Since the coalition government came to power in 2010 the British economy has been stagnant. Unlike other advanced economies, the United States in particular, national income has failed to recover back up to the level it reached before the crisis struck in 2007 (a more correct turning point, in my view, than the more commonly used 2008). In particular the government has failed to meet its own projections, with plans to reduce the government deficit behind target. A common view in the media, backed by a number of distinguished economists, is that the government’s austerity policies are “not working”, and need to be loosened. This view was strengthened this week by two events: some comments in the IMF’s World Economic Outlook, and the discrediting of an influential academic paper Growth in a time of debt by eminent economists Carmen Reinhart and Kenneth Rogoff (you can read The Econonist’s coverage here). This had put forward the idea that economic growth collapses when government debt reaches 90% of GDP, and had been used to give intellectual heft to the country’s austerity policies. Stepping back from the political ding-dong, what lies behind this controversy.
First, some perspective on this week’s two events. I have had a look through the IMF report to see what it says about the UK economy, and it is … almost nothing. With a world perspective it is, of course much more interested in the US, the Euro zone, and even Japan, never mind less developed economies, whose influence on the world economy is growing. There is a single sentence that causes the furore, repeated in the executive summary: “Greater near-term flexibility in the path of fiscal adjustment should be considered in the light of lackluster private demand.” Still, the IMF will be looking at the UK in more detail shortly, and today’s Financial Times, no less, is billing this as a major confrontation. Does the IMF matter? IMF analysis is academically rigorous, politically neutral and based on detailed factual analysis. This stands it apart from most economic comment, even that from distinguished economists, which is little more than grandstanding. It also has an institutional bias towards conservative financing of government. Criticism from that quarter saying that the government should relax fiscal policy lends weight to the notion that the government’s economic policy is based on a naive Treasury orthodoxy that has changed little since Maynard Keynes railed against it in the 1930s.
As for the Reinhart-Rogoff paper, I give this a lot less weight. Its core claim is based on the statistical analysis of past episodes growth and debt. Such regressions used in macroeconomics are always flaky, never mind any mathematical errors, as the various assumptions needed to give them validity rest on wishful thinking. We looked at a few when I was an economics student, and noted how no two independent statistical regressions came close to agreeing with each other. There are no economic laws of motion out there waiting to be discovered by careful data analysis. And if there were, their validity would generally be broken by the act of discovery and its effect on people’s behaviour. The value in such studies is in posing questions, not answering them.
So what issues of disagreement might there be between supporters and critics of the government’s policy in terms of generally accepted economics? First let’s start on the points what they should agree on. The reason why the UK has not met government forecasts made in 2010 has been weakness in demand from two areas: exports and investment. Consumer demand has been fairly much as expected. It is difficult not to see the shadow of the Euro crisis in both, though a case might be might be made for a weak banking sector causing lack of investment (though I wouldn’t buy it). This weakness in demand is damaging because it causes persistent unemployment, which in turn may damage the economy’s longer term prospects as longer term unemployed people become unemployable. Meanwhile living standards are being squeezed by the depreciation of the pound, which is spreading hardship and pain far and wide. A further point of agreement amongst most is that the economy needs to rebalance: for some areas of the economy to shrink relative to others, in particular towards areas of the economy that strengthen exports, rather than just fuel borrowing. This point is not accepted by many Labour politicians, especially those close to the last government though (for example Tony Blair in his recent New Statesman article). It implies that the last government’s economic strategy was mistaken in causing these imbalances. However I suspect most neutral observers accept that substantial rebalancing is needed.
There are probably two important points of disagreement. The first is the extent to which any fiscal relaxation will slow or prevent rebalancing. Will it just prop up areas of the economy that will need to be shrunk for the economy to progress? This line of argument is particularly strong when it comes to the expenditure side of the austerity policy. Cuts to government services and reform to the benefits system are not just about cutting the deficit: they are about making the economy more efficient. However, when it comes to temporary tax cuts, it is a lot less clear that it has anything to do with rebalancing. Also expenditure to invest and improve the economy in the long term is not affected by this line of argument.
The second area of disagreement is the ability of the government to borrow money to finance fiscal stimulus, and the effect of borrowing on growth. This was where the Rienhart-Rogoff article was deployed. I won’t attempt to explain it in today’s blog: it gets fiercely technical. In the more public arena both sides like to deploy spurious arguments on this topic. I disagree with most of the arguments used by government supporters, but that does not make them wrong in the round.
Government supporters, especially of a Lib Dem hue, will suggest that the government has already been flexible by stretching out its targets in face of the disappointing economy. There remains a case for some kind of shock treatment, though: a change in policy that is a pleasant surprise to people, and which will improve confidence.
And that is an issue that is at the heart of the matter in my view, but which economists don’t like talking about because it seems so ephemeral. The economy is driven more than they will admit by the zeitgeist: common expectations, confidence, mood, world view, etc. There is little fiscal and monetary policy can do in the face a determinedly depressed outlook that increases saving but reduces investment. That is what we have now. One aspect is welcome: it means that inflation is unlikely to take off. A positive shock can change the mood: but Britain is a small country which depends a lot on what goes on in the rest of the world. There is a real risk that what goes on in the wider world undermines domestic attempts to change the mood, which means that the whole exercise makes things worse. The outlook remains grim, I’m afraid.