The chancellor holds up the Budget box outside 11 Downing Street (photo: HM Treasury)
George Osborne’s Autumn Statement marks the half-way stage in this parliament. It is a moment to reflect on his economic strategy and to look forward—with some trepidation, it has to be said. The strategy to breathe life into the economy, eliminate the structural part of the deficit and bring the debt to national income ratio down by the next election in 2015 has not worked. The economy remains in a mild depression, with periodic ups and downs, and the deficit target has now been “rolled out” to 2017/18. Without a shift in strategy, this state of affairs could continue for a long time, bringing the risk that unemployment will rise, and the coveted AAA sovereign credit rating will fall.
To be fair, the chancellor could not have taken office at a less favourable time. The economy had just experienced the deepest recession since the 1930s. The budget deficit was over 10 per cent of GDP and the ratio of public debt to GDP was 25 per cent higher than in 2008. He introduced an emergency budget in June 2010, based on Alistair Darling’s spending plans in the previous government, and established the Office for Budget Responsibility (OBR) as an independent auditor of public finances. Greece had just received its first financial package from the Eurozone and the IMF, amid fears about a eurozone sovereign debt crisis. The chancellor had to send a message to the country’s creditors and financial markets that the government was determined to regain control over public finances, and to restore sustainable growth.
Osborne has had help in reassuring Britain’s creditors. The Bank of England presided over a 20 per cent fall of the pound’s value between July 2011 and July 2012. The Bank’s unusual monetary policies—quantitative easing—and those of the Federal Reserve in the US, have held down the cost of government borrowing.
But it is clear that the goal of restoring growth has failed, and this is what really counts. Since the election, the chancellor presided over sporadic, weak growth, followed by a decline in GDP, which has all but cancelled the prior rise. The 1 per cent growth towards the end of 2012, widely attributed to special factors and the Olympics bounce, is bound to have fallen back sharply.
It should be clear that if there’s little or no growth, the credibility of the government’s strategy will fray. The deficit target will be missed regularly, and the ratio of debt to national income will just keep rising, regardless of steps that might momentarily flatter the public accounts, for example, the recent decision to have the Bank of England transfer its profits from quantitative easing to the Exchequer. If the debt keeps rising, the risk of sovereign downgrades and loss of creditor confidence will become more significant.
So when did it all go wrong? Sadly, from the start. The strategy was based on unwarranted confidence in the basic structure of the economy in the wake of the crisis, and on a failure to understand the nature of the predicament into which we had fallen. The overconfidence showed up time and again in the forecasts of all the official agencies, including the OBR and the Bank of England. In the March 2011 Budget, the prediction was still growth of 1.7 per cent in 2012 and 2.5 per cent in 2013. These numbers have since come down, now to -0.1 per cent and 1.2 per cent, respectively. But the OBR’s longer-term optimism remains, with growth back to nearly 3 per cent by 2017-18.
Overconfidence was also evident in the belief that the economy would rebalance away from finance and housing towards industry and commerce without government help. This revival of private sector enterprise and investment was never going to happen so simply. UK companies have been saving money for a decade, and although they are not doing so as dramatically as in 2008/09—when they saved 10 per cent of GDP—they’re still saving 5 per cent of GDP. Clearly, they are not assured about the outlook for the economy, investment and employment.
And quite where the government got the idea that banks should simultaneously gather more cash on their balance sheets while lending more to small and medium sized companies, remains a mystery. It is not surprising that the attempts to spur lending —Project Merlin in 2011, Credit Easing in 2012—have fallen flat. Financial policy, especially towards the banks, has been confused—the Bank and the Treasury must share the blame. The Bank’s Financial Policy Committee said in November that banks would need to provide more capital as protection against future losses. The Treasury wants them to lend more. This does not compute, and while the credit offered by banks remains inadequate, there will be no private sector recovery.
Overconfidence can be corrected, and it seems a little humility has crept into official pronouncements about the outlook for our national debt, future economic prospects and so on. But misunderstanding is more liable to linger, and in this respect the Treasury is culpable. It has failed to recognise the nature of our malaise, which professional economists call a “balance sheet recession.” As a result it has made matters worse. You just have to consider the performance of the US, where tough and instant austerity has not been pursued, to appreciate the difference. The US economy has surpassed the level of the last peak in early 2008. In the UK, it is languishing at a level that is still 3 per cent lower.
Conventional recessions usually end as policies are eased, confidence returns, and normal lending and spending patterns resume. The government runs a deficit for a while, but the resumption of expansion in which the private sector spends and borrows more is matched by a retreat in the spending and borrowing of the government. Balance sheet recessions are different. As the name suggests, they involve a fundamental mismatch between the two sides of the national balance sheet—the assets and the liabilities. Lending and spending can’t get going again until this imbalance is remedied, which means saving more to bring liabilities in line with depreciated asset values. In our case, the household, banking and corporate sectors are all trying to save more—but so is the government.
The trouble is that it is impossible for the private and the public sector both to save more simultaneously without causing precisely the kind of economic conditions that we have in the UK. When the private sector wants or needs to restructure its balance sheets, the government is supposed to accommodate it for as long as is necessary. If everyone wants to save more, someone has to borrow more. Had the government understood this at any time since 2010, it is likely that policy would have been quite different.
In the event, the chancellor has underwritten a strategy that, as the table shows (left), has allowed the nominal value of public spending to rise by over £40bn since 2009/10, but once inflation is taken into account, it can be seen that spending has remained frozen. Some of the sharpest cuts have been made in the government’s capital spending, with public sector net investment falling in money terms (worse if you factor in inflation) from £48.5bn in 2009/10 to an estimated £27bn in 2011/12. It is predicted to fade over the next five years to £23bn. This squeeze on potentially productive public investment is ill-advised. The chancellor has announced two infrastructure initiatives since 2010, trying to bring in private finance, but there has been little follow-up. He offered a glimmer of hope in his 2012 Mansion House speech, saying that the government could promote spending on new homes, roads, and other infrastructure, for example, by extending guarantees, if not hard cash. This means the argument may have shifted from whether to use the government’s balance sheet, to how.
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The government could have considered eliminating the structural deficit by, for example, 2020, or adjusting the pace of deficit reduction to bring it into line with the economy’s performance. It could have based its strategy on the fundamental view that there wasn’t going to be any significant expansion any time soon, and therefore no improvement in public finances. It could have been bolder early on by shuffling more current spending on goods and services towards investment, where the benefits in the form of employment and future returns are stronger, especially when the government can borrow at rock bottom rates. We would still have had to embrace painful structural reforms and higher taxes, and a long-term programme to reform welfare, raise the retirement age and address unfunded pension and healthcare costs. But the point is that we might have been able to do this with an economy that was rebalancing in an environment of steady, if moderate growth.
The government’s misunderstanding has not just been about the balance sheet recession. It has also been party to muddled thinking about what we call the “fiscal multiplier,” which helps calculate the effects of tax and spending changes on the economy. The OBR has been working on the assumption that the multiplier is around 0.35-—meaning, for example, that if the government tightens budgetary policy by 1 per cent of GDP, the effect would be to lower GDP by 0.35 per cent. But the IMF caused an economic storm at its annual meeting in Tokyo in September by suggesting that in current conditions, it may lie somewhere between 0.9 and 1.7, significantly larger than in previous adjustment programmes. In other words, the scale of austerity is exacting an equivalent or greater toll on the economy.
It is also unfortunate that the government hasn’t levelled with the country about its own responsibilities, and the problems caused by the euro crisis, which have aggravated its problems. At the IMF annual meeting in Washington DC in September 2011, the chancellor sought to emphasise the severity of the crisis with his “Six weeks to save the Euro” speech, by which he meant the G20 in Cannes later in the year. In the 2011 Autumn Statement, he cited the eurozone crisis, and higher commodity prices as villains, and he has referred to the euro crisis often since as the principal cause for the UK’s predicament. According to the chancellor, it is this, not the government’s failure to get a grip on public finances, that is to blame.
There is no question that the euro area economy and financial markets were in a rotten state. The economy barely grew in 2011, and will have declined for two consecutive years in 2012-13. But the view that the eurozone crisis has blown the UK government’s economic strategy off course is an overstatement. The trade sector is important for the UK with exports to the eurozone accounting for about 16 per cent of GDP. But the critical questions today are the same as two and half years ago. How can employment be strengthened and wage and salary incomes be increased so as to help the household sector to recover? How can investment incentives and spending help reverse the long slide in the investment proportion of GDP and get companies to spend some of their £750bn cash pile? How can banks be encouraged to lend? And why is the government dashing forwards with an austerity plan that is only making things worse?
George Osborne’s Autumn Statement offered few new answers, but the disappointment over growth and pressure from within the coalition may be starting to have an effect. He announced measures, spanning an extra £5.5bn of infrastructure spending, the creation of a £1bn business bank, a large rise in investment allowances, simpler and lower business taxes, and initiatives to exploit shale gas, and to get UK companies to sell more to emerging markets. These are encouraging from the standpoint of longer-term competitiveness and productivity. But they still leave huge questions over the government’s economic management.
