Time for plan B?

[Sheilbh]

Martin Wolf on the UK economy, I've also put his blog-post with charts at the end:

Flexibility is no sin when policy is failing
By Martin Wolf

In a democracy, willingness to inflict economic pain is rarely a route to credibility. Investors will refuse to believe that the policies will survive. Once they reach that conclusion, credibility disappears.

I learnt this in 1992. With the UK economy in recession, the credibility of the government's commitment to membership of the exchange rate mechanism of the European Monetary System came into question. Many thought that a willingness to raise interest rates when sterling came under pressure would restore credibility. It did the opposite: few believed the pain could be sustained. The government could not enhance the credibility of an incredible commitment.

This experience informs my view on the options for the UK's government. The arguments put forward for continuing with the planned fiscal tightening are that, in its absence, credibility will be lost and interest rates on government bonds explode. I suspect the reverse will ultimately prove to be the case. In the absence of policies likely to restore economic growth, the planned fiscal tightening will itself be incredible. Investors will believe that attempts to cut fiscal deficits in a prolonged slump will ultimately force a change of course. Commitments to delivering the incredible weaken credibility.

The background to such thoughts is news that the first estimate of gross domestic product showed a fall in the first quarter of 2012 and so a technical recession on the popular definition of two quarters of negative growth. Far more important is the fact that the UK economy has stagnated for a year and a half. GDP is stuck at more than 4 per cent below its pre-crisis peak, close to where it was back in the third quarter of 2006 and 9 per cent below its 1970-2007 trend. True, the unemployment rate of 8.3 per cent is not high, given the length and depth of the slump. But one in five young people between the ages of 18 and 24 is out of work.

Yet the fiscal squeeze has barely begun. According to the Office of Budgetary Responsibility, net borrowing fell by just 1.8 per cent of GDP between 2009-10, just before the coalition government came into office, and 2011-12. A further tightening of 7.2 per cent of GDP is due by 2016-17. The assumption that this will coincide with economic expansion is, in today's economic conditions, bordering on the heroic.

Remember that official short-term interest rates are half a per cent, 10-year government bonds yield 2 per cent and index-linked gilts yield zero. Yet, despite these extremely low costs of funds and the benefits of commitment to sustainable public finances, the corporate sector ran a huge financial surplus (excess of retained earnings over investment) of 5.3 per cent of GDP last year. The view that the fiscal retrenchment will now generate a surge in private spending seems improbable. More likely is stagnation, if not worse.

So can anything be done to avoid the immediate and long-term costs of a further prolongation of the slump?

The response of those who insist that no change may be considered in the government's plans is that credibility would be destroyed. Indeed, they claim that today's low interest rates are themselves proof of credibility. Yet remember that when the chancellor announced his fiscal plans in 2010, net borrowing was supposed to be just £206bn between 2012-13 and 2015-16. In the March 2012 Budget this was up to £317bn. Did that colossal failure to hit his target destroy credibility and so lead to explosive increases in bond yields? No. But why not? The answer is that with a central bank sure to keep the gilts market liquid and a floating exchange rate, low interest rates are what one would expect in an economy with such huge private sector surpluses. The slump, not the credibility, delivers these low rates.

Worse, the biggest danger to credibility is a prolongation of the slump, which might indefinitely delay the closing of the deficit. How might this risk be addressed? The answer is to convince private decision makers that the economy will grow, which requires policies aimed at demand. The trick is to introduce them without threatening the long-term sustainability of public finances. The best way to do this is to combine the commitment to reducing the share of current public spending in GDP with flexibility on taxation and greater public investment. Both of the latter can credibly be temporary. At current interest rates, even a large medium-term increase in borrowing would almost certainly pay for itself in the greatly enhanced present value of current and future output. The best tax cuts would increase investment, consumer spending and the incentives to hire idle workers.

The mistake made by the government was to announce fixed plans for so many years ahead. The recovery has not materialised. Flexibility in response is no sin. On the contrary, it is a great virtue.

The state of the UK economy

In my latest column, I discussed the state of the UK economy. Since the column does not contain charts, I have decided to post a few on the Wolf Exchange.

Let us start with gross domestic product since 1970. The chart shows quarterly GDP at constant prices and the pre-crisis trend in quarterly GDP, extrapolated up to the first quarter of 2012. Over this period the trend rate of annual economic growth was 2.5 per cent a year. It will be seen that we do see a period of above trend levels of activity in the 2000s. It will also be seen that, since the third quarter of 2008, GDP has shown a growing negative deviation from the trend. In the first quarter of 2012, the deviation was 8.9 per cent below the long-term trend.


The second chart shows what has happened to sectoral financial balances (differences between sectoral incomes and expenditure ) in the UK. The story is both familiar and obvious.

Household and corporate sectors have moved sharply into surplus since 2007. This is the result of a whole set of decisions to cut back on consumption and investment. Meanwhile, government fiscal policy itself changed little. But the long period of unexpected economic weakness lowered revenue and increased spending. The Office for Budgetary Responsibility argues that nearly all this deficit ‑- close to 80 per cent of it in 2011-12 -‑ is in fact structural.

For the government's fiscal tightening to work, it must indicate why and how it expects the surpluses of domestic businesses, households or foreigners to fall. If needed offsetting changes do not occur through voluntary surges in consumption and investment, relative to incomes, fiscal tightening may still eliminate the surpluses of the private and foreign sectors, but only by causing a still deeper slump. In other words, the policy might well drive the other sectors of the economy into balance by making their incomes collapse even more than their spending. That would be a calamity.


Finally, I noted that the government has failed to deliver its fiscal targets. Perhaps the most intriguing point is that the most recent fiscal forecast is closer to that offered by Alistair Darling in his last Budget, condemned by the coalition government for its failure to close the deficit quickly enough, than to that in the incoming government's emergency budget.

[The Brain]

TL;DR

[Richard Hakluyt]

I'd be in favour of some public housing construction project. We need the houses, the construction industry is somewhat flat or falling, the wages paid for such work will likely be recycled right back into the economy. I think the Chancellor has some room to manoeuvre providing he can target such spending rather than losing it in a general morass of bureaucracy, bank guarantees and social services spending.

[crazy canuck]

In a democracy, willingness to inflict economic pain is rarely a route to credibility

That is too broad a statement.  As just one example, in this country the Liberals gained a great deal of credibility when they cut government expenditures and brought the budget into surplus.  Indeed as things began to fall apart on them that was the only claim of legitimacy they could cling to as their ship went down for reasons completely unrelated to their budget cutting.

It seems to me the issue isnt whether it is prudent for governments to attempt to balance the books but rather when governments should recognize there are times when deficits are a necessary evil.  That seems to be the problem with the Cameron government.  They thought the time for belt tightening had come but they were caught by surprise when the forecasts for growth turned out to be wrong and they were tightening at the wrong time.

The is some chance that might happen with the Conservatives here.