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The destruction of animal spirits

George Osborne's plan to galvanise the economy through austerity has failed, as the Keynesians predi

The mess that the economy is in was predictable from the moment this economically naive coalition government took office in May 2010 with no plan for growth. For all the bluster of the autumn statement delivered by the Chancellor, George Osborne, on Tuesday 29 November, there is a double-dip recession coming and several years of low growth, courtesy of the men ensconced in numbers 10 and 11 Downing Street.

The bitter experience of the 1930s should have served as a warning to Osborne of the dangers of withdrawing government stimulus before a recovery was fully established. He had plenty of advice from economists, including me, as well as several Nobel Prize winners, who warned of the dangers of a punitive austerity programme. But that advice was ignored and now the government is already expected to borrow at least £158bn more than planned a year ago.

It hasn't helped that Osborne, David Cam­eron and Nick Clegg have continued to repeat two outrageous calumnies. The first is that, at the time of the general election, the country was bankrupt, or close to it, when it demonstrably was not. The second calumny the coalition leaders have continued to repeat is that the UK economy is comparable to those of stricken Greece, Italy, Spain and Portugal, countries that are stuck in monetary union without their own central bank or exchange rate. Talking down the economy destroyed what John Maynard Keynes called "animal spirits" and has pushed the UK into a vicious cycle of decline that is unlikely to be reversible for a generation.

The claim that the government has made the UK a relative safe haven in the sovereign debt storm and helped to keep interest rates at record low levels is without foundation. UK bond yields are so low because the markets have no expectation that the Bank of England's Monetary Policy Committee (MPC) will raise rates any time soon and because we have a central bank that is free to do quantitative easing. Plus, there is zero chance of a default. Every country that has its own currency and can borrow in it, including Denmark, Switzerland, Norway and the US, has even lower bond yields.

We know from WikiLeaks that, prior to the 2010 general election, my old adversary Mervyn King, governor of the Bank of England, presciently told Louis Susman, friend of Barack Obama and US ambassador to London, that Cameron and Osborne lacked experience and depth. King argued that they operated too much within a narrow circle, dealt in broad generalities, tended to think about issues only in terms of their political rather than their economic impact and surrounded themselves with a weak team of young advisers. We are all now paying the price for such inexperience.
Beyond the autumn statement, the bad news from private-sector firms continues to come in thick and fast. The fear is that these latest measures from the Chancellor have come too late to prevent a further round of business failures.

Cries from the right

The Organisation for Economic Co-operation and Development (OECD), the Office for Budget Responsibility (OBR), the British Chambers of Commerce, the MPC and the European Commission have all lowered their growth forecasts for the UK (see adjacent table). The OBR members Robert Chote, Stephen Nickell and Graham Parker apparently accepted Osborne's claim that the economy would benefit from "expansionary fiscal contraction"- in other words, that public spending cuts and austerity would lead to a resurgence in the private sector. It hasn't happened.

The OBR is now much more in line with other forecasters, in lowering its estimates of GDP growth. However, rather surprisingly, it has still raised its growth estimates to 3.0 per cent in 2015 and 2016, which seems overly optimistic, when unemployment is predicted to hit a high of 8.7 per cent by 2012. The OBR now predicts a total reduction in public-sector employment of around 710,000 between the first quarter of 2011 and the first of 2017, compared to 400,000 between the first quarter of 2011 and the first of 2016 in the March forecast.

The OECD is forecasting a double-dip recession in Britain, with negative growth predicted in the next two quarters. It has also slashed growth rates for other major economies, including the US, and is predicting that the euro area will have a double-dip recession. This is a frightening prospect, not least because the eurozone is the UK's major export market.

Where does all this leave us? Plan A has failed, we know that. Growth has ground to a halt and public borrowing, expected by the OBR to total £127bn or 8.4 per cent of GDP this year, is likely to fall much more slowly than Osborne predicted only eight months ago in his March Budget. The tinkering at the edges that he announced in his autumn statement - such as the small right-to-buy housing programme and two additional "enterprise zones" in Humberside and Lancashire - are too little, too late, given the considerable time lags between announcement of the proposals and their likely impact on the economy. The problem is here and now and not in two years' time. The proposed £20bn infrastructure spending for road building and rail upgrades is welcome. As part of the plan, two groups of UK pension funds will provide funding for more than 500 public-sector projects but few details have emerged, because all that has been signed is a so-called memorandum of understanding.

Despite cries from the Tory right, I am unaware of any convincing evidence that bureaucracy and "red tape" are significantly holding back growth or job creation. Reducing job protection by making it easier to fire workers is not going to make firms start to hire when there is little demand for their products.

The credit-easing programme, in which the Treasury will underwrite borrowing by the banks so that they can lend more cheaply to small businesses with a turnover of less than £50m, is something I have advocated on these pages and I welcome it. However, questions remain on how quickly it will be implemented and whether the scale announced is large enough to get small and medium-sized businesses investing and hiring again.

blanchflower table

Courage under fire

In an important recent paper, published in the Oxford Review of Economic Policy (see end note), Nicholas Crafts and Peter Fearon explore the lessons to be learned from the Great Depression of the 1930s, which is the only previous experience we have of attempting fiscal consolidation when interest rates are close to the zero bound. Drawing largely from the American experience, they conclude: "Inappropriate tightening of policy precipitated the downturn, while the subsequent failure to provide greater monetary stimulus allowed recession to develop into depression."

The lesson from the double-dip recession in the US of 1937-38, they argue, "seems to be explained by deflationary moves in both monetary and fiscal policy". In contrast, the UK did not experience a double dip at the end of the 1930s, because of the "stimulus" of its rearmament spending.

My concern has long been that Osborne is repeating the mistakes made in the 1930s by tightening too much when less than half of the drop in output experienced in 2008 and 2009 has been restored. This crisis, which threatens the future of the European project and our long decades of stable prosperity, demands a largeness of vision and a capacity of our leaders to act not out of party but in the national interest. I suspect that Osborne is neither courageous nor pragmatic enough to change course and introduce much-needed policies that would give the economy a major stimulus, through tax cuts, investment subsidies and a huge, state-funded infrastructure spend.

The principal focus of government policy should move from deficit reduction to attempting to avoid the death spiral of decline - of falling growth, deflation, increased unemployment, falling living standards and ever-rising business failures. Those who do not read history are doomed to repeat it.

“Lessons from the 1930s Great Depression" by Nicholas Crafts and Peter Fearon was published in 2010 in the Oxford Review of Economic Policy, volume 26, issue 3, pages 285-317

David Blanchflower is the NS economics editor and professor at Dartmouth College, New Hampshire, and the University of Stirling

David Blanchflower is economics editor of the New Statesman and professor of economics at Dartmouth College, New Hampshire

This article first appeared in the 05 December 2011 issue of the New Statesman, The death spiral