David Cameron’s “there is no alternative” speech last week on the UK economy has aroused much criticism. This is justified. The British prime minister’s arguments for sticking to the government’s programme of fiscal austerity were overwhelmingly wrong-headed.
It is easy to understand why he had to defend the government’s failing flagship policy. The incoming coalition embarked on a programme of austerity with the emergency budget of June 2010. The economy, then showing signs of recovery, has since stagnated. Even the fiscal outcomes are poor. Indeed, according to the latest “green budget” from the authoritative Institute for Fiscal Studies, this fiscal year’s borrowing requirement may be bigger than last year’s. Only a productivity collapse saved the day – by keeping unemployment surprisingly low, ameliorating the social impact of the output disaster.
How does one defend this record? Simon Wren-Lewis of the University of Oxford and Jonathan Portes of the National Institute of Economic and Social Research have demolished the prime minister’s views. Here are the key points.
'Magic money tree'
Mr Cameron argues that those who think the government can borrow more "think there's some magic money tree. Well, let me tell you a plain truth: there isn't." This is quite wrong. First, there is a money tree, called the Bank of England, which has created £375 billion to finance its asset purchases. Second, like other solvent institutions, governments can borrow. Third, markets deem the government solvent, since they are willing to lend to it at the lowest rates in UK history. And, finally, markets are doing this because of the structural financial surpluses in the private and foreign sectors.
Again, Cameron notes that “last month’s downgrade was the starkest possible reminder of the debt problem we face”. No, it is not, for three reasons. First, Moody’s stressed that the big problem for the UK was the sluggish economic growth in the medium term, which austerity has made worse. Second, the rating of a sovereign that cannot default on debt in its own currency means little. Third, the reason for believing long-term interest rates will rise is expectations of high inflation – and so higher short-term rates. But such a shift is going to follow a recovery, which would make austerity effective and timely.
Cameron argued: “As the independent Office for Budget Responsibility has made clear . . . growth has been depressed by the financial crisis . . . and the problems in the euro zone . . . and a 60 per cent rise in oil prices between August 2010 and April 2011. They are absolutely clear that the deficit reduction plan is not responsible.” This brought a rejoinder from Robert Chote, OBR director, who noted: “Every forecast published by the OBR since the June 2010 budget has incorporated the widely held assumption that tax increases and spending cuts reduce economic growth in the short term.”
Serious researchers, including at international organisations, argue that the multiplier effect of fiscal austerity may be far bigger than the OBR has hitherto assumed, at least in today’s depressed circumstances. Moreover, even if the OBR believes the outcome turned out worse than forecast because of adverse shocks, rather than its underestimation of multipliers, this is an argument for active policy, not against it.
The prime minister also stated: “[Labour] think that by borrowing more they would miraculously end up borrowing less . . . Yes, it really is as incredible as that.” What truly is incredible is that Cameron cannot understand that, if an entity that spends close to half of gross domestic product retrenches as the private sector is also retrenching, the decline in overall output may be so large that its finances end up worse than when it started.
Bradford DeLong of Berkeley and Larry Summers, the former US treasury secretary, have shown that, in a depressed economy, what Cameron deems incredible is likely to be true. A recent International Monetary Fund paper argues that “fiscal tightening could raise the debt ratio in the short term, as fiscal gains are partly wiped out by the decline in output”. Mr Portes adds that, even if this is not true for the UK on its own, it is likely to be true for Europe since almost everybody is retrenching simultaneously.
Cameron argues that “this deficit didn’t suddenly appear purely as a result of the global financial crisis. It was driven by persistent, reckless and completely unaffordable government spending and borrowing over many years.” In a way, this is the most worrying error – not because the fiscal policy of the Labour Party, then in power, was perfect. Far from it. Fiscal policy should have been tighter. But that is not the main reason the UK has a huge structural deficit.
It is the economy, stupid. In 2007, according to the IMF, UK net debt – at 38 per cent of GDP – was the second-lowest in the Group of Seven leading economies. These levels were also exceptionally low by UK historical standards. In the March 2008 budget, the treasury estimated the structural cyclically adjusted deficit on the current budget at minus 0.7 per cent in 2007-2008 and minus 0.5 per cent in 2008-2009. The collapse in output has caused the explosion in deficits and debt. Almost everybody underestimated the vulnerability, the Conservative leadership among them: pre-crisis, it committed itself to continuing the plans Cameron now calls “reckless and unaffordable”.
Reckless spending
Some think reckless spending explains the jump in government spending from 40.7 per cent of GDP in 2007-2008 to 47.4 per cent two years later. Yet, between 1996-1997 (the year before Labour came into office) and 2007-2008 (the year before the crisis), the share of spending in GDP rose by only 1.2 per cent. No: the collapse in GDP, relative to expectations, caused the jump in spending and decline in receipts, relative to GDP. The green budget compares the forecasts for 2012-2013 made in the 2008 budget and the 2012 autumn statement: nominal GDP is down 13.6 per cent, receipts are down 17.6 per cent, spending is down 5.6 per cent and borrowing is up 372 per cent. It is because the OBR (and others) believe most of this lost GDP is permanent that the position seems so grim.
Mr Cameron’s argument against fiscal policy flexibility is wrong. But, beyond this, we have to consider why the economy has proved so fragile and rebalancing so difficult. That is for next week. – (Copyright The Financial Times Limited 2013 )
