Refreshed by his summer holiday, David Cameron vowed to “get Britain moving again”. A slew of kick-starting initiatives has followed, most of them the brainchild of his government’s one-man think tank, Vince Cable.
The figures are dire. After a tepid recovery from the collapse of 2008, the British economy has started shrinking again. Most forecasters expect a negative growth outcome for this year. The same is true of the eurozone.
What has gone wrong? In the spring of 2009 all the major economies, including Britain’s, were given a large fiscal and monetary stimulus. Then in June 2010 George Osborne, the Chancellor, entered the Treasury with a large dose of austerity. It is true that a correlation isn’t a cause, but could it be that the earlier recovery had something to do with the stimulus, and the subsequent decline with the austerity? At any rate these are striking coincidences. By contrast, the United States, which escaped Dr Osborne’s cure, has continued to grow, albeit feebly.
It would be foolish to say that Osborne’s budgets have caused the slump. The charge is that his budgets, far from offsetting, have aggravated the collapse of demand that followed the banking crash of 2008. Austerity has not caused the economy to shrink, but has kept it from recovering. Meanwhile, it is wonderful to see how we clutch at straws. For example, the fall in retail sales in July compared to July last year has been attributed to people preferring to watch the London Olympics rather than go shopping. Could it just be that they had less disposable income than last year? Then there was the Queen’s Diamond Jubilee. This was blamed for the poor second-quarter showing. In a healthy economy, however, parties don’t typically lead to such severe hangovers.
The government clutches at straws of its own. The Prime Minister and the Chancellor assert ad nauseam that Britain’s recovery was derailed by the eurozone crisis. Unfortunately, the dates are wrong. The British recovery petered out before the eurozone crisis started. It actually petered out as soon as the coalition got started.
Yet surely it was only the government’s austerity policy that prevented Britain from going the way of those big European spenders? Here is David Cameron in the Mail on Sunday (2 September): “When I became Prime Minister our market interest rates were the same as Spain’s. Ours are now less than 2 per cent; theirs more than 6 per cent. Why? Because we threw a lifeline around the British economy and pulled it back from the cliff edge.”
But wait a minute: Spain had a budget surplus and a low public debt in the run-up to the crisis. Since then Spain has followed much the same austerity policy as the UK. So how can the difference in the yields of the two governments’ debt be due to the differences in their fiscal policies? There must be “other factors”.
Now we come to some good news. “Yes, growth has been disappointing,” Cameron admits, “but in the past two years we’ve also seen more than 900,000 jobs created in the private sector.” This may be true, but the number we are most interested in is net, not gross, employment. In fact, unemployment has risen in the two years of coalition rule, from 2.48 million to 2.59 million. More importantly, almost half of the new jobs created under Cameron are part-time. Agreed, better some employment than no employment, but hardly the resounding success story it’s made out to be.
There is still a puzzle. The government takes comfort from unemployment having fallen recently, even though the economy has continued to shrink. The headline figure of 2.59 million unemployed is actually slightly lower than it was six months ago. The reason for this is almost certainly that employers are hanging on to skilled labour for fear of losing it altogether, with the consequence that there has been a fall in recorded productivity. As the Guardian put it, “. . . it now requires many more of us to labour away to churn out the reduced volume of stuff” (15 August).
The figures have to be spun to disguise Osborne’s failure. The present situation is the predictable and, by some of us, predicted outcome of policies of fiscal austerity pursued in the face of the worst economic crisis since the Second World War. That prediction rests on a straightforward Keynesian analysis.
Keynes explained how conditions of semi-slump can get established. Let’s start from a situation of full employment and high private indebtedness. This latter does not matter so long as the economy is growing. But suddenly the next step up the ladder is no longer there and a lot of people find themselves “living beyond their means”.
The only thing they can do is to reduce their spending: that is, save more. But what happens if all households and firms try to increase their saving at the same time? Well, then the total spending in the economy will fall because everyone’s spending is someone else’s income. There will be less demand for goods and services and therefore for labour. Our collective attempts to get back into balance – get rid of our credit-card debt, as the Prime Minister likes to put it – will have made us all poorer, and, indeed, reduced the amount of saving as well, given that we will have smaller incomes out of which to save. So the economy will go on shrinking until the excess saving is eliminated by the growing poverty of the community.
The essence of this insight is captured in the phrase the “fallacy of composition”. The fallacy consists in the claim that what is true of the parts must also be true for the whole. The best-known application of this fallacy is the “paradox of thrift”. New acts of saving, though virtuous for the individual, make us all poorer when the demand for new capital has declined.
That is why Keynes rejected more saving as the remedy for a slump. The correct response was more spending. And if private agents lack the resources or incentive to increase their spending then the government needs to increase its own spending. This, in a nutshell, is the theory of the stimulus.
We all worry about debt, yet the important figure is not what I owe but the ratio of what I owe to my income. I can try to reduce this ratio either by saving my income to pay off the debt or trying to make my income larger. Reducing the national debt is more complicated. It can only be done by taxing more or spending less, and this drives down people’s incomes and creates unemployment. Furthermore, by reducing incomes, it also reduces people’s ability to pay taxes, and this can be self-defeating. Something like this has happened in Europe, where falling incomes due to austerity have driven debt ratios up, not down (see chart).
Offloading private debt on to the public sector may help stabilise the economy, but does not, of itself, produce recovery; and may, in addition, frighten the bond markets into raising their default premium on government paper.
So we seem to be between a rock and a hard place. International organisations such as the OECD and the IMF are more or less agreed that the present austerity policies are preventing growth; but they offer no alternatives. Here is Ángel Gurría of the OECD: “Deleveraging necessarily means higher savings, and that means lower consumption and therefore lower demand. And the lower demand means even lower employment and even lower incomes for households and lower revenues from governments. And both of these mean slower deleveraging. It is a vicious circle.”
And here is the latest IMF study: “The recovery has stalled and unemployment is still too high . . . Additional macroeconomic easing is needed to close the output gap faster. Scaling back fiscal tightening plans should be the main policy lever if growth does not build momentum by early 2013 even after further monetary stimulus and strong credit easing measures.”
To a Keynesian, these belated insights are hardly news. Gurría, for instance, is merely repeating Keynes’s argument that to withdraw demand from an already demand-deficient economy will lead not to recovery, but to a shrinking economy, a growing debt (private and public) and the need for more austerity.
Today there is a silent U-turn going on in the UK as well as in eurozone countries, hence Cameron’s call to “cut through the dither”. But there is still great disagreement about what the recovery policy should be.
The debate is broadly between the supply-siders and the demand-siders. The supply-siders argue that there is too little money in the economy, the demand-siders that there is too little spending power. It might seem that the two come to the same thing, but as Keynes pointed out, the holder of money has a choice: whether to “hoard” it or spend it. Those who argue that any increase in the money supply is bound to be spent on buying goods and services ignore the existence of “liquidity preference” – the desire to hold on to cash because of uncertainty about the future.
The favourite tool of supply-side expansionism is quantitative easing (QE), or “printing money”. Ben Bernanke of the Federal Reserve and Mervyn King of the Bank of England, together the most powerful central bank governors today, believe that the reason the Great Depression of the 1930s was so deep and lasted so long was that the monetary authorities allowed the money supply to collapse. They are determined not to make the same mistake this time. The technique of printing money is for the central bank to buy government (and possibly corporate) securities from non-financial companies and give them cash in return. The recipients deposit this additional cash in their bank accounts. They then spend it buying assets. Alternatively, the banks’ increased cash reserves enable them to reduce the rates they charge for loans. Either way, there is a stimulus to spending.
Despite attempts by the Bank of England to devise “more economically relevant” measures of money, the evidence is that only a small fraction of the “new money” has got out into the economy, enough to stop a slide all the way down into another Great Depression, but not enough to produce a recovery. The main benefit of QE has been to keep down the cost of government borrowing: one of the inestimable advantages of having your own central bank able to print money. This gives the government more room for fiscal manoeuvre.
So, contrary to Cameron’s claim, it is not fiscal austerity that has kept the cost of government borrowing low, but QE – plus the lack of business confidence in alternative investment prospects.
The government has dangled a succession of carrots before the banks to induce them to “lend more” of the extra money they are getting. In March, there was a National Loan Guarantee Scheme. This was replaced less than six months later by the Funding for Lending Scheme. However, attempts to increase the volume of lending by lowering banks’ funding costs have largely failed. Since July, when the new scheme was launched, bank funding costs have fallen by 0.5 per cent, but the rate for new mortgages has fallen by only 0.1 per cent; that is to say, the spread between the two has in fact widened, to the great advantage of banks’ balance sheets, but not borrowers. Now the government has promised a £40bn guarantee for private infrastructure investment. These schemes all help, yet the basic problem is not too little credit, but too little demand for credit. Would people borrow more, even at lower interest rates, when the economy is shrinking? As economists used to say, “You can’t push on a string.”
The alternative expansionary tool is an increase in the government deficit. Instead of the Bank of England buying bonds, the government sells bonds – that is, incurs debt – to finance its spending. There would be no point in doing this if the private sector was already investing its money productively. If, in this situation, the government started selling more of its debt, it would merely “crowd out” existing private investment. Yet this is not the case when there is a deficiency of aggregate spending. Government borrowing then absorbs “idle” savings and puts them to use.
There are many ways it can do this. The least promising is the policy of tax cuts for the rich advocated by the political right. The reason is that the rich save more of their money than the poor, so the stimulating effect may be quite small; and the non-saved part of the tax windfall is quite likely to go into the kind of financial and real-estate speculation that precipitated the last crash. Tax reductions for the poor, though, in the form of temporary relief from National Insurance contributions, would be helpful.
In the present situation there are two quick ways for the government to boost total spending. It could supply all households with time-limited spending vouchers – a Christmas present of, say, £100 for each family in the land. Some of the extra spending power would be used to buy imported goods or repay debt, but there would still be some net increase in domestic spending.
On the investment side, the easiest thing that the government could do would be to reinstate capital spending programmes cancelled in the drive for deficit reduction, with social housing and school-building given priority. Easing planning regulations (a favourite supply-side measure) to stimulate construction will help, but the private sector will not construct buildings if there is no effective demand for them.
The government should also set up a national investment bank with its own portfolio of investment projects focused on infrastructure and cutting-edge technology. A firm, long-term commitment by the investment bank would not only give the country new roads and energy sources but spread jobs to small and medium-sized suppliers.
The crucial difference between the National Investment Bank and the government’s plan to guarantee £40bn of private infrastructure projects is that the investment bank would be an active investor with its own funds, whereas the government’s plan leaves the initiative to the private sector. Even Vince Cable’s so-called small business bank is not expected to do more than “shake up the market in business finance”. This is based on the fallacious doctrine that the private sector will always be better at “picking winners” than any public authority, however shielded an authority may be from political interference. This largely reflects the failed experiments of the 1960s, such as British Leyland. The experience of many European and Asian countries gives the lie to the notion that state-led investment is bound to fail. And the recent catastrophic performance of the financial services industry should guard us from the belief that the private sector always knows best.
The important requirement, as our success in the Olympics showed, is the identification of potential winners and sticking with them long enough to show results. The bane of British “industrial policy” has been not the inability of public authorities to pick winners, but the chopping and changing of policy in response to temporary financial exigencies. The cancellation of public capital projects after 2008 is a good example of this unsteadiness of aim.
This is where the economic debate rests. It is high time to move it from academic discussion to the political arena. This will be necessary in any case if, as I believe, the prospect under present policy is for semi-permanent continuation of conditions of semi-slump.
Robert Skidelsky’s most recent book – written with Edward Skidelsky – is “How Much Is Enough? The Love of Money and the Case for the Good Life” (Allen Lane, £20)