Conservatives: Beware your flatterers

An IMF report tells us why Osborne can't talk up growth: there won't be any.

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As David Cameron brings the Convervative conference to a close, the botched and political cut to Child Benefit -- and its Thick of It Travelodge*-corridor-hashed denouement -- has, to the consternation of the rank and file in the Conservative party, made their first conference in power since 1996 a "cuts" conference, rather than a celebration of a return to office.

The overriding message of austerity has also increased the frustration within the party that the Chancellor's speeches consistently lack a "growth narrative". John Redwood said "We know the bad news - now let's hear the good news" and "I hope David Cameron will move us on from "cuts" and constant reminders of the deficit crisis inherited from Labour". David Davis, who spoke out against the rushed child benefit cuts yesterday, has urged his party to "rediscover the case for growth". In the press, Jeremy Warner at the Telegraph also bemoans the lack of growth talk.

It's not often that you'll find me defending George Osborne, least of all from critics in his own party. However, an international body much loved by the Conservatives and their sympathetic press has given me good reason to do so.

George Osborne can't honestly articulate growth narrative because, according to the chapter in IMF's World Economic Report entitled Will it Hurt? Macroeconomic effects of fiscal consolidation (pdf), well, there isn't one.

IMF: no takers this time

In brief, the IMF's answer to "Will it hurt" is: "yes, for several years". As a result we should not be surprised that, unlike with the last missive from the IMF, Osborne has decided not to rush out and praise this report. The sole dark phrase in the IMF's recent love letter that the "downside risks [of the government's austerity plan] are also sizeable" may come back to haunt him.

Incidentally, as reported by the Economist, the IMF report comprehensively trashes a recent Harvard paper that claims fiscal retrenchment leads to a short-term boost to economic growth. Naturally, Tory attack dog Matthew Hancock was fond of citing this Harvard study. The IMF report advises, having rubbished the means by which the Harvard economists reached that conclusion, "the idea that fiscal austerity triggers faster growth in the short term finds little support in the data." On the back of their report, the IMF has today reduced it's forecast for UK GDP growth in 2011. I wonder what Mr Hancock makes of the IMF now.

The IMF statistics show that, based on historical examples, we can expect after two years to see a contraction in GDP of 0.5 percent, an increase in unemployment of just over 0.25 percent and a fall in domestic demand of just over one percent in the event of a fiscal contraction of 1.5 percent of GDP. This analysis includes fiscal contractions from benign economic conditions, which the UK does not currently enjoy, so the picture is likely to be worse in our case.

No escape?

So how bad could fiscal contraction be for the UK? This depends partly on the relative size of the austerity package announced in the Comprehensive Spending Review, and it's knock-on effect on the private-public sector. It will also depend on whether other factors can mitigate the contraction predicted by the IMF.

The IMF's report does point out two historical factors that typically mitigate post-austerity decline, which a recent Roosevelt Institute paper entitled The Boom Not The Slump: The Right Time For Austerity (pdf) deems of primary importance in mitigating the ill-effects of austerity.

The first is growth in net exports, which typically occurs as the relative value of a currency falls as GDP declines, making export prices more attractive to foreign buyers. Hence the Chancellor's frequent prayer for an export-led recovery. The second is the reduction in the central bank interest rate as austerity bites.

Neither factor will come to the aid of the UK economy when the CSR takes effect.

UK interest rates are already at 0.5 per cent, and so the Bank of England has almost no-where to go in terms of monetary policy to soften the impact of austerity measures: the Bank of England pulled that lever to arrest the initial decline. The IMF's analysis shows that in such circumstances, a fiscal contraction of 1.5 per cent of GDP typically doubles a decline in GDP.

To compound the problem, the export escape route is also likely to remain closed, for reasons beyond our control. Many countries in Europe, in particular the 'PIGS' (Portugal, Ireland, Greece, Spain) have also introduced swingeing austerity programmes. This compounds the effects of austerity in the UK by reducing export demand into much of the EU, the UK's biggest export market. In this way, the downward trend of global demand may accelerate, as fewer and fewer people can -- or want to -- buy British.

Likewise, wider global demand is weak. Developing nations are "decoupling" from previous symbiotic trade relationships with western countries, which will make international trade along established lines more difficult.

Added to this, we are entering a period of austerity when domestic demand is already on the slide.

The UK also has to contend with the increasingly shrill voices from economics ministers from several nations that, with weak domestic demand, economic growth is only likely to come at the expense of their neighbours. Talk of currency wars abounds, which are looking increasingly necessary, but from which the UK is likely to suffer collateral damage.

Competitive currency devaluation has ramped up in a bid to boost exports (hence the gold rush). While the UK has been printing £200 billion, and may do so again (our so-called 'QE2'), dominant exporters like Japan and China have raced ahead with aggressive monetary measures; China now spends half its GDP buying US government debt to keep the Renminbi low against the dollar. We can't win this fight. As the IMF report says "because not all countries can have real depreciations and increase their net exports at the same time, simultaneous fiscal consolidation by many countries is likely to be particularly costly."

In short, there is no evidence to suggest that the UK will obtain any currency-related competitive advantage over exporting nations. Even though the European Central Bank allows the euro to appreciate against sterling -- which would usually give the UK an export advantage -- austerity across the continent is likely to prevent anyone wanting to buy our stuff anyway. The dismal outlook for global demand, the negative impact of austerity for the UK may be significantly worse than predicted by the IMF's most pessimistic historical analysis.

There are alternatives

There is one thing the IMF report claims that doesn't apply to the UK, namely "fiscal consolidation is likely to be beneficial over the long term. In particular, lower debt is likely to reduce real interest rates and the burden of interest payments, allowing for future cuts to distortionary taxes." This is, in a sentence, the Tory gamble: after all, is it really economics that dictates the deficit must be erased by 2015? What's more, market credibility is not currently at issue: the Treasury can already borrow at historically cheap rates - 2.45 percent over 10 years.

If the post-austerity economy does not recover --and the lessons from Japan is that its may well not -- the implicit promise of future tax cuts Osborne is making to his party will ring of "jam tomorrow". But that would be the last of his problems.

There's another, better narrative to tell (yes folks, its Keynesian) and, as Mehdi Hasan says elsewhere, it's got some luminary backers.

 

UPDATE: The IMF has today released the rest of its World Economic Outlook: it contains little cause for cheer.

*I'm informed the hotel chain in question was a Hyatt.