Still waiting.

bored pugProgress is to the UK economy as words have been to my blog. Lacking. News on economic fundamentals, and the associated policy discourse, have consistently underwhelmed. Government concern remains fixed on the same, narrow goal of fiscal consolidation, with inadequate regard of how this consolidation is achieved. 2012 bears evidence to the claim that this concern is misdirected and that the derivative economic strategy is self-defeating. December has born witness to yet another downgrade in UK growth prospects and the rise of measured government debt has only been slowed by the inclusion of projected departmental underspends and the proceeds from the 4G license sales to projections. This post is a summary piece on the the state of the UK recovery and outlines the economics behind why the policies pursued to date have been unhelpful (at best).

The economy, …. 

The underlying picture remains much as it has been for the past two years: one of persistent weakness. Fifty shades of grey minus anything remotely stimulating if you will. The economy performed less strongly in 2012 than anticipated. The OBR cut its growth forecast to predict a 0.1% fall in output this year, followed by growth of 1.2% in 2013. Output is thus at roughly the same level as 2 years ago, 4% below that in 2008. This recession by now far exceeds the “Great Depression” in length. The graph below from the NIESR illustrates the point nicely.

Screen Shot 2012-12-17 at 18.27.43

It is unclear whether below par growth this year derives from “cyclical” (temporary) or “structural” (permanent) weaknesses. Cyclical weakness sits on the “demand side” of the economy– people and businesses just aren’t buying enough stuff–, whilst structural weakness is more pernicious and difficult to tackle, the result of a “supply side” contraction — we can’t make as much stuff. The two are related as cyclical weaknesses can be locked into structural ones via a process called “hysteresis” — see this post for more. There is disagreement as to how much of our current troubles to attribute to one or the other but, regardless, the OBR now forecasts systematically weaker economic growth for the coming years than it previously predicted in March.

Screen Shot 2012-12-18 at 11.00.08

Difficulties (understatement) in the Eurozone have continued to depress net exports and confidence. However, our lacklustre performance is by no means implied by the economic woes that plague Europe and other Western countries. Growth in the US and Germany has consistently dominated that achieved on these shores, and the UK pales in comparison to a host of countries in any ranking of capital investment.

And what of the lauded deficit reduction strategy? Despite (because of?) Plan A(usterity), good news isn’t forthcoming in this domain either. The size of the of the public finance hole is of a similar magnitude to that of 2011. However, even this underwhelming achievement is sullied by the knowledge that without the inclusion of funds from the one-off 4G licensing auction and the predicted “underspends” by certain government departments, the funding shortfall facing the government would have grown this year.

… stupid. 

In his Autumn statement, Osborne upped the dosage of existing prescriptions to cure the UK economy and added a few new measures to the mix. However, don’t expect a return to health soon. Policy remains inadequate and misdirected. There continues to be insufficient concern about the ends that sustainable public finances are supposed to advance. This has contributed to a lack of attention surrounding the composition of the policy mix conjured up on order to coax fiscal sustainability back to UK shores.

Just to remind ourselves, what is a budget deficit? When people talk about the deficit they are referring to the gap between what’s coming into the government coffers through taxes/other revenue sources (call this amount “T”) and what’s being spent (amount “G”).

Budget deficit = G – T

We care about the size of the budget deficit because of the impact that unsustainable public finances have on the economic prosperity of a country and the wellbeing of its citizens. It is not of value in and of itself to pursue low government borrowing (see this post for more on the cost of a deficit). Therefore, the obsession with fiscal consolidation is misguided and has resulted in a misdirected, overly narrow economic strategy. The size of the budget deficit is not the most salient economic ill plaguing the UK at present. If financial markets were overly concerned with the sustainability of the UK fiscal position, we would see interest rates rising with market risk. We have not witnessed this, the opposite in fact, suggesting that indebtedness is not the primary concern in financial markets (see this piece by Adam Posen, former MPC member, for more evidence on why reducing the debt should not be the top priority right now).

A blinding focus simply on the extent of the debt reduction required, without much regard to the how’s and why’s, has promoted a self-defeating economic strategy. The experience of the last 12 months is testament to this. Given that what we actually care about is general prosperity and wellbeing, we should aim for a deficit reduction strategy that protects these ends as far as possible. This demands a detailed analysis of the composition of spending and taxation changes, rather than just a pure focus on levels. This is because the austerity-growth dichotomy often presented in the media and by politicians is a false one. By reallocating government resources to activities with a high “fiscal multiplier” (to be explained!), growth can be supported whilst the budget deficit is reduced.

The Fiscal Multiplier

What does it mean to reallocate spending to activities with a “high multiplier”? The fiscal multiplier gives the impact that changes in government spending have on overall demand in the economy. With a multiplier of 1, an extra pound of government spending raises total demand in the economy just by a pound. However, we generally expect the size of the multiplier to be greater than 1. Imagine government spending is increased by £1. This additional £1 then represents income for someone that can be spent. Let households spend a fraction c of their income. c is defined as the “marginal propensity to consume”. This extra c of spending then represents income for someone else…..who spends c of it….and so on. Thus, one can think of the total increase in demand leading from the £1 of government spending as

1 + c + c+ c3 + …

Therefore, there can be a more than proportionate increase in demand for an increase in government spending.

The actual size of fiscal multipliers is difficult to measure but a moment’s thought suggests they will vary across government activities. The introduction above was clearly overly simplified; there is not one fiscal multiplier but a set of them associated with different government programmes. Resources should be shifted to high multiplier activities and the burden of cuts should be disproportionately concentrated on those with low propensities to consume. To illustrate, imagine a balanced budget policy, that simply takes income from one group in society and transfers it to another. Although fiscally neutral, the policy will boost growth if spending rises by more among the recipients than it falls among the funders. This will be the case if the marginal propensity to consume is higher among the recipients. This helps to highlight that through redesigning the austerity strategy to shift resources to high multiplier groups and activities, growth can be stimulated, and output protected, without a need to increase the debt burden.

The Autumn statement flirted with this principle by earmarking funds for capital spending and investment. These are potentially “high multiplier” activities given the employment and productive projects they facilitate. However, the scale of proposed new capital spending is insufficient. £5bn over the next two years. An amount that, at best, is expected to add 0.1% to GDP. Not exactly pushing the boat out… Secondly, and more importantly, the funding source for the proposed investments has the potential to undermine their (already small) impact. Cuts to welfare and tax credits will be used to fund these measures. However, such cuts will have a significant negative impact on demand in the economy given that they fall on those at the lower end of the income distribution. Such households tend to have a high marginal propensity to consume and little way of smoothing their spending. Therefore, the policy is largely funded by those who’s incomes the government should really be trying to protect if it is to be true to a multiplier guided philosophy. (Note that this is before any equity based arguments are even considered.)

A new voice

“For last year’s words belong to last year’s language

And next year’s words await another voice.

And to make an end is to make a beginning.”

— T. S. Eliot

In the next few weeks, I will write a number of more targeted posts on specific policy proposals and Eurozone developments. However, hopefully this post will have equipped you with some background knowledge on the economy and convinced you that a significant shift in economic strategy and dialogue is required in the UK. The singular focus on austerity has been self-defeating and has contributed to the prolonging the country’s economic woes. We’re long overdue a change in vision and vocabulary. The Autumn statement highlighted some appreciation of the arguments laid out here. In 2013, the government must go further to nurse the economy back to health.

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