold? Both countries had the courage to push through the kind of cuts that in most others have so far been considered unthinkable.

In Ireland in 2009, the government imposed huge cuts in public spending. Public-sector wages were cut by up to 15%, child benefit by 10% and social welfare by 4%. It has followed that up with tough budgets every year since then, raising tax where it can and slashing spending where possible.

Latvia has been just as brutal. In 2009, it pushed through an austerity programme equivalent to 9.5% of GDP the highest fiscal retrenchment in the world. Some of it came from tax increases, but the bulk came from spending cuts. Public spending came down from 44% of GDP in 2008 to 36% now. In both countries, there was a lot of pain.

In Ireland, the economy went into a deep slump. Output collapsed and unemployment soared. The jobless total tripled, and still stands at 15% of the workforce. House prices collapsed and are still going down. In Latvia, it was just as bad. The unemployment rate went from 5% before the crisis to more than 20% in 2010.

But although the medicine was harsh, it has worked. Ireland is now growing again not very fast, admittedly, at an expected rate of 1.7% this year. That is nonetheless more than Britain is likely to manage.

In Latvia, the results have been better still. The economy is now expanding at more than 5% a year, one of the fastest rates in Europe. Even the fact that most of its exports are to the troubled eurozone does not seem to be holding it back. Indeed, if Europe was not in perpetual crisis it would probably be growing even faster now.

What that shows is that austerity can work but the cuts have to be very deep, and made as quickly as possible. True, both countries are small, and it is easier for tiny economies to bounce back than it is for big ones. They only need one or two industries to be doing well for growth to return.

They also had the safety valve of emigration. Huge numbers of Latvians found work abroad, and the Irish, as they always have done in hard times, started looking for jobs in London and New York when work dried up in Dublin. That stopped unemployment rising even faster.

The key point is that they got themselves growing again reasonably quickly. By contrast, Britain has adopted half-hearted austerity. The rate of increase in government spending slowed, but it has not actually been reduced. Wages have been held back but not cut. The state consumes just as much of GDP as it did, and the total national debt keep rising.

Britain would be better off with Irish or Latvian austerity a short, sharp shock that would put public finances decisively back in shape; or else a Keynesian dash for growth which at least might get the economy expanding enough to bring down the deficit. Either would be high-risk but would surely be better than flatlining forever.