John Eatwell explains why George Osborne is continuing to get it wrong on growth
What is to be done to get Britain back onto a secure growth path? Should we follow the recommendation of the Chancellor, George Osborne that we stick with austerity, accepting his declaration that “Britain is on the right path”. Let’s call this Plan A. Or should we adopt Plan B, following the advice of Olivier Blanchard, chief economist of the IMF, who said last week, “if things look bad at the beginning of 2013 - which they do - then there should be a re-assessment of fiscal policy .... Slower fiscal consolidation in some form may well be appropriate.”
The Coalition government came to office during the midst of the global economic crisis – everyone is aware of that. But over the past two and a half years, has its policies made things better or worse?
The previous Chancellor, Alistair Darling had by Spring 2010 succeeded in turning things around, so that Mr Osborne inherited an economy growing at an annual rate in excess of 2%. Osborne then killed that recovery stone dead, and destroyed business confidence by preaching the coalition dogma of austerity and his foolish and demeaning comparisons with the plight of Greece. And parallel to this, he slashed public investment and with savage glee set about shrinking the state and impoverishing the poor.
But the deficit has not been cut, and this year it is up by over 7% on the equivalent period last year. So what should be done to turn the position around again, and to set the economy on a new growth path? Or to put the question more practically, why do firms invest?
Firms invest because they are reasonably confident in the future demand for their products. Without demand, it doesn’t matter how cheap money might be, as no-one will invest. That’s why monetary policy isn’t working. Interest rates can go no lower and the positive announcement effect of Quantitative Easing, evident in the first round, has now worn off.
But if there is the prospect of growing demand, firms need finance to invest, and access to the very best skills and technologies to secure markets in a competitive world. Demand is the key, and the government must take the lead.
That is why Ed Balls has proposed a temporary cut to VAT to boost family incomes, together with the further boost from bringing forward infrastructure investment, including building thousands of affordable homes. Enhanced demand prospects would then be underpinned by a British Investment Bank to boost lending to small businesses, complementing fundamental regulatory reform of the banks. And to sustain confidence, a compulsory jobs guarantee for the long-term unemployed; and, further up the employment chain, investment in skills and transformational science and technology.
“But” the Coalition cries “this is a policy for borrowing more when debt is the problem”. At the moment however, it is spending cuts that are resulting in a growing deficit. How could this be happening?
The relationship between changes in spending and the overall performance of the economy is measured by what in economics jargon is called the multiplier. If a cut in government spending of say £2bn, results – for whatever reason – in a fall in total output of £1bn then the multiplier is a half. That is what the IMF believed the multiplier to be back in 2009.
The share of taxes in output is about 40%. So if government spending is cut by £2bn and output falls by £1bn, then tax revenues fall by about £400 million and the deficit is cut by £1.6bn. But now the IMF, acknowledging a previous error, is estimating a multiplier of a little less than 2. A £2bn cut in Government spending will drive the economy down by £4bn and, when cuts in revenue are taken into account the deficit will fall by only £400 million. Throw in a depressed EU, and you arrive at our miserable destination – ever bigger cuts and a growing deficit.
But what goes down can also go up. If government spending is increased and the multiplier large, then the expansion of the economy will result in greater tax revenues that minimise the need for borrowing. And there’s more.
Government cuts, particularly those in investment, don’t only reduce output now by cutting demand, they also cut future output by reducing the productive capacity of the economy. This long-term loss of capacity brings with it reductions tax revenue. Conversely, increased capacity increases long-tern revenues. The measures proposed by Ed Balls, will be substantially self-financing in the medium term, and will stimulate tax revenues in excess of spending in the longer term.
But there’s another issue that must be confronted. Whenever the Coalition’s destructive policies are challenged, they argue that unless the vice on Britain is tightened then the financial markets will lose confidence, interest rates rise, any prospect of recovery destroyed. There are 3 things wrong with this argument.
First, as no-one is suggesting a spending spree. Plan B is a cautious expansion to begin building the foundations for growth.
Second, it is austerity that is undermining market confidence. All three of the main credit-rating agencies have put Britain on ‘negative outlook’, citing concerns over the weak recovery and public finances.
Third, consider the experience of the United States that lost its AAA rating last year. Would you rather have our AAA rating and zero growth, or the lower US rating and 3% growth in the last quarter?
Lord John Eatwell is Shadow Treasury Minster in the House of Lords
Published 29th January 2013