Same problem, different answers: Cameron and Obama have diverged on the treatment of the deficit
Britain’s recovery has proved even more sluggish than expected. Troubles in the euro area have dragged on and oil price increases are adding pain by constraining consumers’ purchasing power. The result is that the British economy is now close to a standstill.
Last year, our analysis at the Organisation for Economic Co-operation and Development (OECD) suggested that Britain’s economic recovery would be weak, on the basis that recoveries from financial crises always tend to be slow. The excessive private and public debts that result from such crises are eliminated slowly. Though it is necessary to restore financial sustainability, the policy of paying down debt is slowing domestic demand. At the same time, economic difficulties faced by Britain’s trading partners, particularly in the euro area, are holding back exports. This is unfortunate, especially now the UK needs to rebalance itself away from debt-financed private consumption and public spending, and towards exports and investments.
Should the government be doing more to support economic activity? With a budget deficit of over 8 per cent of national output, spending remains constrained. From the start, the government plan was to restore public finances; the plan is so far meeting objectives. This has boosted the government’s credibility despite disappointing economic growth. Still, Britain’s deficit is not yet within the comfort zone and as the global recovery is still fragile, emergency policy options should be held back in case of future external shocks, such as further difficulties in the euro area or a jump in oil prices.
But there are also less alarming moves that occur in the economy, and the government has factored these everyday undulations into its deficit reduction plans. This means that its plans can withstand temporary cyclical weakness in the economy and can limit cuts in public investment. The creation of the Office for Budget Responsibility and meeting deficit targets has earned credibility from financial markets, as evidenced by the very low interest rates on government gilts. This new-found credibility will allow government temporarily to increase the deficit as cyclical conditions worsen. It will also allow the UK to avoid further austerity in response to slower growth and lower tax receipts, an option that has unfortunately been unavoidable for some euro area countries.
As the effects of the increase in VAT and the declining value of sterling dissipate, inflation will begin to fall. This will give the Bank of England the chance to introduce an additional round of quantitative easing (a process by which money is created by the bank and pumped into the economy). Lower inflation increases the purchasing power of households and this should boost consumption, even though high household debt, unemployment, uncertainty and limited access to credit are generating powerful headwinds.
Beyond the short-term, Britain needs to create conditions for higher long-term growth. Protracted periods of stagnation will lower the growth potential of the economy, as investment is reduced and skills are eroded. High unemployment, particularly with one in five young people out of work, is of great concern. Action is needed to prevent young people who are not in employment, education or training from being excluded from work for long periods, the consequences of which are dire. Improving education and skills is essential for long-term growth. It would also contribute to reducing social inequalities, which are higher in the UK than in most OECD countries.
The competitiveness of the British economy also needs to be improved. Infrastructure has to be upgraded. The tax system—with lower rates, but less room for tax relief or avoidance—should become more efficient and fairer. The reform of land-use planning needs to continue, to create better opportunities for housing and business developments. Implementing the measures recommended by the Independent Commission on Banking will restore the ability of the financial system to finance the economy. It is important that Britain preserve the role of the City of London as an international financial centre, but the crisis has shown that over-reliance on the financial sector is not in the long-term interest of the economy.
Downturns are tough, but they are also times of opportunity. Government policies and action have the potential to create the conditions for sustained, long-term growth. This must now be the British government’s primary aim.
Britain’s recovery has proved even more sluggish than expected. Troubles in the euro area have dragged on and oil price increases are adding pain by constraining consumers’ purchasing power. The result is that the British economy is now close to a standstill.
Last year, our analysis at the Organisation for Economic Co-operation and Development (OECD) suggested that Britain’s economic recovery would be weak, on the basis that recoveries from financial crises always tend to be slow. The excessive private and public debts that result from such crises are eliminated slowly. Though it is necessary to restore financial sustainability, the policy of paying down debt is slowing domestic demand. At the same time, economic difficulties faced by Britain’s trading partners, particularly in the euro area, are holding back exports. This is unfortunate, especially now the UK needs to rebalance itself away from debt-financed private consumption and public spending, and towards exports and investments.
Should the government be doing more to support economic activity? With a budget deficit of over 8 per cent of national output, spending remains constrained. From the start, the government plan was to restore public finances; the plan is so far meeting objectives. This has boosted the government’s credibility despite disappointing economic growth. Still, Britain’s deficit is not yet within the comfort zone and as the global recovery is still fragile, emergency policy options should be held back in case of future external shocks, such as further difficulties in the euro area or a jump in oil prices.
But there are also less alarming moves that occur in the economy, and the government has factored these everyday undulations into its deficit reduction plans. This means that its plans can withstand temporary cyclical weakness in the economy and can limit cuts in public investment. The creation of the Office for Budget Responsibility and meeting deficit targets has earned credibility from financial markets, as evidenced by the very low interest rates on government gilts. This new-found credibility will allow government temporarily to increase the deficit as cyclical conditions worsen. It will also allow the UK to avoid further austerity in response to slower growth and lower tax receipts, an option that has unfortunately been unavoidable for some euro area countries.
As the effects of the increase in VAT and the declining value of sterling dissipate, inflation will begin to fall. This will give the Bank of England the chance to introduce an additional round of quantitative easing (a process by which money is created by the bank and pumped into the economy). Lower inflation increases the purchasing power of households and this should boost consumption, even though high household debt, unemployment, uncertainty and limited access to credit are generating powerful headwinds.
Beyond the short-term, Britain needs to create conditions for higher long-term growth. Protracted periods of stagnation will lower the growth potential of the economy, as investment is reduced and skills are eroded. High unemployment, particularly with one in five young people out of work, is of great concern. Action is needed to prevent young people who are not in employment, education or training from being excluded from work for long periods, the consequences of which are dire. Improving education and skills is essential for long-term growth. It would also contribute to reducing social inequalities, which are higher in the UK than in most OECD countries.
The competitiveness of the British economy also needs to be improved. Infrastructure has to be upgraded. The tax system—with lower rates, but less room for tax relief or avoidance—should become more efficient and fairer. The reform of land-use planning needs to continue, to create better opportunities for housing and business developments. Implementing the measures recommended by the Independent Commission on Banking will restore the ability of the financial system to finance the economy. It is important that Britain preserve the role of the City of London as an international financial centre, but the crisis has shown that over-reliance on the financial sector is not in the long-term interest of the economy.
Downturns are tough, but they are also times of opportunity. Government policies and action have the potential to create the conditions for sustained, long-term growth. This must now be the British government’s primary aim.
