Why the UK must reverse its economic course
It is the mark of science and perhaps rational thought more generally to operate with a falsifiable understanding of how the world operates. And so it is fair to ask of the economists a fundamental question: What could happen going forward that would cause you to substantially revise your views of how the economy operates and to acknowledge that the model you had been using was substantially flawed? As a vigorous advocate of fiscal expansion as an appropriate response to a major economic slump in an economy with zero or near-zero interest rates, I have for the last several years suggested that if the British economy – with its major attempts at fiscal consolidation – were to enjoy a rapid recovery, it would force me to substantially revise my views about fiscal policy and the workings of the macroeconomy more generally.
Unfortunately for the British economy, nothing in the record of the last several years compels me to revise my views. British economic growth post-crisis has lagged substantially behind U.S. growth, and the gap is growing. British GDP has not yet returned to its pre-crisis level and is more than 10 percent below what would have been predicted on the basis of the pre-crisis trend. The cumulative output loss from this British downturn in its first five years exceeds even that experienced during the Depression of the 1930s. And forecasts continue to be revised downward, with a decade or more of Japan-style stagnation now emerging as a real possibility on the current course.
Whenever policy is failing to achieve its objectives, as in Britain today with respect to economic growth, there is a debate as to whether the right response is doubling down – perseverance and intensification of the existing path – or recognition of error or changed circumstances and a change in course. In Britain today such a debate rages with respect to the aggressive fiscal consolidation that the government has made the centerpiece of its economic strategy. Until and unless there is a substantial reversal of course with respect to near-term fiscal consolidation, Britain’s short- and long-run economic performance is likely to deteriorate.
An effective policy approach to Britain’s economic problems must start with the recognition that the principal factor holding back the British economy over both the short- and medium-term is the lack of demand. It is certainly true that Britain faces important structural issues, ranging from difficulties in promoting innovation to deficiencies in the system of worker training. But it is apparent from the relatively low level of vacancies, the reluctance of workers to leave jobs, the pervasiveness across industries and occupations of increased unemployment and the testimony of firms regarding the formation of their investment plans that it is lack of demand that is holding the economy back from producing as much as it could.
Keynes writing during the Depression compared Britain’s economic problems to a “magneto” problem, referring to the fact that a car might have many infirmities, but if its electrical system did not work, the car would not go, and if it were fixed, the car would go even with other problems. So it is today. Moreover, to an extent that is greatly underappreciated in the policy debate, short-run increases in demand and output would have medium- to long-term benefits as the economy reaps the benefits of what economists call hysteresis effects. A stronger economy means more capital investment and fewer cutbacks to corporate R&D; it means fewer people lose their connection to good jobs and get addicted to living without work; it means that more young people get first jobs that put them on ladders to success; and it means more businesses choose leaders oriented to expansion rather than cost-cutting. The most important structural program for raising Britain’s potential output in the future is raising its actual output today.
The objection to this view comes in many forms, but it is in essence that “reversing course on fiscal expansion now would undermine credibility, backfire with respect to growth by risking a spike in capital costs, and risk catastrophe down the road as debts became unsustainable.” This line of argument is profoundly flawed. First, the behavior of financial markets suggests that it is economic weakness rather than profligacy that is the main source of concern about credit problems down the road. Why else would the tendency be for the costs of buying credit insurance on the UK to rise overall as interest rates fall? In similar vein, a strong tendency has emerged in both the UK and U.S. for interest rates to rise and fall together with stock prices, implying that it is evolving optimism and pessimism about the future, not changing views about fiscal policy, driving market fluctuations. Second, the reality is that the primary determinant of fiscal health in both the U.S. and UK over the medium term will be the rate of growth the economy achieves. An extra percentage point of growth maintained for five years would reduce Britain’s debt-to-GDP ratio by close to 10 percentage points, whereas austerity policies that slowed growth could even backfire in the narrow sense of raising debt-to-GDP ratios and turning the unsustainability of debt into a self-fulfilling prophecy.
A change in the pace of fiscal consolidation is necessary for Britain to have a chance to avoid a lost decade of economic performance. It is, to be sure, not sufficient. Rather than starving public investment today, now is the time to add to confidence by making plans for structural reforms to contain the growth of public consumption spending over time. It is also time to take overdue measures to promote exports and, after years of appropriately low investment, to restart housing investment. But at a time when demand is needed for growth and the private sector is hanging back, the first priority must be for the public sector to stop exacerbating the contraction.
PHOTO: Britain’s Prime Minister David Cameron gestures while viewing a parade of British Olympic and Paralympic athletes through London September 10, 2012. REUTERS/Adrian Dennis/POOL