Where did it all go wrong for George Osborne?

It is the government's policies that are causing economic stagnation, not the wider economic crisis.






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Publication: Soundings
Author: Burke, Michael
Date published: December 1, 2011

The depression of the British economy is not a unique event: two other large economies in the European Union are also in a depression. The performance of this group of three countries (the others are Italy and Spain) is in contrast to a number of EU countries that have (nearly) recovered the total loss of output incurred in the course of the recession. This group includes Sweden, which has recovered all the lost output of the recession; Germany, which is back to it pre-recession peak; and to a lesser extent France, which is still 0.8 per cent below its own prior peak in output. A third group consists of economies that have been the subject of 'bail-outs' by the Troika of the EU/ECB/ IMF. If not beforehand, then since the imposition of deep public spending cuts, Greece, Ireland and Portugal have experienced very deep domestic recessions. The economies in the intermediate grouping of Britain, Italy and Spain are all effectively stagnating. The GDP data for the second quarter of 201 1 show that the British economy grew cumulatively by just 0.1 per cent in the three quarters since the Comprehensive Spending Review, while Italy and Spain grew by 0.5 per cent and 0.7 per cent respectively.

However only in Britain was this stagnation a matter of domestic political choice. Policy choices and stagnation

Of the three large stagnating economies, Spam had a much milder recession than either Britain or Italy. Spanish GDP contracted by a severe 4.9 per cent in the course of the recession, but this was exceeded by both Britain and Italy, which experienced contractions of 7.1 per cent and 6.9 per cent respectively, despite the fact that neither British nor Italian policy-makers had to cope with any problems on the scale of Spain's debt-fuelled construction boom.

The reason for the less severe downturn in Spain, despite arguably worse circumstances, is that the initial response of the Spanish government was the most effective of any of the leading European economies in combating recession. While the scale of the initial stimulus measures was only slightly above the EU average of 2 per cent of GDP, Madrid overwhelmingly concentrated its stimulus on public investment, especially in infrastructure projects. These are widely and authoritatively recognised as producing the most effective bang for buck in terms of government spending (technically speaking, they have by far the largest fiscal multipliers attached).1 In addition, at no fiscal cost at all, the minimum wage was raised - and transfers to the poor are regarded as the next most effective means of stimulating the economy, since the poor are obliged to spend by far the greater proportion of their incomes (in Keynesian terms, the poor have the greatest marginal propensity to consume).

As a result, the recession was less severe in Spain, even though its construction boom had been far greater: in the years 1997 to 2007, investment in Spanish construction expanded by 90 per cent in real terms, nearly twice the rate of the economy as a whole; by contrast the British construction boom saw an expansion of 50 per cent, and growth m Italian construction over the same period was a much more modest 26 per cent.

Prospective recovery has been halted in Spain, however, because of a combination of actions by financial markets, ratings agencies and the European Central Bank, which together conspired to drag Spain into the debt crisis. The initial actions of Spain's socialist government were enough to cushion the effects of the recession. But its subsequent capitulation to the pressures for a bail-out of its creditors and the accompanying cuts to public spending have since consigned it to the economic doldrums.

Italy represents an altogether different case. Italy is the Japan of Europe. While Japan is now widely described as having losl decades in the form of negligible growth since 1990, Italy's economic performance has been marginally worse over that period. Italian GDP has grown by just 20 per cent since 1990, 0.6 per cent less than Japan in real purchasing power parity terms, and much less than the British economy's 48 per cent growth. The severity of the Italian recession is not a function of a preceding boom - there wasn't one. Instead it is a function of structural weakness exacerbated by a political leadership which is far more interested in keeping out of jail and attacking foreigners than in resolving the crisis.

The first Italian 'austerity' measures have only recently been announced, and are yet to be implemented. Italy was caught up in the generalised crisis and responded in the now customary European fashion with a reduction in government spending, even though the public sector deficit had already fallen to below pre-recessionary levels. When the measures are enacted, the current period of economic stagnation may come to be regarded fondly as a growth interlude, as the economy responds negatively to the withdrawal of government spending. In common with the Euro area as a whole, Italian government spending accounts for approximately half of GDE As will be discussed below, it is a fallacy to believe that other agents, consumers or businesses will expand their own spending in response. Households will be directly hit by cuts in public sector wages, benefits and services; while expecting business to increase their investment under those circumstances is foolish in the extreme.

By contrast to Spam, where external agents forced a turn towards spending cuts, and Italy, which is in long-term stagnation, Britain was in recovery mode when the current government took office. It is worth emphasising this point, not least because George Osborne's explanation for what the Office of National Statistics calls 'flatlining' is that the Tory-led coalition government inherited an economy in recession when they came into office. This is wholly factually incorrect.

As Figure 1 below shows, the British economy had been expanding moderately until the Coalition government took office, and had been making up lost ground on the Eurozone economy. It has been diverging from Eurozone growth since the Tory economic policies were implemented. Taken together, the economy expanded by 2.8 per cent over the course of five quarters that began in the third quarter of 2009 and ended with the third quarter of 2010. Uniquely, Osborne inherited a moderate but sustained recovery. It is the policies adopted since which have produced stagnation.

No external agency has obliged the government to adopt this course, and indeed many seasoned economic commentators - such as Martin Wolf of the Financial Times - have cautioned against it. There has been no imposition of cuts from the EU, acting in concert with the ECB, as occurred in Spain. Nor was Britain panicked into a policy because of its place in a general European-wide contagion, as Italy has been.

It is sometimes argued that the policy was pre-emptive, in that it forestalled a bond market crisis that would have otherwise occurred. In a similar way to the Chancellor's focus on the elusive 'structural deficit' rather than the actual deficit, this claim is designed to prevent conclusive debate, since by its nature it is not possible to disprove it on the basis of empirical evidence.

But the argument is nevertheless demonstrably false. The Labour budget of March 2009 provided a significant stimulus to the economy (though slightly below the EU average), equivalent to 2 per cent of GDP. Yet in the year following this increase in government spending, the real yield on benchmark gilts was unchanged, and remained close to zero. In other words, a significant stimulus led to no increase in borrowing costs. There was no imminent bond market crisis to address.

Policies leading to stagnation

There are two main levers in formulating economic policy - fiscal and monetary policy. British monetary policy is in the hands of the Bank of England, and was unchanged throughout the period between the two Labour budgets of March 2009 and March 2010. Monetary conditions were also broadly unchanged. As we have seen, real long-term interest rates were unaltered, while sterling's trade-weighted index mostly appreciated over that period (thus producing a moderate headwind against recovery), but ended more or less where it started.

The recent sharp deterioration in economic outlook and performance must be a function of a change in fiscal policy alone, as monetary policy has continued to be more supportive, via unchanged base rates, 'Quantitative Easing' and a lower exchange rate for the pound. And the main change in policy implementation arose after the Coalition government took office in May 2010: in June 2010 it announced an 'emergency budget', which was soon followed by a much more thoroughgoing attack on public spending in the October Comprehensive Spending Review. The net effects of these changes can be seen in the Treasury Budget table set out below in Figure 2 (taken from the March 201 1 budget). They show the net fiscal tightening under the Coalition government as 9.4bn in the last financial year (of which 5.5bn is spending cuts and 3.8bn is tax increases). This proposed fiscal tightening rises to 41bn in the current financial year.

At the time of writing, the financial year April 2010 to March 201 1 has only recently ended. The financial year 201 1-12 is just a few months old. Therefore the impact of the cuts that has been seen to date relates much more to the 9.4bn of spending cuts and tax increases from the financial year 2010-11 than to the much larger 41bn fiscal adjustment in the financial year 2011-12. Disentangling monthly government accounts is not a simple task, but the best guess is that the first three months of the financial year 201 1-12 account for a scheduled one quarter of the total fiscal consolidation for the year, or approximately 10bn. But even these data do not reflect the full proportion of the effect of the cuts. This is because economies respond with a time lag to changes in economic policy. (Alan Greenspan used to say that this time lag was 'long and variable', providing the ultimate get-out clause for policy-makers. But though the former Fed Governor may have wanted too much leeway, there is clearly some lapse in time between policy change and economic impact.) This means that, since the 10bn in cuts of the first quarter of the financial year 201 1-12 is contemporaneous with the second quarter of GDP data, they can hardly be said to have affected it. Therefore the transition from recovery to stagnation during this period can be seen as almost entirely a reflection of the earlier 9.4bn in fiscal tightening.

The crisis of private sector investment

The British economy has undergone a zig-zag - boom, recession, recovery, stagnation. But during all the period following the boom there has been a single constant - the crisis of private sector investment. The peak of the last business cycle was in the first quarter of 2008, and the trough of the recession was in the second quarter of 2009. Over that time the economy contracted by 88.6bn in real terms, on an annualised basis.

This fall in GDP can be broken down into its main components. Thus household consumption fell by 41.5bn, a drop of 4.9 per cent - one of the biggest percentage declines of the major economies. In the OECD as a whole the fall in household consumption was a much more modest 1.5 per cent. (This suggests that the social safety net in Britain is both too weak and too porous.) By contrast, government current spending rose by 7.4bn. Net exports also rose, making a positive contribution to growth of 16.4bn during the recession, but this was entirely a function of collapsing demand for imports, which outstripped the fall in exports. Investment (gross fixed capital formation), however, fell by 43bn. The private sector is in fact responsible for a decline of 51.1 bn, because the total figure for investment also includes government investment, which expanded during the recession by 8.1bn. This means that, out of a total decline in GDP of 88.6bn, the decline in private sector investment accounts for 51.1bn, or 57.7 per cent of the total. These main aggregates of the national accounts in the recession are shown in Figure 3 above.

Despite a recovery that began in the fourth quarter of 2009, the level of GDP remains well below its peak of the first quarter of 2008. At the end of the first quarter of 201 1 GDP was still 56.3bn below the peak level three years earlier, a shortfall of 4.1 per cent (detailed data are not available for the second quarter at the time of writing). Household consumption has recovered to some extent, so that at the time of writing it is 36bn below its peak level. Government current expenditure and net exports have both risen, by 13bn and 17.3bn respectively. But investment has resumed its decline in the last two quarters. It is now 36.1bn below its peak, a figure that is fractionally worse than the fall in household consumption. The private sector is in fact responsible for a 44.9bn decline in investment, but this has been offset by government investment, which has risen by 8.8bn. This private sector investment strike thus accounts for 44.9bn of a total loss of output of 56.3bn - 79.8 per cent ol the total. The main aggregates of the national accounts from the end of the boom to the first quarter of 2010 are shown in Figure 4 below.

Cause of recovery

As previously stated, recovery began in the fourth quarter of 2009 and lasted for four quarters, with the economy expanding by 32.8bn. During these four quarters household consumption rose by 1 l.Tbn, up 1 .4 per cent; net exports fell by 12.6bn; government current spending rose by 3.8bn; and investment rose by 12.5bn. The private sector contribution to this increase was 15bn, as government investment fell over the period as a whole, once the impact was felt of the new governments policies.

These figures may have encouraged the government and the Office for Budget Responsibility in the false idea that the recovery would be driven by investment even as government spending was cut. (The other officially projected component of growth is net exports, but, as noted, the rise in net exports currently remains entirely a function of the slump in import demand. British exports in the first quarter of 201 f remained below their pre-recession peak, despite the sharp rebound in world trade.) Thus the Office for Budget Responsibility forecast in March 2011 that private investment would rise by 6.7 per cent during the financial year. The reality is that it is currently moving in the opposite direction: in the first quarter private sector investment fell by 3.8 per cent from the final quarter of 2010.

To understand why the government and Office for Budget Responsibility have been proved wrong in projecting higher private sector investment, the dynamic underlying the recovery and subsequent stagnation must be examined. This can be understood through looking at Figure 5, which shows the trends in GDP and investment in the thirteen quarters since the end of the boom in the first quarter of 2008.

As already noted, the figures show that decline in investment is the driving force behind the recession and the subsequent failure to recover to the previous peak level of output. Private sector investment accounts for 79.8 per cent of that total shortfall in GDR As Figure 5 shows, public investment moved in the opposite direction, increasing through 2008 and rising sharply in 2009, peaking in the first quarter of 2010 - the last quarter of the Labour government. By the time GDP began to recover modestly in the fourth quarter of 2009, public sector investment had risen by an annualised 10.5bn. This was far greater than the initial rise in GDP, which was just 6.1bn higher. Therefore the rise in public sector investment was entirely responsible for the recovery.

Private sector investment did not rise as soon as the economy began to expand. It began to rise only after recovery had begun. Since all private investment is determined by anticipated profits, this inability of the private sector to lead the recovery should be no surprise. However, over the course of 2010 private sector investment was the biggest single contributor to growth, rising by 22.3bn. This private sector investment increase was the result of growth that had been fostered by the sharp increase in the level of public sector investment. But instead of understanding that public sector investment was leading to economic recovery, including stimulating private sector investment, both the Tory-led government and the OBR subscribe to the idea that government spending 'crowds out' the private sector, so that if public spending is cut, private investment will increase. The opposite is in fact the case. Increased government investment 'crowds in' private investment.

The false Tory/OBR idea is further demonstrated by the negative reaction by the private sector to the subsequent cut in public sector investment. Public sector investment peaked in the first quarter of 2010, when it was 38.4 per cent higher than it was at the end of the prior business expansion. It began to lall as soon as the Tory-led Coalition took office in the second quarter of 2010. Shortly afterwards, in the fourth quarter of 2010, GDP began to stagnate. Immediately afterwards, private sector investment also began once more to contract. Clearly, the reason for the renewed decline in private sector investment - which accounts for 80 per cent of continued economic weakness - is the renewed weakness of the economy; and this is itself a function of the reduction in government spending.

An alternative policy

The problem of the private sector investment strike is a chronic one for the British economy, but it has recently become acute. The stagnation of the economy and the damage this is doing to Tory popularity has sparked a debate about the need for growth - led by Boris Johnson's call for tax cuts for those earning over 150,000 and for corporations.2 But, predictably, this kind of response ignores that fact that the recovery was fostered by increased government spending, including investment, and is now being throttled by government spending cuts. The Tories' focus is on tax cuts for corporations and the rich, with many of them calling for an end to all carbon reduction policies, a reduction in the minimum wage, the abolition of employment laws, more privatisation, and so on.5 This is a recipe for continued economic decline: as in other countries, such as Greece, Ireland and Portugal, the effect of such a huge transfer of incomes from poor to rich would be to depress economic activity even further, as well increasing the public sector deficit. Indeed, few of these ideas are likely to find much support outside Tory circles.

But one suggestion that has received some support is the idea of a corporate tax cut to boost investment. It is important to note, however, that this call ignores two important facts. First, the government is already cutting corporate tax rates from 28 per cent to 23 per cent, yet the private sectors investment strike is continuing, accounting for 80 per cent of total lost output. Secondly, the nonfinancial corporate sector is already sitting on a cash mountain of 695bn, which is simply financing dividend payments, enormous executive pay and takeovers - that is, everything but investment.4

The call for lower corporate taxes obscures a central truth about the current crisis. In any normally functioning market economy the household sector is a net saver. It retains a portion of its income and does not consume it immediately. These savings are mainly held in banks. The corporate sector is a normally a net borrower for investment, and borrows from the banks. The government can either be a saver (budget surplus) or borrower (budget deficit). This depends on its own tax and spending policies, but also on what happens in the rest of the economy. In the chart below, the level of lending or borrowing for these three main sectors is shown. Borrowing is a negative number and lending positive. Other important sectors (especially financial corporations and the rest of the world) have been disregarded for the sake of clarity. What the chart shows is that the British non-financial corporate sector has not been performing its designated role over a prolonged period. It has been a net saver. Disregarding the sectors not shown, in general the sum of these three sectors must balance to zero. Saving by one sector must have another sector its borrowing counterpart.

The saving of the corporate sector has had two effects. In the first instance corporate saving (achieved through lack of investment and low wages) has obliged the household sector to become a net borrower to finance consumption. It has also obliged the government to increase its borrowing as the lack of investment has depressed taxation revenues. When, at the beginning of 1998, the household sector took fright and returned rapidly to its traditional role of net saver, the government was obliged to sharply increase its own borrowing and the public sector deficit ballooned. The primary cause of both the unsustainable nature of the prior business expansion and the subsequent recession was the failure of the corporate sector to borrow to invest. Rather than cut their taxes and thus increase this saving, the whole thrust of policy should be designed to oblige the corporate sector to invest and to borrow for investment.

This highlights the essential failure of Labour to grasp the effects of its own policy proposals. Figure 2 above shows the planned fiscal tightening that was announced but never implemented in the March 2010 budget co-authored by Alistair Darling and Peter Mandelson. It shows that Labour would now be making a 26bn drain on the economy, in roughly the same proportion of tax increases and spending cuts that Osborne has implemented. Given that stagnation has been caused by just 9.4bn in cuts, the impact of a package nearly three times as great would evidently have been extremely damaging. But there has as yet been no clear break from this policy, and its accompanying mantra that Osborne is going 'too far, too fast' - though the call for a temporary cut in VAT and small boost to house building is a step in the right direction.5

It should by now be clear that it is not Osbornes speedometer that is faulty, but his navigation. His policy is diametrically opposite to that required. The corporate sector is saving, not investing. So, the failing policy prescription of cuts to the real incomes of households, via wage cuts, benefit cuts and public spending cuts, is entirely misdirected. It reduces the household sector's ability both to consume and to save. As a result, it increases the propensity to save of the corporate sector itself. Why would any business increase its investment when its two main customers, government and households, are both cutting back on their own spending?

Instead, it is the policies of the 2009 Labour budget which can be seen to have worked: they produced an economic recovery and a falling public sector deficit. And this public-sector-led growth prompted a short-lived revival in private sector investment. But the improvement in public finances also appears to have stalled now, along with a stalled economy. However the revival of the economy and the reduction of the deficit are linked, the latter dependent on the former. Only an investment-led recovery can achieve sustainable growth and deficit-reduction. The corporate sector has demonstrated that it cannot lead that revival but will participate if it is sustained by public sector investment. Thus only increased government investment can currently lead economic recovery.

Notes

1. IMF, 'Effects of stimulus in structural models': www.imf.org/external/pubs/ft/ wp/2010/wpl073.pdf.

2. 'Boris Johnson tells George Osborne to cut National Insurance and 5Op tax': www.telegraph.co.uk/news/politics/8664414/Boris-Johnson-tells-GeorgeOsborne-lo-cut-National-Insurance-and-50p-tax.html.

3. Conservativehome, 'Here you go George, a growth manifesto from London's think tanks', retrieved 26.7.11: http://conservativehome.blogs.com/ thinktankcentral/2011/07/growthmamfesto.html.

4. ONS, UK Summary Accounts, Ql 2010, Table 9.1M (pl56).

5. Ed Balls, speech to LSE, New Statesman, 16.6.11. www.newstatesman.com/ politics/20 11/06/george-osborne-growth-deficit.

Author affiliation:

Michael Burke is an economic consultant who was previously senior international economist with Citibank in London.

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