The economic strategy of the Coalition government was relatively simple: make a credible plan to eliminate the budget deficit in order to placate the markets, and private sector growth will more than compensate for diminished government spending. To that extent, the strategy relies on the idea of expansionary contraction: growth will occur precisely because the size of the state is reined in. There are historical and international precedents to suggest that this can occur, but the major assumption which belies the plan is that conditions are such that Britain’s underlying long-term private sector growth rate is relatively strong.
A recent study by Tullet Prebon explained why this might be misguided. The economic growth with which we became associated prior to the onset of the financial crisis, as we all know, was debt-fuelled – the pump for the economy was both huge private mortgage and credit borrowing and increases in government spending, which led to expansions in real estate, financial services and construction alongside side public sector health, education and administration. After the credit crunch and now with state spending cuts, this pump has been turned off. What is unclear is whether the economy has the strong underlying characteristics for the rest of the economy to make up for the loss of the old pump.
So far the evidence is weak. GDP growth has underperformed OBR forecasts over the past year, making George Osborne’s desire to eliminate the deficit seem increasingly unobtainable. If this trend continues, it would have huge implications both politically and economically. The Conservatives, perhaps wrongly, have staked much of their economic credibility on ‘restoring the nation’s finances.’ But if growth is half that forecast by the OBR across this Parliament, the deficit will still be 9% of GDP in 2015 and debt as a proportion of GDP would not peak until 2025. Let alone the sustained high unemployment results that would result from such sluggish growth.
In this sense, it is possible that both George Osborne and Ed Balls could be right. It is clear that the current huge borrowing binge by government is unsustainable, and the UK would likely be at the mercy of the bond markets if it about-turned. But unless other fundamentals are geared to growth, then reducing government spending is not in itself a guarantee of the private sector picking up the slack. In addition, political uncertainty in the US, the on-going Eurozone financial crisis and the clear lack of domestic consumer confidence, mean the overall picture is decidedly bleak.
We therefore appear to be mired in a high-debt, low-growth trap, with little in the way of policy options to escape.
The expansionary monetary policy and low base rates have thus far been effective in limiting the costs associated with debt interest repayments. Given the high levels of consumer and business debt, as well as public debt, people are (perhaps understandably), using this time to pay down some of their debts rather than engage in consumer spending or investment. Though of course some inflationary pressure is likely to result from this monetary expansionism, it seems obvious now that the more significant threat is deflation – which makes it all the more remarkable that the European Central Bank has, over the past months, been hiking rates. The exchange rate effect of this loose monetary policy has not resulted in the deluge of exports which one would usually associate with large depreciation of the currency, but this is likely to owe much to the lack of consumer confidence amongst our trade partners. Nevertheless, there is little room for manoeuvre with base rates at an all-time low of 0.5 per cent.
The big debate, as we have seen, centres on fiscal policy. Shadow chancellor Ed Balls and campaigners like Richard Murphy seek a ‘courageous state’ solution, with higher government spending and borrowing to break the cycle. In Ed Balls’ words: “the global economy is sliding into that rare and dangerous "special case" that Keynes identified in the 1930s and Japan suffered in the 1990s. With growth stagnating around the world, every country pressing ahead with deep cuts risks being a catastrophic mistake.” This view point is misguided when applied to the UK, both because of the interest rate risk and the nature of the recession. Continuing to run deficits at anywhere near the 2009/10 level through this Parliament would push the public debt to ratio to 100% by 2015 and 150% by 2021, with the risk of default and even bigger cuts as result. The risk of interest rates spiking would make both the debts unsustainable and reduce those with mortgages to penury. But equally, this recession is different. The whole thing is predicated on high debt. As has been seen following Barack Obama’s failed first stimulus package, the multiplier effects of deficit spending in this recession are minimal due to the huge deleveraging. Indeed, the IMF published historical data showing that there is no multiplier for deficit spending when a country’s public debt ratio is 60% or above. And it’s not just public debt that is the problem in the UK, both business and consumer debt are much higher than in other countries too.
With monetary policy exhausted and fiscal policy restricted, the conclusion that the Tullet Prebon report makes, and I am inclined to agree with, is that the government must continue to walk the macro tight-rope whilst doing everything it can to implement supply-side reforms which will raise the underlying growth rates of the non-debt funded UK industries and markets. With economic conditions changeable, and interest groups attempting to blockade reforms, this will be difficult. But it is absolutely necessary to restore the long-term competitiveness of the economy. At the moment, they are doing nowhere near enough. Both George Osborne and Ed Balls are arguing over the direction of fiscal policy, but the amount that can be done there given the constraints of the market and the size of our deficit is restricted. Prior to the recession we were fooled into thinking that a debt-fuelled boom represented real economic growth, meaning the only real long term solution is to substantially increase the flexibility of the factors of production.
The Coalition has made a positive start on reforming human capital development – and the free schools and academies revolution is likely to halt the decline in educational standards. On other supply-side measures, more immediate action can be taken. The Government must win the battle for reform of planning laws. It must scrap the HS2 programme, which will have little net economic benefit, and instead divert funds to improving the capacity of the road and rail network. It must undertake a fundamental review of the regulatory and employment legislation faced by small businesses, and be unashamedly pro-growth in jettisoning those that hinder both business expansion and job growth. It should seek innovative financing structures for private infrastructure investment. It should attempt to undertake a balanced-budget rebalancing of the tax system away from high marginal taxes on employment across all income levels by closing loopholes, exemptions and avoidance on stamp duty and capital gains tax, as suggested by Mark Reckless MP, and pension tax relief. And finally, it should re-examine the costly consequences on industry of the current energy policy, through which we seem unilaterally hell-bent on destroying our remaining manufacturing base.
These policies alone would not guarantee strong economic growth: many would have delayed effects and a secondary banking crisis would outweigh all of the above. But they would leave the UK in a far stronger underlying position to recover from the recession, and would wean us off the debt culture which, through the financial crisis, is now actively restricting our economic prospects.