In justifying his deficit reduction plan, George Osborne traded heavily on the support of those the American economist Paul Krugman mockingly refers to as “Very Serious People”. As if afraid to make the case for his strategy in his own voice, the Chancellor presented himself as ventriloquising the view of the economic establishment.
Among Osborne’s backers were 20 prominent economists who signed a letter to the Sunday Times on 14 February 2010 endorsing his pledge to reduce the structural deficit (the part of the deficit that remains even after growth has returned to normal) at a faster rate than Labour, and to implement immediate spending cuts. They stated: “. . . in order to be credible, the government’s goal should be to eliminate the structural current Budget deficit over the course of a parliament, and there is a compelling case, all else being equal, for the first measures beginning to take effect in the 2010-2011 fiscal year.” Osborne hailed their letter as a “really significant moment in the economic debate”.
Two and a half years later, the facts have changed and so, to paraphrase Keynes, they have changed their minds. The private-sector-led recovery anticipated by Osborne has not materialised and the UK is mired in a double-dip recession. The Chancellor, who is poised, over the course of this parliament, to borrow £11.8bn more than Labour planned, has been forced to delay his goal of eliminating the structural deficit until 2017. We asked the 20 how they see the world now. Edited extracts of the 11 replies follow on the next three pages. Of the rest, eight were either “on holiday” or did not answer our requests; Anne Sibert, professor of economics at Birkbeck College, University of London, refused to comment.
Roger Bootle, the managing director of Capital Economics, writes: “If I were Chancellor at this point, I would alter the plan, I would stop the cuts to public investment and I might even seek to increase it.”
With the UK able to borrow at the lowest interest rates in 300 years, the signatories are both surprised and dismayed at Osborne’s failure to invest for growth. The Cambridge University economist Hashem Pesaran laments that the government’s policies “have not followed the balance I had in mind when I signed the letter”. Osborne, he says, has pursued “fiscal reductions at the expense of growth-inducing policies”.
Danny Quah of the London School of Economics states simply: “Have I changed my mind since signing the letter? Yes. Because circumstances have changed.” He notes that “the fear that UK borrowing would become overly costly has become much less relevant”. His LSE colleague Tim Besley, a former member of the Bank of England’s Monetary Policy Committee, urges Osborne to seek “creative ways of using the government’s balance sheet”, with “more focus on housing in the near term”.
Michael Wickens of York University writes that “if the government has made a mistake, it is in cutting capital expenditures – expenditures that have to be made at some time and would be cheaper to do now than in the future”. Yale’s Costas Meghir notes that “both capital and labour are very cheap and available; there is little danger of crowding out private investment . . . It is a mistake not to take up this opportunity.”
When Osborne delivered his “emergency” Budget in June 2010, he told the House of Commons that “unless we deal with our debts, there will be no growth”. But he has learned that the reverse is true: unless you stimulate growth, you can’t deal with your debts.
The Spanish economist Albert Marcet declares that there is “no room for Keynesian-type policies” and warns against “any change in the commitment to reduce the public deficit”. But those who replied to us substantively are all calling for some shift in the Chancellor’s strategy towards tax cuts and higher infrastructure spending.
It is now only Osborne’s political pride that is preventing a change of direction. If he is not to condemn the UK economy – and his party’s poll ratings – to permanent stagnation, there is no alternative.
It was right to take that stance when we did. That’s not to say I wouldn’t do something, I would. When you have credibility you should use it. If I were Chancellor at this point, I would alter the plan, I would stop the cuts to public investment and I might even seek to increase it.
Supply-side reform might be welcome but what we’re talking about here is a shortage of demand. The key thing is to try and get the private sector to spend its money and that may require a bit of government spending to prime the pump.
Roger Bootle is the managing director of Capital Economics and author of “The Trouble With Markets” (Nicholas Brealey, £12.99)
London School of Economics
Discussion of appropriate UK debt reduction policy cannot occur independently of, in this case, at least two other large factors: first, the international environment; second, the stance of UK monetary policy. In my view, dramatic swings in both of these have occurred since I joined the group that signed that letter. We need to remember that in February 2010 the UK’s debt and deficit position was not dramatically different from those of the eurozone countries now experiencing considerable sovereign debt distress. It doesn’t take a lot of imagination to see how, all else equal, UK government borrowing could easily have become just as expensive and as difficult as in those economies. In the event, however, the eurozone economy went into free fall much faster and much further than I expected. This has had two effects on the UK fiscal position: on the one hand, UK debt has turned out looking, well, not so bad after all, relative to comparable advanced transatlantic economies. The fear that UK borrowing would become overly costly has become much less relevant.
On the other hand, the continued inability on both sides of the Atlantic to resume economic growth means a dramatic drag on UK economic performance. Unlike, say, Germany, the UK has historically consistently exported mostly to the slowest-growing advanced economies, and so this transatlantic slowdown has considerably depressed UK exports and thus the UK economy. (Germany, by contrast, today exports more to developing Asia than it does to the US.) So, the international environment has shifted in such a way that the urgency for rapid debt reduction has lessened.
The other large factor is how market perception of UK monetary policy has shifted, too. For most observers now, the Bank of England has made clear that it is willing to put considerable resources into monetary easing. That has also reduced the pressure for debt reduction, compared to the perceived monetary stance at the time I signed the letter. So, have I changed my mind since signing the letter? Yes. Because circumstances have changed.
Danny Quah is professor of economics and Kuwait Professor at the LSE
At the time, the statement was correct. A lack of an explicit commitment to deficit reduction could have had catastrophic consequences, with market credibility being lost and interest rates increasing, leading to an even stronger contraction. However, under current circumstances (and in part because of the credibility the UK gained by the cautious policy), there is a huge opportunity to carry out important infrastructure projects and improvements in education. Currently, both capital and labour are very cheap and available; there is little danger of crowding out private investment; and infrastructure and human capital spending properly thought through (not roads leading to nowhere or just beautiful school buildings but targeted educational interventions and projects useful to economic activity, such as airports and transport) can have high returns in the future, making the whole enterprise profitable. It is a mistake not to take up this opportunity. However, spending to increase entitlements or in other ways that lead to a larger public sector would be wrong.
Costas Meghir is the Douglas A Warner III Professor of Economics at Yale University
The original letter to the Sunday Times on 14 February 2010 stressed the importance of reducing the UK’s structural deficit as part of a credible medium-term fiscal consolidation plan and that remains just as important today. It was, however, only half of the need for fiscal restructuring. The situation facing Britain in 2008 (and arguably for some time before) was that the government was spending more on consumption than it could finance from its tax revenue, particularly when looking ahead to supporting the pensions of an ageing population and with escalating health costs. It was necessary to cut current expenditure but, given the poor state of Britain’s publicly funded infrastructure and the looming recession, the necessary counterpart (taught us by Keynes in the Great Depression) is to increase public investment expenditure even if this worsens the short-run public deficit. That would stimulate private investment, particularly if it relaxed important transport bottlenecks, in a far more positive way than just cutting total government expenditure. That was what the United States did with its immediate response, although many argued that it was at too modest a scale.
So, what should be added to the actions proposed in that Sunday Times letter? Crucially, that it is better to stimulate an economy facing
a lengthy recession by public investment rather than supporting current consumption.
There is no shortage of sensible public investments to undertake. [Sir Rod] Eddington, in his report on transport, found large numbers of road projects with benefit-cost ratios above four – that is, they produce benefits worth four times as much as they cost. Contrast that with the admission that High Speed 2, which will not appear (and then only half-done) until the 2020s, has a benefit-cost ratio of only 1.2.
By most measures, Britain has worse traffic congestion than almost all the other European countries, and its cost to the productive economy is high. Indeed, when Eddington took account of the wider social, environmental and economic costs and benefits associated with road projects, he found they strengthened, not weakened, the urgent case for investment.
Finally, for roads, motorists pay considerably more than the interest on the cost of building in road fuel taxes. The M1 delivers something like
a 40 per cent return to the Treasury in extra taxes alone. If, as many argue in opposition to road-building, pent-up traffic demand expanded to at least partly fill the new road space, the taxes generated would more than pay for the cost.
A third runway at Heathrow is not only desperately needed, but would be entirely privately financed, exactly as the Treasury wants. With planes landing now making less noise than they did in the 1970s, and the rising importance of India and China as commercial destinations, we need more critical air links from the key hub airport now, not in 15 years’ time. Instead of encouraging public and private investment, the Treasury seems to view cutting capital expenditure as an easy short-run win.
What else makes sense for the growth agenda that we hear so much about but see so little sign of? Why not invest in activities where Britain currently excels? Why not expand support to universities and their research? Why not encourage legitimate foreign students to come and learn here, building up future sympathies abroad? Instead, we are putting the world-class status of our universities at grave risk.
Finally, if we look at the 1930s, we see that the rapid rebound was driven by a massive privately financed housing boom. At present, we are building less than half the number of houses needed to keep up with family formation, let alone relieving the high pressure on housing and rents in the more dynamic parts of the economy. In the 1930s land was cheap. So it is in the current era – if only we could transform agricultural land worth £6,000-£9,000 per acre into land with planning permission worth £600,000 to £900,000 per acre (that excludes London, where values are £2.6m per acre). To put it another way, releasing land at agricultural values would possibly halve the cost of some houses and would allow many now pushed out of the housing market access to affordable property.
Instead, the haves (with houses) keep their values intact at the expense of the have-nots (aka the next generation, which we hope will support us in our old age). Some harness concerns about diminishing our green and pleasant land to lobby against relaxation of the old Soviet-style planning system (aka the new localism). But houses and their gardens take up less than 5 per cent of Britain, so we could double the land available for housing and reduce often boring prairie-farmed “countryside” by only 5 per cent.
So, there was plenty left unsaid in the original letter, but many have since made similar points, including the International Monetary Fund and most serious economists. We need growth, and that requires investment. In a recession bordering on a depression, public investment in infrastructure that has a high pay-off even in good times must make sense. If we have to reform planning to deliver it, that would be an added benefit. The bankers are asking failing economies to remove barriers to productivity – we should do the same.
David Newbery is emeritus professor of economics at Cambridge University
My views have not changed – but this does not mean that I have agreed with this government’s obsession with credit ratings and fiscal reductions at the expense of growth-inducing policies. I was in favour of taking account of the possible adverse effects of large and unsustainable government deficits on borrowing costs and financial stability. I believe this government’s policies have not followed the balance I had in mind when I signed the letter.
Hashem Pesaran is professor of economics at Cambridge University
Thanks, but I’ll pass on this.
John Vickers is professor of economics at Oxford University. He has criticised the government for watering down his recommendations for reform of the banking sector
London School of Economics
Whatever happens next, policy has to be laid out clearly in strategic terms and having points of agreement across the political spectrum would be helpful. Thankfully, we have an independent Office for Budget Responsibility to monitor the implications of policy based on well-laid-out assumptions – whether these turn out to be valid or not. And any new plans, wherever they come from, have to stand up to such scrutiny. I would prefer to see government resources used in a targeted way and there may be creative ways of using the government balance sheet. I am particularly keen to have more focus on housing in the near term. We have an economy that is flexible and competitive, but there is scope for improving education, for generating a far-sighted and less politicised strategy for infrastructure investment and planning to promote science and innovation, and to deal with deficiencies in management and finance.
Tim Besley is the School Professor of Economics and Political Science at the LSE
As my 2009 book with Carmen Reinhart, This Time Is Different, shows, there is no simple escape from a long period of slow growth after
a deep financial crisis. Nor is it easy to escape the huge debt build-up and subsequent wave of sovereign defaults that often follows within a few years. Indeed, today’s profound debt problems in the eurozone are hitting growth hard around the world, not just the UK. Structural reforms to make the economy more flexible and efficient would help immensely, but political resistance everywhere is high. There is scope for temporarily higher inflation to help relative wage adjustment and to accelerate deleveraging. However, the US and UK are right to bring down their budget deficits only slowly, both now around 8 per cent. Today’s high and rising debt levels have surpassed important historical thresholds associated with long periods of slow growth. US debt is already at a level likely to lead to 1 per cent lower growth for a decade or more. There is no free lunch any more at these high debt levels. I am not impressed by today’s low interest rates, which characterise many other slow-growth debt-overhang periods across advanced economies since 1800. That said, I have always favoured investment in high-return infrastructure projects that significantly raise long-term growth.
Kenneth Rogoff is professor of economics and Thomas D Cabot Professor of Public Policy at Harvard University
Normally, governments should tax-finance permanent expenditures (such as defence, health, education and welfare) and debt-finance temporary expenditures or tax losses (such as those arising from recession) and public investment. The problem in 2010 was that, for many years, Labour had increased permanent expenditures without raising taxes to pay for them, so debt had increased to levels exceeding even those of Italy and Spain. The danger was that unless fiscal policy was adjusted the UK would face a much higher cost of borrowing – like Italy and Spain today. In effect, Labour was subsidising the current generation and making future generations pay the cost. This was why I signed the letter.
This problem has been made a lot worse in the current recession by some unusual features: in addition, we have a banking crisis, a eurozone crisis and high private indebtedness. The banks are now highly risk-averse and will lend only at very high rates. The private sector has been reducing its debt by saving more (up from 1 per cent of income to around 7 per cent), spending correspondingly less. And exports have been hit by the recession in the eurozone.
This is a really tough situation, which the government can’t do much about. Monetary policy is largely ineffective and the benefits of quantitative easing are greatly exaggerated as banks have used the money to rebuild their balance sheets rather than lend. Since the government is trying to cut debt, it has been reluctant to raise it through a fiscal expansion, as would normally happen in a downturn caused by deficient demand where there is no accompanying debt crisis. Even so, both government expenditures and its debt have continued to rise due to the severity of the recession.
The basic problem is that the current generation (partly through its governments) has been greedy, consuming too much and financing it through too much debt, and is now expecting future generations to bail it out. This applies to the UK, the eurozone and the US. It has taken some time to reach this position and it will take some time to unwind it.
Other solutions involve letting off borrowers at the expense of savers. Defaulting on debt lets borrowers off at the expense of the lender. The borrower would then not be able to borrow in the future. Inflation would erode the real value of debt and savers would find the value of their assets fall; their rectitude would prove costly.
If the government has made a mistake, it is in cutting capital expenditures – expenditures that have to be made at some time and which would be cheaper to do now than in the future. This could be debt-financed. If the government explained this clearly, I believe the market would not charge higher rates for this additional borrowing. Such a strategy, not reneged on, would help – although probably not that much. It is all about confidence: the confidence to lend and to be able to pay back what is borrowed. This applies to the private sector, banks and government. You can’t buck the rules indefinitely without someone paying a price.
Michael Wickens is professor of economics at the University of York
Barcelona Graduate School of Economics
I am quite sure there is no room for Keynesian-type policies to encourage growth in the fourth year of a recession; there is virtually no economic theory that will support that. I see no urgency to change the schedule in deficit reduction. The UK cannot unilaterally change the fact that there is a global recession, so growth will be below average. Furthermore, there is the danger of becoming the focus of the market’s speculation if there is any change in the commitment to reduce the public deficit.
What can be done? There is room for less wasteful spending. Much more conditionality on benefits from the state should be established. Although the UK system for monitoring those on unemployment benefits is much better than Spain’s, it is much worse than the one in Scandinavian countries. The UK should establish a system similar to Sweden’s, where those on unemployment benefits have to spend several hours daily at the work centre. I am all for welfare payments – it is crucial to fight social exclusion – but those on welfare should show they are making the effort to get out from social exclusion.
Now, for an odd recommendation: I don’t see how manufacturing in the UK can take off under the pound. Being out of the Economic and Monetary Union has had some obvious advantages, but it leaves any UK manufacturer with the enormous cost of currency risk. It is hard to be a big gun in manufacturing if you do not have access to a large market with a very low currency risk. It may not be the right time to join the euro, but it is a big cost to be out of it. It would be really healthy for the UK to start planning to join the euro.
Albert Marcet is research professor at the Barcelona Graduate School of Economics
London School of Economics
Professor Pissarides was on holiday and unable to contribute to this feature, but these words are an edited extract from an open letter he wrote to Osborne, published in the NS of 17 October 2011
I know you worry about the deficit but I think that you worry about it too much. Keynesianism of the kind that guided policy after the Second World War no longer works, but there are still lessons in it for us. Worrying too much about the deficit in a recession makes the recession worse. The problem with a recession is that it punishes a relatively small number of people and it punishes them a great deal. The unemployed, new school leavers and ethnic minorities bear the brunt of it. The cost of recession to them is not only lower income, but loss of self-esteem, loss of skill and damaged future career paths. Less concern about the deficit and more attention to the economy’s ability to create jobs will reduce unemployment and improve well-being.
Let me emphasise that we do need a plan for deficit reduction. But it does not have to start so soon – when the economy is still in recession – go so deep and be so inflexible. Your approach to deficit reduction reminds me of Margaret Thatcher’s approach to reducing inflation. She was right to be worried about it, and the reforms that she introduced were badly needed. But she squeezed the economy so much, in such a short period of time, that she caused a severe – and unnecessary – recession. It took almost ten years for unemployment to recover.
I fear that the way you are squeezing the economy now will have similar consequences. Your plan for deficit reduction should start the spending cuts gradually and respond to the state of the economy. It should go deeper only when the recovery is more robust. A more flexible approach to the cuts is good both for economic growth and for the size of the deficit.
Christopher Pissarides is the Norman Sosnow Chair in Economics at the LSE