UK: Punch and Judy Show Ignores Fiscal Reality

For those looking for guidance on whether the government is doing the right thing by cutting the budget deficit they get, instead, a Punch and Judy show.

Larry Summers, former US treasury secretary, has become the darling of the “don’t cut” school with remarks he made last month at a George Soros-sponsored event at Bretton Woods, New Hampshire.

“I find the idea of expansionary fiscal contraction, in the context of the world in which we live, to be every bit as oxymoronic as it sounds,” he said. “And I think the consequences are likely to be severe for the countries involved.” Only if Britain’s economy booms over the next two years would he change his mind, he said.

At the other extreme are those who argue that while tax hikes will damage growth, spending cuts will not, merely making room for the private sector to grow. You get this from free-market think tanks such as the Adam Smith Institute.

Somewhere in the middle are the OECD and IMF, which back the government’s deficit-cutting programme while at the same time predicting only a modest recovery.

Let me adjudicate. Summers says he would be astonished if Britain boomed over the next two years and so would everybody else. He has set up a straw man. The government’s deficit programme has removed the threat to Britain’s AAA rating and probably kept interest rates low. You cannot, however, hike taxes and cut spending without some impact on growth, even if there was no realistic alternative.

As for the free marketeers, it is true that over time the private sector will expand into the space left by a smaller state. But in the short-term, in an economy when bank finance is scarce, growth will be slower than without cuts. As I say, Britain had little choice but to get the deficit down.

Surely, however, the GDP figures shift the argument in favour of the “don’t cut”, or at least the “don’t cut so fast” school?

As everybody will know, first quarter growth of 0.5% just offset the 0.5% snow-affected fall in the final three months of 2010. The result, according to the headlines, is an economy that for six months has been “stagnant” or “flatlining”.

Ed Balls, the shadow chancellor, timed this stagnation to October, when George Osborne announced his comprehensive spending review, even though that review’s plans did not kick in until April.

Balls, a former student of Summmers, is not completely barking. It is possible there was an “announcement effect” from Osborne’s spending review. After the election, the coalition’s use of bloodcurdling language on the cuts hit confidence. That lesson has been learned. David Cameron has taken to saying that of every £8 to be cut this year, £7 was in Labour’s plans.

David Blanchflower, former monetary policy committee (MPC) member, said the GDP figures were “Osborne’s fault; the economy slowed sharply because of his incompetence”, adding:. “There is no convincing evidence such policies [a fiscal tightening] have ever succeeded in pulling an economy out of a deep recession.”

I find myself a bit torn about the GDP figures. Cameron and Osborne deserve some heat for the way they seized on bad news when Labour was in power. I remember their glee when GDP failed to rise, as expected, in the third quarter of 2009.

On the other hand, it is clear the numbers were strange. Anybody who thinks the economy has been “on a plateau” since 2010’s third quarter, as Joe Grice, chief economist at the Office for National Statistics said, is to my mind some way out.

On any rational reading the economy enjoyed a decent bounce in the first quarter, close to 1% growth. Service sector output rose 0.9%, manufacturing by 1.1%. The lion’s share of the economy grew well.

What dragged it down to 0.5%? Despite much milder weather, construction output slumped by 4.7%, bigger than its 2.3% fall in the snow-affected fourth quarter, lopping 0.3% off GDP growth. That milder first three months of the year led to a 3.5% drop in utilities (gas and electricity) output, taking off another 0.1%, while North Sea shutdowns also hit growth.

The construction figures, based on a series that only began last year, were odd. The ONS has risked its reputation on estimates that look as dodgy as Donald Trump’s hairstyle. So concerned is the Construction Products Association (CPA) it has written to the chancellor saying something is “seriously awry” with the figures and that “the implications for policy making of this kind of inaccuracy are extremely significant”.

The inaccuracies do not all go one way – last summer the construction figures looked too strong – but on this occasion fundamentally changed the debate. We should take them with a huge pinch of salt.

So what does the evidence tell us on the great fiscal debate? Even the GDP figures show the economy grew 1.8% over the past year, 2% if you take non-oil GDP. That, you may say, is pretty paltry when we are just heading into the fiscal tightening.

The point is that we have had a significant fiscal tightening, equivalent to 1.5% of GDP in 2010-11 according to the Treasury. It includes the reversal of emergency crisis measures such as the Vat cut, together with the new 20% Vat rate and other hikes.

Growth of 1.8% in the early stages of a recovery and in the context of a 1.5% of GDP fiscal tightening is not bad. It is also in line with previous experience.

Contrary to Blanchflower’s assertion, the last three recoveries have all been associated with significant fiscal tightenings; after the 1976 IMF crisis, Sir Geoffrey Howe’s austerity budget of 1981 and the long upturn after the 1990-92 recession.

Punch and Judy aside, let us just accept that necessary fiscal medicine has the effect of slowing growth but rarely brings it to a halt or throws it into reverse. That has been true before and likely to be true again.

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.


This post originally appeared at David Smith’s EconomicsUK and is reproduced here with permission.