I’m a fan of Paul Krugman – he writes well and frequently, I share many of his views and he has the added enhancement of having won a Nobel Prize. Because of this many left leaning commentators in the UK (myself included) frequently quote him to add credibility to a view they are expressing. So I don’t disagree with him lightly. But I worry that one argument he has been pushing lately may be off-target in a US context and actually dangerous in a UK one. I’m talking about the idea of the ‘confidence fairy’.
Krugman argues that much of the US (and indeed European) right are basing their economic agenda on a believe in an imaginary ‘confidence fairy’. They (the right) argue that any increase in government spending would cause more uncertainty, damaging the confidence of business (and possibly consumers) further and leading to a fall in investment (and possibly consumption) that would more than offset the expansionary effects of further government spending.
The US has the advantage of being the world’s sole issuer of the reserve currency of choice, so in a US context Krugman is on firmer ground. But this isn’t an advantage which the UK has.
I think it’s right to worry about the ‘confidence fairy’, indeed I think not to worry about the confidence fairy would be actually dangerous.
As I’ve been trying to explain for the past few months, the fiscal policy debate is actually fairly nuanced. The real debate is about a balance of risks – the risk of extreme austerity hammering the recovery versus the risk of a bond market taking fright at a slower pace of fiscal adjustment and driving up interest rates. The Treasury places more emphasis on the later risk, whilst I worry more about the former.
But that isn’t to say that the later risk doesn’t exist.
I supported the then government’s fiscal stimulus in late 2008 and would have liked to have seen a second stimulus at the 2009 budget. Demand was falling off a cliff in late 2008 and the VAT cut (not my ideal type of stimulus it must be said) together with the bringing forward of investment stopped the economy falling off a cliff. A second stimulus (more focussed on investment) possibly would have meant that the recession ended earlier than it did and helped to kick start a more robust recovery. We’ll never really know.
But I think there is a difference between arguing the case for a stimulus in late 2008/09, at a time when most world governments were doing the same, and arguing for one now (as some on the left are doing|).
Britain is a very open economy, we have a high propensity to import – I worry that a stimulus in Britain alone would mainly leak abroad with less macroeconomic impact that it’s proponents claim. In effect government debt would be increased without a large kicker to growth. And much as many on the left don’t want to face this – there would be a market reaction. Osborne, Cameron, Clegg and co are wrong to argue that Britain was ‘on the brink of bankruptcy’ last May. There is simply no evidence for that in the market prices of UK government debt at that time. But this was, at least partially, because of the existence of the strong framework for deficit reduction set out by Darling.
There is room for a more growth friendly fiscal consolidation – using a higher banks’ levy and/or bonus tax to fund specific earmarked, high impact programmes such as more social home building for example. Equally the pace, if not the end point, of deficit reduction can be changed. As I have argued before I am a fan of the Dolphin/Lent proposed ’deficit reduction averaging’ approach – whereby the pace of reduction would be adjusted to reflect the strength of the underlying economy. I think this is actually a more credible and realistic course than either the Darling or Osborne plans.
We have seen since May last year the importance of confidence. Osborne’s over-tough talk and the general air of gloom he created, led to a collapse in consumer and business optimism. The result of which has been six months of zero growth and stagnation before his fiscal adjustment has even started to really bite. As I have argued, Osborne has placed too much stress on appeasing bond markets and not enough on supporting the real economy. But that doesn’t mean there should be no stress on keeping the markets on side.
What I am trying to say is that the traditional macroeconomic policy levers are failing. A spending led stimulus programme risks higher debt for no real growth impact, tax cuts (Osborne’s preferred ‘growth package’) seems a exercise in wishful thinking with little evidence that it would help, interest rates cannot be cut further and more monetary stimulus (QE) would probably simply result in higher asset prices.
George Osborne has got it wrong. His fiscal contraction is too deep and damages the economy, his corporation tax cuts and emphasis on further labour market flexibility are unlikely achieve higher growth. But that doesn’t mean proposing the opposite is the right course either. Talking about a ‘confidence fairy’ is unlikely to help.
In an ideal world we won’t be starting from here. But here is where we are.
Labour needs new and original policies. Policies which aim to make the economy less dependent on increasing debt (either government or private), policies which help wages to grow and allow for solid, domestic, private sector growth.