A Stimulating Debate.
The upcoming budget is the most important in generations. Economies, like aircraft, can only be allowed to slow so much before they hit ‘stall speed’. Once this point is reached, and I think we are pretty close, then any downturn can become much worse, much quicker, than anticipated – like a plane falling from the air. The drop in economic activity becomes self-reinforcing as consumers cut back on spending, industry reels back production and cuts jobs, leading to even less consumer spending as unemployment rises. Add in the potential for this drop off in demand to cause prices to fall, thereby raising the real burden of existing debts, and one has the perfect recipe for economic catastrophe.
The role of government is to prevent this. Reagan famously said ‘The most terrifying words in the English language are: I’m from the government and I’m here to help’. I find ‘I’m afraid the government can’t actually help because I’m a tad concerned that government debt is too high’ a lot more concerning. I am not arguing that the government can abolish the business cycle, it can’t. That’s the nature of capitalism, it’s inherently unstable. But its excesses can be alleviated.
Like Hopi, I worry that the Chancellor is pulling back from a new stimulus programme. I hope this is just an exercise in expectations management, because we need a bigger stimulus.
We are currently dealing with two separate, but heavily entwined problems: a severe economic downturn and a dysfunctional banking system. These problems have different solutions. The aim of the budget is to deal with the slowdown.
Monetary policy is reaching the edge of its effectiveness. Rates can only be cut another point before they hit zero. I will discuss quantitative easing at some other point. Suffice to say, I hope it works, I fear it won’t. We need to aggressively use fiscal policy as an instrument of macro-economic management in a manner that was last in fashion twenty five years ago. Callaghan said in 1976:
‘We used to think you could spend your way out of recession by boosting government spending. I tell you, in all candour, that option no longer exists. And in so far as it did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by higher unemployment as the next step’
He was partially wrong. You can’t spend your way out of an inflationary recession, you have to spend your way out of a deflationary recession. And that is what we are facing, the first nominal contraction in UK GDP since 1949.
The chart below shows roughly where we are. The ‘lower’ down the chart a country is the more monetary policy has been eased, the further to the ‘right’ a country is the easier fiscal policy.
(Hat tip Alphaville)
As can be seen interest rates have been cut massively, but in terms of a fiscal stimulus Britain is lagging much of the world. Bringing forward some spending and cutting VAT by 2.5% are helpful in some ways, things would be worse now if those decisions had not been taken but they are not enough in and of themselves. The role of government now is to act as spender of last resort.
I imagine that many Tories will not react well to do this. I fully expect to be told something along the lines of ‘what do you mean Darling isn’t spending enough? He has already pledged to run up the highest national debt since WW2!’ Well, I’d refer such people to the Institute of Fiscal Studies’ green budget. Which as ever offers a fair and balanced assessment. I’d ask them to look at figure 3.4, which shows the level of estimated public debt between now and 2014 both with and without the currently planned ‘stimulus’. Only 21.1% of the planned increase in debt is related to the actions taken at the Pre Budget Report last year, the rest is simply the effects of a recession of the ‘automatic stabilisers’ (i.e. the tax take falls and benefits rise). We need more.
Christina Romer, the Chair of Obama’s Council of Economic Advisors, has recenrly published a well argued note on the lessons from the Great Depression. The whole thing is well worth a read, but I think there are three key takeaways.
(i) A small stimulus only has small effects.
(ii) Beware of cutting back the stimulus too quickly.
(iii) If all countries are cutting rates and launching stimulus programmes, then this is great help. As Dr Romer puts it:
The implications for today are obvious. The more that countries throughout the world can move toward monetary and fiscal expansion, the better off we all will be. In this regard, the aggressive fiscal action in China and the reduction in interest rates in Europe and the U.K. announced last week were welcome news. They are paving the way for a worldwide end to this worldwide recession.
So, in the spirit of this, I’d argue that Alistair Darling has to be bold. The economy did not growth in the second quarter of 2008, it started to fall in the third and had the largest fall in over twenty years in the final quarter. It is likely that the current quarter will be worse. Things do not seem to be stabilizing at this level. With unemployment rising, consumer spending will likely keep dropping.
It is hard to put a precise number on how big the stimulus should be, but I would have thought something in the region of 3% of GDP seems reasonable. That would put us in line with the average of other countries. We may need more and I would not be surprised if this had to be raised in this year’s PBR. But we will deal with that when it arises.
The balance of tax cuts and benefit rises to spending is one that can be debated a length. I tend to side with Paul Krugman on this issue. The crucial issue is the multiplier, this can be thought of as ‘bang for the buck’. I.e. how will each type of stimulus effect the wider economy.
How much do tax cuts and spending raise GDP? The widely cited estimates of Mark Zandi of Economy.com indicate a multiplier of around 1.5 for spending, with widely varying estimates for tax cuts. Payroll tax cuts, which make up about half the Obama proposal, are pretty good, with a multiplier of 1.29; business tax cuts, which make up the rest, are much less effective.
In other words, actual spending on ‘stuff’ is generally a more effective way at stimulating the economy then simply giving people money. The Bush tax rebate of last year pretty much failed despite the praise it picked up from the right here. This is not to say we shouldn’t have any tax cut/benefit increases, but they should not be the majority of the package. I’d argue to go one third tax cuts/benefit increases broadly aimed at those most likely to spend, i.e. those that save the least. So raise pensions, raise IB, raise JSA, raise tax credits.
In addition consider raising the personal allowance for all income tax payers. Even if this money is saved that is still, to an extent, helpful. If all of this money was saved or used to pay down personal debt then it would be a simple transfer of debt in the economy away from households and onto the public balance sheet. The public balance sheet will mean less credit risk and hence lower interest payments.
I’d also argue that tax cuts aimed at businesses have not generally succeeded in the past. The level of corporation tax does not make a difference if you are not making profits.
But two thirds of any package should take the form of direct government infrastructure spending, aimed at keeping people in work. Preventing unemployment rising should be the explicit aim of the budget. Only by slowing down the rate of job losses will we slow down the rate of economic decline. Someone more stable in their employment prospects is more likely to keep spending.
So let’s build some stuff. Schools and hospitals, more social housing, transport infrastructure – anything. I hear there is a prison shortage, right let’s build some more. I would like to see Alistair Darling ask every local authority in the country to come out with a lost of ‘shovel ready’ projects on which work can begin within weeks.
Over the next few years the UK is going to face some serious challenges. We have to overcome a serious over dependence on the financial and property sectors, we have to reduce debt in the household and corporate sectors, we have to reduce our reliance on imports and start exporting more. But these are not issues that can be addressed in one budget. The Tories had to deal with such a structural shift in the 1980s. They left in their wake destroyed local economies that still suffer the after effects. We must plan for how best to manage the coming transition. But this is a debate for later. The priority now must be jobs, jobs jobs.