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‘Plan B’ is not the answer

17 October 2012

Is George Osborne’s plan working? You can see why his enemies are circling. If you take his own definition – his ‘fiscal rule’ that the debt/GDP ratio should be falling by the end of the Parliament – then no. But this is mainly because Osborne has been flexible – some would argue too flexible – following the eurozone crisis and high commodity prices, which have hampered growth prospects through weaker-than-expected net trade and higher than expected inflation (see the OBR yesterday).

Last autumn, the Chancellor had a choice between more cuts or more debt. He chose more debt, and stuck to his old spending plans knowing that the growth (and tax revenues) would not be as he had hoped. He chose to abandon a ‘deficit reduction’ policy, in favour of a ‘sticking to spending plans’ policy. That’s why his so-called ‘sado austerity’ will add over £605 billion to the national debt by 2014/15, with no balanced budget in sight until well into the next Parliament.

And let’s not pretend that Alistair Darling would have done it so very differently. Remember, the Coalition has so far hiked taxes and slashed investment spending, whilst actually increasing current spending. Yet the investment cuts were inherited from Darling, he’d have hiked National Insurance, didn’t oppose the 5.2 per cent benefit rise this year, and would not have prevented the external forces we’ve seen. Whilst it’s ironic the Coalition’s planned borrowing outturns are now similar to Labour’s 2010 forecasts, comparing the two is meaningless given the changed circumstances. The fact is, as the IFS has outlined, Labour’s 2010 plan would have entailed even more borrowing than we have seen so far.

At this stage, supporters of more stimulus spending make a leap of faith. ‘Ah,’ they say, ‘but given the bond markets haven’t reacted to the higher-than-expected borrowing so far, and interest rates are low, then we could spend even more without risking a crisis of confidence’. To be sure, the bond market has not punished Osborne for his extra debt (a few big doses of QE and the eurozone crisis help here). But does it follow that we should ramp up spending now in the way Ed Balls now suggests? Of course not. The risk of a crisis of confidence is just one argument against ‘stimulus’. There’s also scant evidence it would be desirable in the short or medium term for growth in the UK.

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First, there are real risks of abandoning a fiscal plan. Despite what Balls suggests, increasing spending would not be self-financing. Our deficit is still over 7 per cent of GDP, and even if you take the new IMF fiscal multipliers as given, spending more would add significantly to borrowing. Abandoning a medium-term plan not only risks a loss of confidence and increased borrowing costs (which might be offset by QE) but alongside our current high trade deficit risks a collapse in sterling which could mean another damaging bout of imported inflation.

Second, there is little robust evidence it will be good for growth. For our short-term prospects, stimulus advocates cite the more recent IMF multiplier estimates as evidence that expansionary policy now would lead to large increases in output. But these results are highly dependent on the countries selected, which seem somewhat arbitrary and are distorted by the Greek euro-induced meltdown. Previous work suggests that for countries with high debts and flexible exchange rates, multipliers from public spending are very low indeed. The UK ticks these boxes.

What’s more, this only tells half the story. Higher debts of course mean higher interest payments and higher future taxes. Presuming you wish to balance the budget eventually, you will get negative multiplier effects of the extra consolidation required later. Robert Barro’s work suggests that the overall medium-term effect is to depress output overall. Evidence from previous recessions also suggests the private sector might even save more today in expectation of these future tax burdens.

This is one of the reasons why the work of the Reinhardts and Rogoff suggests gross public debt above 90 per cent of GDP impairs growth for a long period. We’re set to breach this by 2013/14.

Third, whilst it’s true that the deficit plan so far has been heavily weighted towards investment cuts and tax hikes, it’s important not to judge the economic benefits of investment by the amount spent. New Labour’s deficit spending does not appear to have led to investments which generated sustained future tax revenue – why should we expect different now? Furthermore, few projects are genuinely shovel-ready in the way that stimulus advocates idolise.

More importantly though, we can only judge our current plight in the context of the sustainability of the preceding boom. An uncomfortable fact for the Labour party is that the structural deficit was already 5.2 per cent of GDP when Gordon Brown left the Treasury in 2007. Having peaked at 9.7 per cent, it is now 5.4 per cent. This high borrowing, coupled with cheap credit meant that pre-crisis the UK economy was warped towards industries dependent on credit and high public spending. As Ben Broadbent of the Band of England has outlined, the combination of robust employment, moderate inflation and poor productivity suggests the economy is currently rebalancing, but struggling to reallocate misplaced capital. This adjustment would not be helped by more government borrowing.

The Government can of course look at supply-side policies to boost medium-term growth. Cheap energy, fixed banks, trade expansion, a liberal skilled immigration policy, small business deregulation, university liberalisation, and tax reform spring to mind. But expansionary fiscal policy now would bring significant risks with little long-term benefit. Debt is no free lunch. It has to be paid back, defaulted on or inflated away. Britain has only two options: Plan A, or an even more ambitious variant of it. Plan Balls is no answer for our economic challenge.

Ryan Bourne is Head of Economic Research at the Centre for Policy Studies and is responding to Jonathan Portes’ postTo book your seats for the Alistair Darling vs Norman Lamont debate, a week on Monday, click here.

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  • Anthony Makara

    One wonders how much Austerity is a petty attempt to undo everything set up by Labour and whether in so doing the government is undermining its own efforts to rebalance the economy? Like so many I fail to see how economic contraction can lead to growth? The lack of investment at home and from abroad is a vote of no confidence in the government’s policies. For all the fantastic talk of a million new jobs having been created and Britain being open for business we still have the worst economic data of modern times. The government must accept that it has miscalculated and must change policy, far better to lose face now than to lose an election and give Labour a 100 plus majority. People should not be fooled by the smoke,n,mirrors jobs data today, we saw similar under Labour and more recently from Obama, its easy to fix the figures and those of us who study these matters carefully know a million full-time jobs haven’t been created under this government just as we know that snapshot figures that purport to show a fall in the numbers unemployed are bogus. Investment will only return when the smart money has confidence in the government. That requires a change in policy, and a move away from scorched earth economics, The government would also do well to bear in mind how the electorate rejected Austerity after the Second World War and returned a Labour government with a big idea. Voters will always prefer those who are bold and create over those who merely destroy.

  • Mike Barnes

    Absolutely tragic how so many people are still worried about ‘crisis of confidence’ and the mythical bond market vigilantes who are on their way to get us!

    All today’s jobs figures underline is how much spare capacity is going in our economy. So many underemployed people who could be doing more, earning more, paying taxes.

    When is this crisis of confidence going to hit Japan by the way, with its 200% debt to GDP ratio? They borrow money cheaper than we do!

    The low interest rates you hail are a sign that investors have no faith whatsoever in our economy recovering. They’d rather pay the government to hold onto their money (when you take inflation into account) rather than invest in business or the private sector and try and get a return that way.

    • Archimedes

      “When is this crisis of confidence going to hit Japan by the way, with its 200% debt to GDP ratio? They borrow money cheaper than we do!”

      No they don’t. Japan has had deflation for the last four years, and very low inflation preceding that with low inflation in the future – gradually rising to slightly below 1% by 2017, meaning that there is a positive real-term return on Japanese bonds.

      The UK has had high inflation for the last four years with a 2% target (which we usually overshoot) through to 2017, meaning that there is a negative real-term return on Gilts.

      Gilts have lower real-term yields than bonds issued by Japan, Germany, the US and Switzerland.

    • Daniel Maris

      I know one thing about Japan – virtually all their debt is owed to Japanese – the economy itself isn’t in debt to anyone.

      People tend to disregard this important fact when looking at national debt figures.

      What I find most interesting about these economic analyses is how at variance they are. Weather forecasting wouldn’t be much cop if meteorology was as conflicted as a discipline!

      I think that gives us licence to be more creative.

      We should certainly copy Japan’s approach of issuing gift tokens to its citizens to stimulate the economy.

      We need to put legislation into effect to force companies to create shareholdings for employees.

      We need to begin planning for a 4 day week. The fact that we now have 1.5 million doing part time work who want full time jobs shows how much scope there is for reducing the working week.

      We need to plough QE funding into a green energy infrastructure whihc will reduce energy bills and provide energy earnings for households.

      • Archimedes

        Yes. QE is the answer to everything. Why don’t we stop playing games and just let the government reach into our bank accounts and take what they want? Or better yet…they could it all – and give us back what they think they ought to…it would be just like Soviet Russia but oh, so much more!

        • Daniel Maris

          I am not sure what you are proposing. Just pay of the national debt in five years? Would it be possible or would our economy go into a nosedive? The nosedive could prove politically impossible leading to social breakdown. Suppose your economy lost say 30% GDP in one year, tax revenues plummet…you have to start closing down hospitals, sacking teachers ,police officers, soldiers, cutting pensions. You could well do into a downward spiral.

          No help to anyone.

          As someone (Keynes?) once said – the cure would be worse than the disease.

          I am arguing that there are better ways of doing QE.

          • Archimedes

            You’re arguing that it should be used more freely. There is a big difference between using QE as a way to stop a depression, and an entirely different thing to use QE to achieve a target growth rate.

            QE is just taxation by the back door. You’re suggesting that the government knows best how to invest. We already went through all this: it ended at the same time as the cold war. Money is a zero sum game. Anyone that says that they can create it out of thin air is lying. It is always a case of taking it from one place and putting it somewhere else.

            A central banker is a person who is accomplished in the art of finding ever more creative places to take money from: the consequences will also be ever more creative.

            • Daniel Maris

              Money is created out of thin air every day of the week – by the private sector (through credit) as well as government ! Money is simply a voucher accessing production and services.

              The issue is whether we now have a problem of a lack of confidence that has infected the consciousness of businesses and commerces. I think we have. That makes printing money – what QE really amounts to – is a good response as we do have overcapacity of productive and service facilties.

              I am not talking about government civil servants picking winners. I think we could use panels drawing on a range of people but with established investors at their heart. Or we could tender out that function to investors who would be rewarded on the basis of their success over a reasonable time frame.

              • Archimedes

                No, it is not created out of thin air, or through credit – it is created through investment. Credit is a means of investment, and the risk is balanced by the possibility of loss in the private sector (please don’t pollute the argument with some teary-eyed response about the bank bailouts).

                Yes, there is a lack of confidence: it may be well founded. The cash that is being built up will be spent at some point. Leave people to do it in their own time: they’ll spend it wisely when they choose to.

                The government picks winners because it is subject to political pressure. Are you going to tell me that a government can plausibly invest in both a DVD distributor and an online video store without being called up before some Newsnight presenter to be asked: “Well, one of them is going to lose…so is the government just throwing taxpayer money down the drain?”.

                • Daniel Maris

                  Archimedes –

                  Are you sure you know what money is? It sounds like you are talking about production and services – which are indeed created through investment of labour and other factors of production.

                  It’s perfectly legitimate to point out to you that the banks have cost us something like £70 billion in government subsidies in just a few years.

                  Is the lack of confidence justified? Well that is at the heart of the argument. I think not and I can point to the underused resources – the unemployed workers and specialists and the unused office space, factory space and retail space.

                  The gift token idea is good because it does leave it to people to choose what to spend it on.

                  I think in terms of investment panels, I would envisage them operating Dragons Den style, but with a lot of research input in terms of economic strategy.

                  It’s not really that different from what China has done over the last few years and what Korea and Japan did. They look around the world and at various industries, they analyse markets and they
                  steer funds into certain enterprises. It’s not perfect but then what is?

                  I think for instance we should make a strategic decision to be in the first wave of robotics. That is going to be a huge future industry. We have the skills here to develop the products. Why leave this industry to Japan and the USA as we left the wind turbine industry to Denmark and Germany. But of course this where you need co-ordinated action. Ideally you need to develop a home robotics industry to help kick start your global operation. And that is where investment panels could be crucial in getting that started.

                  Another area I think is food production. There will I think in future be huge scope for developing food production using hydroponics and polytunnels.

                • Archimedes

                  If it’s just credit, then it is just inflation. Credit can only lead to growth if it creates additional assets that justify an expansion of the money supply, either by increasing productivity, or increasing the amount of disposable income an individual has. I am aware of arguments that say otherwise: they are wrong. Credit is a means of investment: using it for any other purpose is inflationary – as we are finding out.

                  The banks have cost us more than £70bn in total (I know you said subsidies), but ultimately that has to be evaluated over a longer period, and over that period it is likely that the function they provide in allocating resources has saved us far more than that – assuming the state as the alternative.

                  You think that a lack of confidence is not justified when the Eurozone is in the state that it is in? You may well think that the Eurozone will eventually solve it’s problem, you may even be right: you are certainly not right that it is wise to bet on the Eurozone solving it’s problems. This is exactly why we have a free market: so that one person’s whims cannot force a nation to put all it’s eggs in one basket.

                  Everything else you have said shows a distinct lack of understanding of the weaknesses of institutions, an overly zealous view of the power of credit, and a significant lack of appreciation for the scale of the differences between long-term state efficiency and long-term free-market efficiency: you are not a conservative, and you are not a free-market libertarian – what are you doing here?

  • Archimedes

    Isn’t most of the current debt going to have to be refinanced at some point as well…at say 5%, or roughly 3 times the current yield? What would that mean for debt interest payments? And what would it mean if we enthusiastically doubled up on our debt?

  • Slim Jim

    This is a much more coherent and intelligent analysis of the problem than Mr. Portes produced. Mr. Bourne has not shyed away from mentioning debt and its implications. As for the supply side reforms proposed, we can just hear the squeals of outrage from the liberals and leftists. Basically, though, we’re still screwed.

  • DavidDP

    “Whilst it’s ironic the Coalition’s planned borrowing outturns are now similar to Labour’s 2010 forecasts, comparing the two is meaningless given the changed circumstances”
    Could you tell Fraser? He keeps doing this.

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