The Macroeconomics of UK Austerity

In an excellent post on the macroeconomics of UK austerity, Tyler Cowen makes an important point. There is no coherent mainstream macroeconomic theory that explains why austerity should make things worse for the UK economy. The Bank of England has much greater ability than the Federal Reserve to generate inflation for two very simple reasons:

  • The UK is a small open economy
  • Most UK mortgages are floating-rate mortgages which means that small changes in interest rates have a big impact on household balance sheets and spending.

Recent empirical evidence of consistently higher-than-target inflation also confirms that the UK economy is nowhere close to a liquidity trap. The fact that growth is so sluggish simply confirms that much of the UK economy’s troubles are “real”, not nominal.