December 5, 2012 8:25 pm
Time to use room for manoeuvre
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©Ingram PinnNon, je ne regrette rien. This should be George Osborne’s motto.
The chancellor of the exchequer cannot admit that his strategy bears blame for the absence of anything that looks like a recovery. He also insists that “it’s taking time, but the British economy is healing”. If disability is health, the chancellor can make this claim. Otherwise, he cannot.
The strategy is transparent: define failure as success and, to the extent that this does not work, blame one’s inheritance and the external environment. Politically this works. Economically it is unconvincing.
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The legacy is what it was when the government came into office. If things have ended up worse than expected, it is partly because the government failed to understand its inheritance. Again, the claim that events beyond government control are to blame for the disappointing outcomes is specious. This is not only because the UK economy has done badly in comparison with its peers, but because the government decided not to use available policy instruments. The UK economy is suffering the longest period below a pre-recession peak for a century. Given this, employment performance has been good. That, however, is the mirror image of the collapse in productivity growth. If these are signs of the desired return to health, what would chronic sickness look like?
One growth downgrade has followed another. We have also seen huge slippages in borrowing plans, compared with what the chancellor initially expected. Thus, in the emergency Budget of 2010, the forecast for cumulative public sector net borrowing between 2011-12 and 2015-16 was £322bn. In the latest forecast, this increased to £539bn, a rise of £217bn, if one excludes various special factors: the treatment of the Royal Mail pension, the debts of Bradford & Bingley and Northern Rock, and the transfers from the Asset Purchase Facility. (See charts.)
The government is not responsible for the mistaken economic forecasts. Responsibility has been transferred to the Office for Budget Responsibility, which notes that “the error is split fairly evenly between: weaker private consumption (reflecting demand uncertainty and credit conditions); and weaker net trade (concentrated in the first half of 2012)”. But the question is not what is to blame for the weak economy in any given period, but whether the government can and should do more about it and, if so, what exactly it should do.
The government’s conviction is that the overall task for fiscal policy is to balance the structural current deficit and bring net debt under control. But stabilisation of the economy is the responsibility of the central bank. Unfortunately, with the banking industry impaired and interest rates so close to zero, this assignment does not work well. With further fiscal tightening also under way – a structural tightening of the current budget by 4.7 per cent of gross domestic product between 2011-12 and 2016-17, and a reduction in public sector net borrowing by 5.3 per cent of GDP over the same period – the economy will face strong headwinds. Growth is likely to remain sluggish for a long time.
What will be done? Almost nothing, beyond postponing achievement of the fiscal targets further into the next parliament. What should be done is another matter. The government can and should reconsider fiscal, monetary, financial and structural policies, in order to accelerate the recovery.
First, the government could consider credibly temporary fiscal expansion. The obvious policy instruments for this are higher public investment and tax cuts, particularly cuts that are likely to be spent at once. Yes, this means more borrowing. But the government can reasonably argue that with such a weak economy, but cyclically-adjusted net borrowing forecast at only 3 per cent this year, it has given itself the room to delay tightening. This will lead to cries that credibility would be utterly destroyed. On the contrary, with the lowest long-term interest rates in UK history, it is the weakness of the economy that is, alas, all too credible.
The case for temporary increases in borrowing is very strong. Moreover, the promise to tighten further in the next parliament is barely credible, since a parliament cannot bind its successor. But what the government can do is leave a strong economy. Nothing could do more to make consolidation credible.
Second, the arrival of a new governor of the Bank of England is the ideal time to consider a change in the monetary framework. Possibilities would be either targeting of nominal GDP, with an increase of, say, 5 per cent a year for the next five years; a move to targeting domestic inflation, perhaps with a target of 4 per cent for nominal earnings; or even an exchange rate ceiling against the euro, as practised by the Swiss.
Third, the banking industry is far more constrained than most people initially believed. It is essential to find ways of recognising losses and recapitalising banks, without shrinking balance sheets further. Again, the government can borrow the money needed for such purposes.
Finally, the government needs to tackle structural obstacles to growth. Policies that both promote demand and expand supply would be ideal.
The economy is far weaker than expected, while public finances are healing. This gives greater room for manoeuvre to the government’s attempts to accelerate the recovery. What should it do? The answer is: more than it is doing. It is easy to understand the political case for insisting that there are no alternatives. Yet there are. It should adopt them.
Copyright The Financial Times Limited 2012
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