Inaction is now the biggest economic risk

The long-term cost of high unemployment to individuals and to society is huge.

The long-term cost of high unemployment to individuals and to society is huge.

Not surprisingly, NIESR's latest forecast, published today, has led to predictable headlines focusing on our prediction of a "return to technical recession." But this misses the point. We are forecasting that the economy will contract slightly in the first half of this year; some other forecasters agree, others don't. But the differences are within the margin of error; we could well be wrong. The point is that almost everyone expects, even assuming an eventual successful resolution of the eurozone crisis, that growth will be slow at best.

So what should be done? The UK economy currently suffers from deficient demand; the current stance of fiscal policy is contributing to this deficiency. A temporary easing of fiscal policy in the near term would boost the economy. The credible commitment to a sustainable fiscal policy over the longer term provides the government with the flexibility to provide a clearly defined and temporary boost to near-term demand. For example, an increase in government investment would not have a significant impact either on long-run sustainability or - given the way they are defined - the likelihood of the government meeting its fiscal targets.

It is important to be clear that this is not about averting a recession in the short-term. It doesn't matter very much, either to the economy as whole or to individuals, whether economic growth is 0.2 per cent or -0.1 per cent. This is about minimising the long term social and economic damage. On current forecasts - both ours, and that of the Office of Budget Responsibility (OBR) we are set for an extended period where growth will not be enough to reduce unemployment to the levels we saw before the recession. We expect unemployment to rise to about 9 percent - 3 million - this year and to remain high. Even in 2014, it will still be over 7 per cent. This compares to the OBR's estimate that the structural unemployment rate is about 5.25 per cent.

That difference - the "unemployment gap", shown in the chart below, is a measure of the how much extra (or less) unemployment there is as a result of macroeconomic conditions - i.e. cyclical unemployment resulting from labour demand, or lack of it (more explanation here). In other words, if macroeconomic policy is broadly on track, the unemployment gap should be small; it is a measure of the number of people who are not working because macroeconomic policy isn't either.

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The chart shows that the unemployment gap in the aftermath of the 2008 recession will be larger and longer than any recession since 1970 (which certainly means any recession since the war) including the early 1980s, although there is probably some uncertainty about the 1980s estimates. It says that - on the official view and the official forecast - the unemployment gap is a million now, rising, and will be higher in 2013 than now; and that even by 2015, fully seven years after the recession began, it will be over 2 percent of the labour force, about 650,000 people. Unemployment at this elevated level for such a long period is likely to do permanent damage to the supply side of the economy, with large long-run economic costs.

The argument about fiscal policy is often presented as "Yes, fiscal stimulus might do some good, but are you willing to take the risk?" In my view the risks are hugely exaggerated, as I wrote in this magazine. But people talk much less about the downside of inaction. If we do not do something to boost labour demand now, we are not just taking a risk, we are accepting the likelihood of continuing high levels of unemployment that will damage both many individuals and society as a whole. In 1925 Winston Churchill expressed his dismay that policymakers seemed to be "perfectly happy with at the spectacle of Britain possessing the finest credit in the world simultaneously with a million and a quarter unemployed." As Martin Wolf puts it, "How masochistic does one need to be?".

Jonathan Portes is Director of the National Institute of Economic and Social Research. His blog is http://notthetreasuryview.blogspot.com

Jonathan Portes is director of the National Institute of Economic and Social Research and former chief economist at the Cabinet Office.

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There are risks as well as opportunities ahead for George Osborne

The Chancellor is in a tight spot, but expect his political wiles to be on full display, says Spencer Thompson.

The most significant fiscal event of this parliament will take place in late November, when the Chancellor presents the spending review setting out his plans for funding government departments over the next four years. This week, across Whitehall and up and down the country, ministers, lobbyists, advocacy groups and town halls are busily finalising their pitches ahead of Friday’s deadline for submissions to the review

It is difficult to overstate the challenge faced by the Chancellor. Under his current spending forecast and planned protections for the NHS, schools, defence and international aid spending, other areas of government will need to be cut by 16.4 per cent in real terms between 2015/16 and 2019/20. Focusing on services spending outside of protected areas, the cumulative cut will reach 26.5 per cent. Despite this, the Chancellor nonetheless has significant room for manoeuvre.

Firstly, under plans unveiled at the budget, the government intends to expand capital investment significantly in both 2018-19 and 2019-20. Over the last parliament capital spending was cut by around a quarter, but between now and 2019-20 it will grow by almost 20 per cent. How this growth in spending should be distributed across departments and between investment projects should be at the heart of the spending review.

In a paper published on Monday, we highlighted three urgent priorities for any additional capital spending: re-balancing transport investment away from London and the greater South East towards the North of England, a £2bn per year boost in public spending on housebuilding, and £1bn of extra investment per year in energy efficiency improvements for fuel-poor households.

Secondly, despite the tough fiscal environment, the Chancellor has the scope to fund a range of areas of policy in dire need of extra resources. These include social care, where rising costs at a time of falling resources are set to generate a severe funding squeeze for local government, 16-19 education, where many 6th-form and FE colleges are at risk of great financial difficulty, and funding a guaranteed paid job for young people in long-term unemployment. Our paper suggests a range of options for how to put these and other areas of policy on a sustainable funding footing.

There is a political angle to this as well. The Conservatives are keen to be seen as a party representing all working people, as shown by the "blue-collar Conservatism" agenda. In addition, the spending review offers the Conservative party the opportunity to return to ‘Compassionate Conservatism’ as a going concern.  If they are truly serious about being seen in this light, this should be reflected in a social investment agenda pursued through the spending review that promotes employment and secures a future for public services outside the NHS and schools.

This will come at a cost, however. In our paper, we show how the Chancellor could fund our package of proposed policies without increasing the pain on other areas of government, while remaining consistent with the government’s fiscal rules that require him to reach a surplus on overall government borrowing by 2019-20. We do not agree that the Government needs to reach a surplus in that year. But given this target wont be scrapped ahead of the spending review, we suggest that he should target a slightly lower surplus in 2019/20 of £7bn, with the deficit the year before being £2bn higher. In addition, we propose several revenue-raising measures in line with recent government tax policy that together would unlock an additional £5bn of resource for government departments.

Make no mistake, this will be a tough settlement for government departments and for public services. But the Chancellor does have a range of options open as he plans the upcoming spending review. Expect his reputation as a highly political Chancellor to be on full display.

Spencer Thompson is economic analyst at IPPR