The new book by my Dartmouth colleague Doug Irwin, Peddling Protectionism: Smoot-Hawley and the Great Depression, was described by one reviewer as a "judicious telling of a timeless story: what happens when cocksure politicians fall into the grip of a really bad economic idea". In this, the book took on a strange relevance in the week of the Budget.
The really bad economic idea during the Great Depression, put forward by the Republican senator for Utah Reed Smoot and the Oregon representative Willis Hawley, was to raise taxes on more than 20,000 imported goods to record levels. Ignoring the widespread opposition of economists, the politicians made bold claims as to how the new legislation would transform America's economy. Hawley predicted that it would bring "a renewed era of prosperity". Frank Crowther, a New York Republican representative, said that "business confidence will be immediately restored. We shall gradually work out of the temporary slump we have been in for the last few months . . . . We shall dissipate the dark clouds of your gloomy prophecy with the rising sunshine of continued prosperity."
In May 1930, 1,028 economists signed a petition asking President Herbert Hoover to veto the legislation, but the act became law just a couple of weeks later. Unfortunately, the Republican politicians' predictions were wide of the mark and the economy sank deeper into depression. The Smoot-Hawley Tariff proved to be the most damaging piece of trade legislation in US history
George's disastrous medicine
George Osborne's really bad idea is that, in the depths of a once-in-a-lifetime recession, the smaller the government (and the less it taxes and spends), the more the economy will thrive. This is called Ricardian equivalence (see Robert Skidelsky's essay, page 32). Unfortunately for the Chancellor, there is absolutely no believable empirical evidence to suggest it is true. The public, relieved of its fear of higher taxes, is supposed to look past these cuts and spend more, thus creating more productive private-sector jobs to replace the less productive public-sector jobs being shed. This may be possible in good times, but is not likely to happen in a recession, which could even deepen.
If Osborne's idea were right, we should be starting to enjoy the benefits of his policies, but as I have long predicted, that isn't happening and it is unlikely to while banks are not lending. Among economists around the world, there is broad opposition to the idea of an "expansionary fiscal contraction". Early this month, 320 US economists wrote a letter to President Obama opposing fiscal austerity and what they called "short-sighted budget cuts".
Despite David Cameron's contention that Osborne's Budget will be "the most pro-growth for a generation", there is, in my view, zero chance that it will result in a "rising sunshine of continued prosperity". Downside risks to growth have increased over the past fortnight, following the natural disasters in Japan and subsequent nuclear crisis, along with the war in Libya and the spike in oil prices.
Data released in recent days shows that the public finances have not recovered. The deficit increase of £11.8bn in February was almost double the £6.9bn expected by the market. Also unexpected was the increase in the Consumer Prices Index (CPI) rate of inflation to 4.4 per cent, with core inflation jumping to 3.4 per cent. This has increased the pressure on the Bank of England's Monetary Policy Committee (MPC) to raise rates, which would be disastrous for growth. While the substantial increase in the number of apprenticeships is to be welcomed, the Chancellor's growth measures are just tinkering at the edges.
A major concern for Osborne is that consumer confidence is collapsing even before the austerity measures start to hit in April. The Nationwide Consumer Confidence Index fell back 10 points in February, hitting its lowest level since the survey began in May 2004. The fall was driven by a sharp deterioration in the Expectations Index, which shows consumers' assessment of how the economic and employment situation will look in six months' time. Growing pessimism forced the Spending Index down to 52 points in February, also the lowest level since the survey began.
The chart below plots the Nationwide index along with the other main consumer- confidence measure from the European Commission. Both have broadly the same path, although the collapse is not quite so severe on the EU measure. Consistent with these surveys, Markit's latest Household Finance Index indicated the steepest monthly deterioration since March 2009. Almost 35 per cent of households reported that their finances had become worse since February, while just 5 per cent saw an improvement. This is worrying because the collapse in consumer confidence that occurred in 2007 predicted well the collapse in consumer spending that followed. The less consumers spend, the lower growth is.
Making the downgrade
The Office for Budget Responsibility doesn't believe this is a Budget for growth, as it has downgraded its forecasts for GDP and household consumption. Its revised growth forecasts for 2011 and 2012 (1.7 and 2.5 per cent, down from 2.1 and 2.6 per cent in November) still appear overly optimistic compared to others, including those from the OECD (1.5 per cent for 2011 and 2 per cent for 2012), the National Institute of Economic and Social Research (1.5 and 1.8 per cent), the Confederation of British Industry (1.8 and 2.3 per cent) and the consensus of private forecasters (1.8 and 2.1 per cent), though they are less optimistic than those of the MPC (2 and 2.7 per cent).
The evidence suggests growth will continue to disappoint and this Budget will be a failure. Osborne's contribution to the economy will be crushed consumer confidence, lower growth and increased unemployment. That is what can happen when a cocksure politician falls into the grip of a really bad economic idea.
David Blanchflower is NS economics editor and a professor at Dartmouth College, New Hampshire, and the University of Stirling.