Applauding the return to economic growth is like celebrating the release of an innocent prisoner

Nobody doubted a return to growth under austerity was possible - but all the evidence suggests it has been hampered by George Osborne's radically anti-stimulus position.

The IMF’s growth forecast for the UK, which was revised upwards on 21 January, was met with relief, rather than joy: we have finally started to climb out of the worst slump in over 100 years. The Chancellor responded, saying that "Our long-term plan is delivering a brighter economic future."

Really? Below is the UK's real output per person since the crisis, compared with America. Whereas USGDP reached its pre-crisis peak in 2012, we don’t even show signs of reaching ours this decade.

Source: Eurostat for real GDP figures 2007-2012. 2013 forecasted using 2012 real GDP growth rates, also from Eurostat. Accessed 04/02/2013

However, let’s assume that the growth figures forecast by the IMF result in real growth of 2.4 per cent and 2.8 per cent for the UK and US, respectively, in 2014. The picture would certainly be brighter, as shown below.

Source: Same as above and IMF growth figures used to project for 2014. (Population growth not taken into account)

Assuming growth continues at this rate (the IMF predict it to fall next year), we would be back to 2007 levels of GDP by 2016-17. The US economy would, by that stage, be 11 per cent larger than it was in 2007. This is as much a cause for celebration as the release of a prisoner who has spent a wasted decade behind bars.

But the reaction in the mainstream press is that this “success” vindicates the chancellor’s economics and, by proxy, ridicules the shadow chancellor’s. The Economist, this week, said that Labour had been blasted on the economyand mocked Ed Balls's views, calling him a Good Keynesian”. Clearly The Economist thinks that using fiscal stimulus in the aftermath of the Great Recession would have been folly.

Firstly, they are wrong. Nobody suggested that growth would never return with austerity - but we would surely have seen growth years sooner if the government had stimulated demand. (For comparison, America’s stimulus package was almost a trillion dollars).

Secondly, the upturn in growth we are seeing now may actually be the product of an unexpected bout of fiscal stimulus in 2012 by none other than George Osborne. (Don’t believe me? I didn’t at first either...)

I’ll deal with these two points in turn. First, the case for fiscal stimulus. Faced with the task of driving a car up a steep hill, few people would focus on saving fuel. Or as John Maynard Keynes put it: The boom, not the slump, is the right time for austerity...” Now, to be fair, the forces that govern economies are not as well understood as the force of gravity on a car and, yes, economists are divided in many areas of macroeconomics - but the idea that you can create growth by imposing fiscal austerity on a recessionary economy is not one of those areas.

The graph below shows that those European countries who engaged in the most fiscal austerity over 2008-2012 had the biggest slumps.

Source: Krugman, P. “Night of the living Alesina”, NY Times Online; March 12th, 2013. European countries: GDP growth 2008-12 vs the size of their austerity programmes.

The idea that government belt-tightening during a recession causes a further contraction of GDP is as basic as it gets, but in post-2007 recessionary economies there was even more cause than usual to increase government spending. Firstly, normal monetary policy became impotent after we reached 0 per cent interest rates - and while quantitative easing has helped, its possible repercussions are not yet fully understood.

Secondly, multipliers have been shown (by the IMF, among others) to be higher when economies are depressed - so each pound spent by government generates more than just one pound of output - by some estimates, more than £2.50. Thirdly, and perhaps most importantly, countercyclical spending helps to maintain normal levels of output and therefore jobs: this not only decreases human misery, but it prevents the de-skilling of the labour force. In the long run this means higher employment and tax revenues, lower welfare and deficits, and a higher potential GDP.

As an aside, this is one of the biggest conundrums in right-wing economics: free-marketeers believe that growth is determined primarily by the supply side: so they want, for example, to cut red tape and taxes so that companies can more easily create jobs. But they are happy to watch unemployment rise and a substantial proportion of the labour market become deskilled and devalued - making those companies less able to find talent at home. And when those companies turn instead to foreign labour markets? No! Send the immigrants home!

But back to Mr Osborne. The government’s two main theories for shirking Economics 101 - that austerity could actually be expansionary and that debt over 90 per cent would cause investors to think of Britain as equivalent to Zimbabwe - have been proven beyond all reasonable doubt to be based on poppycock. Yet the coalition has remained firmly, publicly committed to austerity. As recently as November 2013, David Cameron told the CBIWe have to continue with Plan A. We have to continue to reduce the deficit.

Indeed, over the past three and a half years, every soundbite we have heard from the government would lead us to believe that Plan A has been motoring on ruthlessly through schools, councils and government departments, oblivious to any potential harm it might cause, like a sort of necessary Evil Kinevil. Not so.

Last summer, I wrote that fiscal austerity had so far been self-defeating as proven by the latest projections, which showed a budget deficit refusing to budge:

Public sector net borrowing excluding the Royal Mail and Asset Purchase Facility transfers. Source: OBR Economic and Fiscal Outlook, December 2013. Light blue=forecast.

My reasoning at the time was that austerity was self-defeating via the automatic stabilisers route: cutting public services in a recession worsens unemployment, which means more people on benefits and lower total tax revenues - so the deficit balloons. This mechanism is even more pronounced when the private sector is engaging in massive hoarding and is unwilling to hire, as we have seen in the past few years

But by breaking down the deficit figures further, it is clear that something else has been going on.

The top red and blue lines are the budget deficit as a percentage of GDP (normal and cyclically adjusted). It is clear that the pace of reduction stalled in 2012, slightly increased last year and is forecast to continue increasing slowly towards 0 per cent - but it is impossible to tell what is causing the reductions.

The green line at the bottom, however, is a measure of total government consumption of goods and services as a percentage of GDP. This measure strips out the automatic stabilisers” - tax and transfers - and is, therefore, a better measure of discretionary government spending - it is, essentially, George Osborne’s signature.

For a chancellor committed to plan A this is a fairly sizeable deviation, but it is a deviation of his own making. And yet while this anomaly has been well documented in the economics blogosphere (see here, here or here), it simply hasn’t made it into the mainstream press.

If a football team won the Premier League on a small budget, they would be well praised. If it was then discovered that they had actually spent a fortune on the sly, it would be front page news.

Instead, we have the FT writing articles with titles such as “Osborne wins the battle on austerity” - and worse, polls showing that more people now think cuts are good, rather than bad for the economy.

To be fair, it is impossible to say for certain that the return of growth was due to a year of increased stimulus (though any basic economics text will tell you that fiscal stimulus takes about 12-18 months to kick in), but that doesn’t explain the strange fact that there was a year of stimulus under an outwardly parsimonious Chancellor. And it begs the question: does George Osborne believe in austerity or not?

If the plan was to create growth two years before an election, while outwardly claiming that this was the result of ongoing austerity under a wise economic custodian, then the political rationale is clear. But if that is the case, then George Osborne has tacitly acknowledged the effectiveness of fiscal stimulus to create growth.

Does George Osborne have full faith in austerity? Photograph: Getty Images.

Dom Boyle is a British economist.

Photo: Getty Images
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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