When the facts change, should I change my mind?
The long economic stagnation of post-crisis Britain.
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The British economy is still operating at levels around or below those before the 2008 financial crisis and roughly 15 per cent below an albeit unsustainable pre-crisis trend. There was next to no growth during 2012 and the prospect for 2013 is of very modest recovery.
Unsurprisingly there is vigorous debate as to what has gone wrong. And also what has gone right; unemployment has fallen as a result of a million (net) new jobs in the private sector and there is vigorous growth of new enterprises. Optimistic official growth forecasts and prophets of mass unemployment have both been confounded.
Arguments about growth and recovery involve different timescales. I share the view, set out well by the LSE Growth Commission, that long-term growth involves a major and sustained commitment to skills, innovation and infrastructure investment. However, we are also currently below trend growth and below capacity.
Two years ago, I responded in the New Statesman to Robert Skidelsky’s “Keynesian critique of government economic policies. He returned to the charge in the NS in September 2012. His contribution has been to lift the dispiritingly low level of public debate about UK economic policy by drawing on the great work of Keynes, of whom he is the definitive biographer and whose disciples taught me economics.
Skidelsky’s central observation is the “striking coincidence” between what he describes as the coalition’s “large dose of austerity” and a period of what he calls “semi-slump”. He is sufficiently gracious and well informed to state that it is “foolish to say that [George] Osborne’s budgets have caused the slump” – unlike the Labour front bench, which has had no such inhibitions. His complaint is a more subtle one: that “austerity . . . has kept [the economy] from recovering”.
In the political bearpit the arguments are less sophisticated. Keynes’s name is often used to dignify any proposal that involves the government spending more money and any opposition to cuts.
This crude Keynesianism sidesteps the causes and effects of the financial crisis, including the drag on growth from damaged banks; as well as other structural problems, such as skills shortages and a long-standing neglect of vital exporting industries, which our national industrial strategy is now trying to address.
In opposition to the cruder “demand-side” arguments are some equally crude “supplyside” arguments, which trace an ancestral link to another of the 20th-century greats, Friedrich Hayek (or the Austrian school more generally). This bastardised supply-side economics often degenerates into a saloonbar whine about HSE inspectors, newts and birds that block new development, bloodyminded workers, equalities legislation and Eurocrats who dream up regulations for square tomatoes and straight bananas. Philosophical cover is provided by the belief that the private sector can always fill the space left by a retreating state.
An eclectic approach
Neither set of prejudices does justice to the complexities of the crisis that has submerged the UK (and other western countries) in deep economic water. A variety of approaches is relevant. Worryingly, few economists beyond Hyman Minsky and Charles Kindleberger have really addressed the phenomenon of financial mania and banking collapses (although Ben Bernanke, the chairman of the Federal Reserve, produced important work on how the banking crisis worsened the Great Depression in the US). Another defining feature of the present crisis has been the accumulation of a large volume of household debt, mostly linked to mortgages, which, as Irving Fisher argued a century ago, leads to “debt deflation”, with a downward spiral of depressed demand, unserviceable debt and weak confidence. Then Milton Friedman understood the importance of money supply in the interwar slump, which has played out in the current crisis in activist, unorthodox monetary policy. And largely ignored in our parochial policy squabbles has been the impact of the rapidly shifting centre of gravity of the world economy towards emerging markets and the impact of this change on capital flows and demand, shifting the terms of trade – mainly through oil – against commodity importers. None of these issues makes Keynes irrelevant, but they suggest the need for a more complex and eclectic framework for analysis.
Skidelsky reminds us of the principal elements of Keynes’s ideas which are relevant. Economic slump is not self-correcting: there may be a deficiency in aggregate demand resulting in spare capacity – the so-called output gap; there can be limits to the effectiveness of monetary policy in dealing with such a deficiency; and there is an important role to be played by active fiscal policy in stimulating demand.
The Keynesian framework was, however, developed in a different context from the present. It is essentially relevant to one country in slump acting in isolation (the assumption in the General Theory, 1936) or to a world that is collectively in slump. The world faced collective slump in the post-1929 crash and it did so again in 2009 when a Keynesian response was required (and was forthcoming) during a brief global recession. The eurozone may now approximate to these conditions and requires collective (German-led) reflation. But Britain is not part of that problem, though affected by it. In the UK, too, certain sectors are being severely affected by lack of demand, notably construction. All in all, the present evidence does indeed – with qualifications – point to some weakness of domestic demand and a low risk of expansionary policies spilling over into significant domestically generated inflation.
There is, however, no global problem of aggregate demand. World trade grew by almost 14 per cent in 2010, 5 per cent in 2011 and perhaps 3 per cent in 2012. The gross domestic product of emerging markets has on the whole grown fast. To be sure, it is not a simple matter to convert Blockbuster checkout staff into workers exporting Jaguars or their parts to China. But whatever the problem is, it is not a deficiency of global aggregate demand – we need only look at the behaviour of commodity markets since mid- 2010 to realise that.
Keynes, of course, fully understood the importance of international trade and in the 1929-31 period fought a bitter battle over the Gold Standard, which had led to British exports being overpriced and unable to grow on the international markets. That pattern does not exist today. The pound devalued by over 20 per cent in real, trade-weighted terms in 2008/2009 and has remained roughly in that position. As a small country (with 3 per cent of global GDP) with more price-competitive tradable products, the UK should benefit from rapidly growing exports, and that is beginning to happen in the big emerging markets.
Banks and the crisis
There is another respect in which the Keynesian model does not deal with the central event in the current crisis – the banking collapse. Skidelsky does not mention it, even in passing. This is a little like trying to explain the disappearance of the dinosaurs while assuming away the asteroid.
The banking system hardly rates a mention in the General Theory: not surprising, as the British banking system, unlike America’s, was stable in the 1930s. To seek precedents for the present position, we need to look at early-19th-century Britain or the recent experience in Japan. A seminal paper by Carmen Reinhart and Kenneth Rogoff suggests that financial crises are typically followed by slow and difficult recovery.
There are several specific factors which reinforce that conclusion for the UK. The UK had the biggest banking sector (assets relative to GDP) of any major country. The financial sector, and the associated bubble in property prices, was relied on to provide a substantial contribution to government revenue. Its demise led to a “structural” deficit, estimated (in 2010) at roughly 6 per cent of GDP. Unlike the Treasury in the interwar period, which insisted on balanced budgets, the coalition government has been Keynesian in approaching fiscal policy in a broadly counter-cyclical manner by letting stabilisers operate. The policy issue is how to address the structural deficit: a problem closer to that of a developing country whose leading commodity export has collapsed and which has to persuade creditors to finance growing sovereign debt until structural budget and wider economic reform has been completed in a credible time frame. Keynesian economics does not provide much insight into such problems.
Furthermore, the damage inflicted on the banking system has severely impaired credit flows, especially to small and medium-sized companies and to infrastructure project fin - ancing. The money transmission mechanism has been badly disrupted, which blunts not only monetary policy but also fiscal policy, by reducing the income multiplier and accelerator by which demand is translated into increased production and investment. Any reliable escape route from the crisis has to have a plausible mechanism for boosting credit to business, especially SMEs. That is why I am working in the government to launch a state-backed business bank and promote non-bank finance.
The supply side
This credit supply problem is sometimes seen as part of a wider “supply-side” criticism that pumping demand into a supply-constrained economy is – in an extreme case – pointless because it will spill over into inflation or imports. The caricature may be wrong but there is some reason for these concerns. Again, analogies with developing countries are relevant. Past attempts to use crude deficit financing to deal with chronic underemployment have been unsuccessful because of such structural problems.
Nonetheless I have no doubt that there is some scope for more demand to boost output, particularly if the stimulus is targeted on supply bottlenecks such as infrastructure and skills. And, like me, Skidelsky believes that state-led banking could simultaneously ease credit and other supply constraints while stimulating demand. He is right that these factors can interact. But, as the ministerial promoter of two such banks (the Green Investment Bank and the Business Bank), I am painfully conscious that progressing quickly from millions to billions is not straightforward. There are EU state aid clearance rules. Projects require careful planning and due diligence.
Numbers are relevant here. Michael Stewart’s 1968 book Keynes and After argues that Keynes was assuming income multipliers of two to three in the General Theory – which is why he saw fiscal policy as so powerful. The Office for Budget Responsibility estimates multipliers in the present context to be much lower: 0.4 for tax cuts and government current spending and 1.0 for capital projects. The International Monetary Fund uses figures of 0.9 to 1.7 (but these include international linkages). This suggests that if fiscal policy is to work in a Keynesian manner, it needs to be targeted carefully, concentrating on capital projects.
Active monetary policy
Skidelsky uses a Keynesian framework to criticise the coalition’s economic policies in two main respects: he argues that cuts in government spending (with increased VAT) since May 2010 – “austerity” – undermined growth and economic recovery; and that attempts to sustain demand through monetary rather than fiscal policy have been ineffectual, as Keynes would have predicted.
To deal with monetary policy first: it has indeed been the first line of defence in the crisis, not only in the UK but in the US (and the eurozone) and under the last government as well as this. So, naturally, monetary policy has been a necessary complement to deficit reduction. Interest rates were cut aggressively; short-term policy rates have been near zero for four years now: negative in real terms. In addition, QE or quantitative easing – gilt purchases by the central bank –has been used extensively and although the mechanism is a source of debate it is widely believed to have stimulated demand and activity through low long-term interest rates, higher asset prices and exchange-rate depreciation.
Keynes fully recognised the importance of utilising monetary policy to counter deflation. In particular, he emphasised low long-term interest rates to encourage investment. He would have understood the monetary policy adopted now. And interwar experience – as documented by Professor Nick Crafts in particular – was far more positive than recognised at the time. In a speech to the Guildhall last year, I drew on this parallel to support expansionary monetary policy. Keynes’s concern was that there were limits to monetary policy. In particular, interest rates could not go below zero. Today’s problem is more complex. Negative official real rates coexist with high lending rates charged by the banks, especially to SMEs. Indeed, the low level of risk-free rates, including our very low gilt yields, actually indicate how monetary conditions have been tight for the greater part of the economy.
Money growth has been low and nominal spending growth in the economy weaker in the past five years than in any other years of our history. Low gilt yields indicate how risk-free government paper becomes an attractive investment in these circumstances, as an alternative rather than a boost to privatesector investment.
The role of QE
There has been growing criticism of QE in western countries, partly on the grounds that it may have diminishing returns but mainly because of undesirable side effects: the impact on pension funds and the distributional consequences of boosting asset prices (benefiting the asset-wealthy). The argument is building that QE may have been useful in the accident and emergency ward but is less useful for long-term rehab. Long-term savers are right to be concerned – yet this merely reinforces how important it is to return the UK to growth and the higher long-term rates that usually follow growth. A premature rate rise would achieve the opposite.
There is currently a pause in QE in the UK and two related ideas are being developed to sustain loose monetary policy. The first is for the central bank to acquire a wider range of assets, from corporate loans to in - frastructure project bonds. By taking risk off the private-sector balance sheet, we encourage it to find new investments. This is surely sensible. However, Mervyn King, the present governor of the Bank of England, regards such interventions as being akin to fiscal policy, in effect replacing government borrowing. To that extent, the debate about fiscal v monetary policy ceases to be one of theory or principle but a more mundane question of statistical classification.
The second idea gaining currency worldwide is to recognise the legitimacy of aggressive monetary policy by changing the mandate of the central bank to incorporate growth in some form as well as inflation. This idea has gained more prominence as people have begun to realise how, before the crisis, Consumer Prices Index inflation hid serious asset (namely, housing) inflation and how, after the banking crisis and with conditions generally depressed, it was not always a useful or accurate regulator of the macroeconomy on its own. In 2011 in particular, the UK economy suffered several negative shocks, notably from fluctuations in oil prices and the European sovereign debt crises. Growth of the UK economy required aggressively easier policy, but because of the mandated focus on CPI, several members of the Bank of England’s Monetary Policy Committee were calling for rates to rise.
So, there are voices asking whether there is scope to be more flexible. On the other hand, inflation targeting helped produce a decade of relative stability for the UK economy and is well understood by the public, so the bar for any change must be high.
Whoever is in government, the UK is probably facing years of fiscal consolidation – so it is essential for the monetary levers to be working well. Keynes may have been right about how difficult monetary policy is at the zero bound, but the first priority must be for it to do no harm, and crucially for it not to snuff out any incipient recovery by tightening inappropriately.
Did austerity kill growth?
The other criticism is that fiscal tightening has more than offset loose monetary policy, killing recovery. This is an empirical question. The evidence is not straightforward. Some of the crucial concepts, such as the “output gap” or the “structural deficit”, are difficult to quantify with any precision.
Nonetheless, the data does not support the conclusion that deficit reduction has had dramatic effects on the economy. There has been only modest reduction in the budget deficit, partly because the government has been allowing counter-cyclical stabilisers to operate, and partly because we have taken the conscious decision not to introduce further cuts at a time when the weaker economy has damaged tax revenues.
The OBR has looked at the contributory factors explaining poor growth performance in the past two years. It suggests that the main factor weakening the economy has been low private consumption, caused by a squeeze in real wages, caused in turn by inflation in global commodity prices as well as higher import prices following devaluation (in 2011 sterling commodity prices rose 6 per cent for food and 15 per cent for oil). The slowdown in the eurozone has played a role latterly, hitting confidence.
What is also clear, however, is that the part of the fiscal consolidation achieved through reduced capital spending has had economic consequences. The OBR itself saw capital investment as having the highest multiplier of all government spending, even before the IMF sharply upgraded its own estimates. The present government has partially reversed the Labour cuts – the autumn statement of 2011 produced £5bn more investment in transport – but without doubt this is the least efficient form of fiscal tightening. It can inflict more damage on output than cuts in current spending or tax increases because the multipliers are much higher. We inherited from Labour a severe cyclical downturn in construction, caused by the collapse of private housebuilding and commercial property development. It has had the effect of reducing supply capability as well as demand (because infrastructure is neglected and the skills of workers in the construction industry have been allowed to degrade).
The coalition government acknowledged these problems in the 2012 Autumn Statement by boosting government investment (and simultaneously top-slicing current spending), yet the increase was modest (£5bn) and in the short run it has little effect on demand because it takes time to organise capital projects. With this increase, publicsector net investment is now higher as a proportion of GDP, under the coalition, than it was between 1997 and 2010. Nevertheless, one obvious question is why capital investment cannot now be greatly expanded. Pessimists say that the central government is incapable of mobilising capital investment quickly. But that is absurd: only five years ago the government was managing to build infrastructure, schools and hospitals at a level £20bn higher than last year. Businesses are forward-thinking and react to a future pipe - line of activity, regardless of how “shovelready” it may be: we have seen that in energy investment, where the major firms need certainty over decades.
The more controversial question is whether the government should not switch but should borrow more, at current very low interest rates, in order to finance more capital spending: building of schools and colleges; small road and rail projects; more prudential borrowing by councils for housebuilding. This last is crucial to reviving an area which led economic recovery in the 1930s but is now severely depressed. Such a programme would inject demand into the weakest sector of our economy – construction – and, at one remove, the manufacturing supply chain (cement, steel). It would target two significant bottlenecks to growth: infrastructure and housing.
Yet nobody knows how the markets might respond. While low interest rates are often an encouragement to invest more, they are also an indication of great uncertainty. But more investment is what the more traditional Keynesians are now arguing for (and essentially what Skidelsky is saying, stripped of the invective).
Such a strategy does not undermine the central objective of reducing the structural deficit, and may assist it by reviving growth. It may complicate the secondary objective of reducing government debt relative to GDP because it entails more state borrowing; but in a weak economy, more public investment increases the numerator and the denominator.
Because the government has wisely issued debt with a long maturity, we suffer less from the risks of a debt spiral, where refinancing maturing debt rapidly becomes impossible. Consequently, the effect on our fiscal situation of higher interest rates is in fact nowhere near as bad as having weak growth.
Why not? The orthodox view has been that higher borrowing (and therefore debt) in the short term will excite the markets, with unpredictable consequences for borrowing costs. Higher borrowing rates are a deadweight that the Treasury would quite sensibly want to avoid, particularly if they knock on to higher rates for heavily indebted private-sector borrowers. At a time when mortgage borrowers are enjoying record low rates, this would be quite a blow.
Balance of risks
Contrary to the rhetoric around economic policy, the real disagreements have had little to do with ideology or economic theory. The government has happily deployed Keynesian techniques where feasible – as in its counter-cyclical fiscal policy. It has been sufficiently pragmatic to allow the fiscal consolidation to drift from four years to seven. The question throughout has been how to maintain the confidence of creditors when the government is having to borrow at historically exceptional levels, without killing confidence in the economy in so doing through too harsh an approach.
When the government was formed it was in the context of febrile markets and worries about sovereign risk, at that stage in Greece, but with the potential for contagion. There was good reason to worry that the UK, as the country arguably most damaged by the banking crisis and with the largest fiscal deficit in the G20, could lose the confidence of creditors without a credible plan for deficit reduction including an early demonstration of commitment.
Almost three years later, the question is whether the balance of risks has changed. The IMF argued last May that the risk of losing market confidence as a result of a more relaxed approach to fiscal policy – particularly the financing of more capital investment by borrowing – may have diminished relative to the risk of public finances deteriorating as a consequence of continued lack of growth.
On the balance of risks, there is no “right” or “wrong” answer. There is no theoretically correct solution: rather, a matter of judgement – which incorporates a political assessment of which risk is the least palatable. There is a body of opinion arguing that the risks to the economy of sticking to existing plans are greater than the risks stemming from significantly increased and sustained public investment targeted at those areas of the economy where there are severe impediments to growth (housing; skills; infrastructure; innovation). But this is also too crude and binary a characterisation of the position; the government has carried out considerable policy reform in these areas, not least in my own department, the fruits of which take a while to mature. The balance of risks remains a matter of judgement.
Vince Cable is the Secretary of State for Business, Innovation and Skills
June 2010 The Chancellor, George Osborne, delivers an “emergency” Budget that includes a rise in VAT from 17.5 to 20 per cent and a two-year freeze on public-sector salaries over £21,000
October 2010 The spending review announces a 29 per cent reduction in capital spending and a cut of 19 per cent on average to all departments except Health and International Development. There is also an annual cap of £26,000 on benefits an out-of-work family can claim
January 2011 Osborne blames “bad weather” after GDP is forecast to
have shrunk by 0.5 per cent in the final quarter of 2010
November 2011 Austerity is extended two years until 2017 after the Office for Budget Responsibility downgrades its growth forecasts from 2.5 to 0.7 per cent
April 2012 A double-dip recession is declared after output shrinks by 0.2 per cent in the first quarter of the year
December 2012 Osborne announces abandonment of the debt-reduction target and extends austerity until 2018