March 10, 2013
Sometimes, when it seems like everybody is against you, it simply means that you are wrong. In a speech on the economy in Yorkshire last week, the prime minister made a number of unfounded assertions both about the British economic situation and claiming support for his government's views on macroeconomic policy. His speech casts the insistent repetition of such demonstrably false statements as an example of Thatcherite standing on principle, but in fact it is at best self-delusion—and like all delusion, harmful to those around the deluded, which is now the entire UK economy.
In the first of such claims, the prime minister stated "we have a clear plan to deal with the deficit." The plan may be clear, but it clearly does not deal with the deficit. Every independent assessment of Her Majesty's Government's budget situation, including those of the International Monetary Fund (IMF) and the Office for Budget Responsibility (OBR), suggests that the structural situation, i.e., the underlying deficit controlling for the effects of the downturn on revenues and outlays, has grown rather than shrunk. That ultimately is what lies behind the recent downgrade of British public debt from AAA status.
Furthermore, the government's plan for budget consolidation has proceeded in ways that were predicted, and have since proven, to be self-defeating—even in the narrowest possible terms of shrinking the deficit. In sum, it is misguided to engage in too much cutting of spending too quickly, rather than balancing cuts with tax increases over a longer period. As the Secretary of State for Business Vince Cable, a mainstream PhD economist, noted in an important recent column, the share of fiscal consolidation achieved through cuts in capital spending was overdone and has had harmful economic consequences. He suggests that "without doubt this is the least efficient form of fiscal tightening." Similarly, in an open letter released the day after Mr. Cameron's speech, OBR Chairman Robert Chote points out that the type of spending cuts with the highest multiplier (impact on the economy per pound cut) are by a huge margin those in capital spending.
In his second unsupported claim, the prime minister asserts that the recent lack of economic growth has nothing to do with the fiscal measures undertaken. Mr. Cameron goes on to assert that the Office for Budget Responsibility has said "They are absolutely clear that the deficit reduction plan is not responsible. In fact, quite the opposite." Agog at this contention, we searched the night of the prime minister's speech, and unsurprisingly we were unable to find any statement from the responsible OBR that the deficit reduction program had boosted UK growth in the short-term—such a statement would have been in total contravention of the known facts. Mr. Chote apparently shares our surprise at this claim about the OBR and the economy, writing: "For the avoidance of doubt, I think it is important to point out that every forecast published by the OBR since the June 2010 budget has incorporated the widely held assumption that tax increases and spending cuts reduce economic growth in the short term." One need not deny the drag on the United Kingdom from the euro area's problems and reduced financial services exports, or even the possible long-term growth benefits from fiscal consolidation, to recognize this simple reality as the OBR does.
There Is an Alternative
The most harmful false claim in the prime minister's Yorkshire speech is that "[While] some would falter and plunge us back into the abyss. We will stick to the course...there is no alternative." Actually there are a few highly plausible and widely discussed alternative policy approaches—we have argued for those concentrating on the encouragement of British public and private investment in the current credit-constrained risk averse low interest rate environment. Secretary Cable set out just such an alternative program recently in the New Statesman. In his article, he argues that "I have no doubt that there is some scope for more demand to boost output, particularly if the stimulus is targeted on supply bottlenecks such as infrastructure and skills." The present government has partially reversed the aforementioned excessive cuts in capital spending by increasing investment in transport by £5 billion in the autumn statement, but Mr. Cable rightly suggests that this is inadequate. As the secretary points out, a further rapid increase is entirely feasible given that only five years ago the government was building infrastructure, schools, and hospitals at a level £20 billion higher than last year.
Mr. Cable goes on to argue that a burst of public works spending would inject demand into the weakest sector of the economy—construction—while targeting two significant bottlenecks to long-term growth: infrastructure and housing. This argument is based on facts, not mere assertion. The Office of National Statistics makes clear in its latest data release that the construction sector is severely depressed. In January, construction output was 7.9 percent down on a year ago, following a contraction of 8.9 percent at an annual rate in the final quarter of last year. The more up to date Construction PMI survey data indicates, as Chris Williamson of Markit (who runs the survey) notes, "that the industry is undergoing a renewed downturn so far in 2013, led by weakening commercial construction and civil engineering activity, the latter attributed in many cases to government infrastructure spending cuts."
Policy Must Adapt
We support Mr. Cable's view that the balance of risks has changed from what it was in spring 2010 when the coalition's economic policy program was formulated. The coalition government should accordingly adapt its program to a better alternative. The IMF has argued since last May that the risks of losing market confidence as a result of undertaking a more measured consolidation path have diminished relative to the risks of public finances deteriorating as a consequence of continued lack of growth. It was never our view that it was appropriate to slash capital investment in the depths of a recession, as the coalition did in 2010, but at this point, we are confident that increased infrastructure investment—initially perhaps of around another £20 billion per annum—would not have adverse market consequences while stimulating growth. Private sector investment needs to be stimulated as well. The chancellor's temporary investment tax cuts for businesses announced in the autumn statement need to be scaled up to meaningful size (as with the infrastructure spend). More aggressive measures such as announcing large and rapidly expiring increases in depreciation allowances or taxing or submitting to shareholders' vote undistributed corporate cash holdings above a reasonable level would be helpful in this regard. Such measures, however, will tend to only work for larger and listed companies.
We thus agree with Secretary Cable that "Any reliable escape route from the crisis has to have a plausible mechanism for boosting credit to business, especially small and medium enterprises (SMEs)." We support efforts to launch a state-backed business bank and promote non-bank finance as well as new entrants into the British banking system. But it needs to be done at scale sooner rather than later, given that the Funding for Lending Scheme does not seem to be working well for the small and new business sector, where net lending continues to decline. Plus more funding is better than less under the current circumstances.
As we have long advocated, Mr. Cable also argues that the Bank of England should purchase a wider range of assets from corporate loans to infrastructure project bonds. "By taking risk off the private sector balance sheet we encourage it to find new investments. This is surely sensible." In fact, this is the logic underlying all quantitative easing (QE) measures undertaken by the world's central banks, most of which (including the European Central Bank and the Federal Reserve) already have bought assets beyond long-duration government debt to good effect. The Monetary Policy Committee already has explicit permission from the chancellor in a letter dated July 5, 2012 to purchase additional private sector assets, renewing permission granted previously by Mr. Osborne and by his predecessor Alistair Darling. The MPC simply has to decide to do it, so recent signs that some MPC members are increasingly ready to make such purchases within the inflation targeting regime are welcome. In any case precedent was set when the MPC bought £1 billion of private sector bonds in 2009, leaving the bank with an operational method of doing so.
An increase in the amount of private sector assets held could be achieved in one of two ways. Firstly, through one or more additional rounds of QE—indeed the two of us would have voted for £50 billion more at the March meeting, directing it to these kinds of private asset purchases. Secondly, this could still be done even if there are not further rounds of QE, by reinvesting the proceeds in alternative assets when the bank's existing gilt holdings mature. That at least assures that there we be no monetary tightening from the balance sheet side.
Sometimes one is driven to assert the incredible in defense of the indefensible. The prime minister's claims about his government's economic program in his Yorkshire speech appear to be such an effort. Yet, there really are many credible alternatives to the current stance of British economic policy, which would actually deal with the government's deficits while promoting growth. We hope that the chancellor will choose to pursue some of them in his budget presentation on March 20th, including putting funding into meaningful action for those constructive measures (infrastructure spending, investment tax credits, and a small business bank) he raised in his autumn statement. Such a responsible reversal towards reality sure would beat the alternative.