When my family went to the Olympic Stadium, we said to our 14 year old, a fan of the Romans, that it must have been just like this in the Colosseum. No, he replied sagely, we would not see anyone thrown to the lions. George Osborne must have been grateful for that when the Paralympic crowd spontaneously started booing him a few days later.
The crowd’s reaction summed up the sense of frustration and impatience which seems to be rife in the British economy at present. The unfortunate Mr Osborne, who has scarcely been around long enough to deserve all of the blame, seems to be a man in the wrong place at the wrong time. David Cameron, generously or not, sees advantage in keeping him there. How can he dig himself out of this hole?
According to Denis Healey, the Labour chancellor in the late 1970s, the first law of holes states: when in one, stop digging. Osborne is not doing that, or is certainly trying hard to give that impression. Plan A was his idea, and it seemed like a very good one at the time. He is sticking to it. His intellectual ally, Mervyn King, governor of the Bank of England, continues to play his required role with determination. Nick Clegg, though lost in the economic maze, cannot find an exit. We are going to fix the economy, says the coalition, even if it is the last thing we do.
The problem is that the economy is not behaving as was predicted when Plan A was launched.
Osborne’s key judgement was that he could reduce overall debt by around 6 per cent of gross domestic product (GDP) in the course of the parliament, while relying on aggressively easy monetary policy-—in this case, printing money—to ensure that GDP growth would remain slightly above its long-term trend. That would eliminate the budget deficit (or more accurately the structural current budget balance) by the last year of the forecast period, 2015/16. And it would bring the public sector debt down thereafter. Around 80 per cent of this budgetary adjustment would come from spending cuts, not through higher taxation.
The new chancellor chose to describe these objectives in the most rigid manner possible, in order to reduce the risk that the bond markets might panic about Britain’s budgetary position. At the time, that risk did not seem far fetched. Furthermore, Osborne was trying to summon what Paul Krugman, the Nobel laureate and Princeton professor, calls the “confidence fairy,” a mythical creature representing the hope that a restoration of confidence in the budget would raise economic confidence more generally. That turned out to be, well, just a fairy tale.
Unexpectedly, at around the time of the last election the economy stopped growing. Although the official Office for National Statistics data for GDP usually prove to be far too pessimistic, this prolonged stagnation is not just an artefact of the number crunchers. Broadly speaking, real GDP is still about 4 per cent below the level attained when the last economic cycle peaked in 2008, which is one of the worst performances in the G20. More amazingly, real GDP is about 15 per cent below the levels it would have reached if it had maintained its long term growth trend after 2008. The loss of 15 per cent of national output each year seems, to many, more than a little careless.
Because of this, the Treasury is naturally missing its budget targets. In a recent critical assessment, the Centre for Policy Studies, the centre-right think tank, pointed out that the small print of the fiscal component of Plan A would almost certainly need to be given a decent burial in the Autumn statement this year. Not only have the original targets for the budget deficit and debt both been missed, it claims, but the ratio of spending cuts to tax increases has been almost the opposite of what the Treasury initially promised (that 80 per cent of government savings would come from cuts and just 20 per cent from tax rises) when the plan was unveiled by Osborne back in 2010. The Tory right, led by David Davis, is incensed and is demanding much larger cuts in both tax rates and in public spending.
Osborne is not likely to be stumped by this. He will use the get-out clauses which were deliberately built into the original plan to argue that this is no more than a mid-course adjustment. Stretching the credulity of some, he will argue that the specific wording of his original mandate required nothing more than structural budget balance in “the final year of the forecast period,” which by definition rolls forward each year. Essentially, the Treasury will simply extend the plan another year or two into the future, without being very specific about where the expenditure cuts will eventually be found. Because the chancellor chose to emphasise the rigidity of the plan when it was first announced, he will take on some collateral political damage from this. But it is unlikely to be fatal.
Osborne’s critics claim that the last two years could have been much, much better if only government budgets had not been tightened so rapidly. When it lost the last election, Labour was committed to a plan which was similar in shape to Osborne’s but which involved only about half of the fiscal tightening in the first few years. We will never know what would have happened if government policy had followed the Labour path. The budget deficit may hardly have fallen at all, which could possibly have panicked the markets, though the global bond markets have been remarkably tolerant of high budget deficits in countries which (unlike Spain and Italy) have their own central banks. The bond market vigilantes who terrorised Bill Clinton and Robert Rubin 20 years ago have been asleep at the switch.
Economists at the National Institute of Economic and Social Research and the London School of Economics recently published econometric simulations sketching out what might have happened if government budgets had not been tightened at all until 2014, and then tightened in the assumed better economic environment of 2015-20. The simulations indicate that real GDP would have been 3 per cent higher in 2014 than it will be under present policy, while the unemployment rate would be 2 percentage points lower.
That proves it, said the Keynesians. Not so fast, said the Treasury’s supporters. If not done now, the budget consolidation would simply have to come later, and that would more than completely wipe out any putative output gains by 2019. And in the meantime, the public debt ratio would be raised by a further 10 percentage points of GDP, which makes the whole problem worse in the long run, even assuming that the markets do not panic in the meantime. Misquoting Macbeth: if ’twere done, ’twere best done soon.
But if an alternative policy is needed, the first question to ask is whether the economy is suffering from a shortage of demand, or a collapse in supply capacity. With output now 15 per cent below its long-term trend, you might expect that economists can explain whether this massive loss is due to supply or demand factors, since the remedies would be entirely different. You would be wrong.
In a masterpiece of understatement, Joe Grice (the excellent chief economist at the ONS) wrote in August that “Recent movements in the UK economy have not been entirely straightforward to interpret.” He can say that again. In particular, there is great uncertainty about the output gap in the economy, a concept which lies right at the heart of both fiscal and monetary policy.
The output gap is the estimated difference between the potential GDP of the economy and the actual level of GDP. When an economy is operating below its potential capacity, inflation is believed likely to fall, and the Bank of England can safely boost demand by reducing interest rates or, if these are already at zero, by a round of quantitative easing. Furthermore, if output is below trend, nevertheless part of the budget deficit will be eliminated automatically as the economy recovers, reducing the need for tax increases or expenditure cuts. All in all, let’s hear it for the output gap, because it makes future macroeconomic policy a whole lot easier on many fronts.
Except that we have absolutely no idea how big it is.
If there are two institutions who would choose “the output gap, 2008-16” as their special subject on “Mastermind,” they should be the Bank of England and the Office for Budget Responsibility, which provides independent analysis of government spending. Neither of them should exist without trying to measure it. And, remarkably, they both seem to agree that it is currently around 3 per cent of GDP, implying that GDP can only rise by that amount before the economy begins to run into supply constraints. (The Bank does not publish official estimates, but does drop broad hints from time to time.)
Consider the implication of that for a moment. After dropping 15 per cent below its previous trend, GDP can only rebound by 3 per cent before bumping into the ceiling. If true, that would be an extraordinarily pessimistic analysis.
This pessimism is based on a number of arguments. Output may have been well above trend in 2007, so that previous peak may not be re-attainable. Inflation has been stubbornly high, despite the recession, indicating that there is not much slack in the system. Productivity, or output per man hour, has been extremely poor for several years, indicating that the financial crash has eviscerated parts of our productive sector, like financial services and housing. These will never return to their former “glories.”
All of which would mean that very little can be done to boost the economy through boosting the money supply. It would also mean that most of the correction needed in the budget deficit will have to come, sooner or later, through extremely painful cuts in public spending or increases in tax rates. If you thought the last few years were difficult, the implication is that you ain’t seen nothin’ yet.
Fortunately, there is another, much more hopeful, point of view about how swiftly the output gap might be closed. This view is held by many conventional Keynesians, and also by Bill Martin and Robert Rowthorn at the Centre for Business Research at Cambridge University. Their work is not part of the consensus view, but is very impressive. They believe that the output gap may not be as large as the entire 15 per cent difference between GDP and its previous trend, but that it still exceeds 9 per cent of GDP.
If that is right, then the budget deficit will automatically drop by a huge 6 per cent of GDP as the economy recovers, leaving much less to be corrected by painful policy adjustments. The OBR’s equivalent estimate of the cyclical element of the budget deficit is only 2 per cent of GDP, which is why the Treasury has been forced to announce such a large policy tightening.
What are the Cambridge authors seeing which others are not? Almost the entire dispute boils down to the behaviour of productivity in recent years. Martin and Rowthorn contend that the collapse in productivity growth has been triggered by a slump in demand, which has been accompanied by “hoarding” of labour by firms. Faced with the urgent need to pay down debt, workers have been willing to accept jobs at very low real wages, and this has encouraged firms to keep on workers who might otherwise have been fired. This explains the one bright spot of the past few years, which is the relatively small rise in unemployment, considering how badly output has performed. But it also explains why productivity has performed so poorly.
Economists opposed to this Keynesian analysis contest the interpretation of the slump in productivity. In their view, the damage to the banking sector has had pervasive effects right across the economy. A healthy financial services sector is needed to intermediate between savers and borrowers in the economy. If banks and other sources of company finance become clogged up, then savings will not be channelled to their most effective uses, and the growth of productive capacity will be damaged.
So who is right? The International Monetary Fund and the Organisation or Economic Cooperation and Development have both published studies which show that in past examples of financial sector crashes, it has been common for real GDP to fall by about 4 per cent on a semi-permanent basis. But even if we allow for a much bigger effect in this particular case—because the crash has been so severe, and because the financial sector is so large in the UK economy—it is difficult to believe that this can account for the full 15 per cent of missing output.
Furthermore, the drop in productivity has been similar in all sectors of the economy, rather than in those sectors which are particularly exposed to financial services and housing.
The ultimate referee in this contest should probably be the rate of inflation. It has indeed risen, which supports the pessimistic supply siders. But most of the rise can easily be explained by the jump in oil and other commodity prices, and in indirect taxes like VAT. Remove those two factors, say Martin and Rowthorn, and you eliminate the entire rise in inflation. And that means that the domestic economy has not been under the kind of strain which the supply siders imply.
William White, who predicted many aspects of the global crash when he was at the Bank for International Settlements, recently wrote: “We do not live in an either-or world.” He was arguing that both supply and demand side problems could co-exist in the same economy at the same time, and indeed that was a common condition in the aftermath of a financial bubble.
Macro-economists are particularly bad at accepting this. The profession is divided into two silos: the Keynesians, who believe in the primacy of the demand side; and the Chicago school, which believes it to be irrelevant. These two camps are now so antagonistic that they are barely ever seen in the same seminar rooms. Political opinion tends to be divided along similar lines, especially in the United States.
None of this makes any sense. Indeed, it serves the economy ill. There are many policy weapons available which can help demand and supply simultaneously, and they should be the weapons of choice. They are available both in the monetary and the fiscal sphere, and they would probably be welcomed in the financial markets if deployed intelligently.
In the monetary realm, the Bank of England has been the most enthusiastic proponent of quantitative easing (QE) among the major economies, out-gunning even the US’s Federal Reserve in this aspect of policy, and the results have been generally good. Immediately following the collapse of Lehman Brothers in 2008, the first dose of QE provided liquidity for the financial system at a time when the liquidity preference of the banking sector had risen in an unprecedented fashion. This injection of liquidity directly avoided the cardinal mistakes of the monetary authorities in the early 1930s, and thus avoided a repeat of the Great Depression.
Since then, the impact of QE has been mainly to bring down long term interest rates, and the scale of the beneficial impact on the economy has been much less. With yields on ten-year UK government bonds now so low, large scale purchases of these bonds, which remain the Bank’s method of choice, can be expected to have even smaller effects (though they may help to keep sterling down, which remains critical to the whole strategy).
Mervyn King is resistant to any more adventurous monetary measures, unless the Treasury is willing to offer guarantees to the Bank which would protect it against the risk of subsequent losses. He rightly wants to avoid blurring the lines between the government and central bank balance sheets, which ultimately would bring inflation risks. This is why the new Funding for Lending Scheme, which aims to encourage banks to make more money available to borrowers, is a joint Treasury/Bank initiative, as it should be.
Before he left the Monetary Policy Committee, Adam Posen suggested that the Bank should sponsor and finance a new institution which would be responsible for lending directly to small and medium-sized enterprises, which are clearly starved of funding. Such an institution could also be responsible for directly funding larger scale investment projects in both the public and private sectors, including infrastructure and machinery and equipment.
Projects which would qualify for this funding would need to be proven to be additional to existing levels of investment, and not in the property sector, and lending would be at preferred rates. The new institution would initially be capitalised by the Treasury, but it would be given a banking licence, so it would be able to use its loan portfolios as security for borrowing from the Bank of England. Any losses suffered by the Bank in funding these operations would be guaranteed by the Treasury.
The last question is whether the chancellor should go further than simply using the flexibility which was built into his plans, and, in the next couple of years, spend more money. There are some limited signs of this happening, with the recent proposals for a boost to housing and other public investment worth about 1 per cent of GDP over a period which has not yet been specified. Whether this would be funded from extra government borrowing, or from the Liberal Democrats’ ultimately very costly idea for a wealth tax, is also unknown.
My own view is that a temporary stimulus which was aimed clearly at the supply side of the economy, and which did nothing to relax the medium-term framework for borrowing and debt, would be readily accepted by the markets. Marginal tax rates on business and enterprise could be reduced for a period, and businesses could be offered a tax holiday on the creation of new jobs. That would represent a powerful pro-growth signal from the government to the economy at a time when it is most needed.
For this to happen, two important shibboleths would need to be abandoned by the coalition. Osborne would need to admit that he is relaxing his short-term fiscal objectives for the over-riding purpose of boosting growth. And the Liberal Democrats would have to accept that their general approach to taxation is the enemy of enterprise.
There is only one person who has the necessary clout to get this done. That person is David Cameron.