Co-authored with Prof Marcus Miller
The fragility of the British economy in face of the Great Recession demands a rethinking not just of macroeconomic policy, but of the balance between consumption and investment, between finance and industry. In response to this challenge, George Osborne, the shadow chancellor, set out a “new economic model” in the annual Mais lecture last week. But there is little evidence of new thinking. There is no reference, for example, to what one might learn from the experience of Japan, which faced a similar “balance sheet recession” in the 1990s. Mr Osborne harks back to the old view that government is the problem not the solution – a philosophy that led to widespread financial deregulation and the current crisis.
Leaving aside the party-political stock-in-trade, the intellectual issue raised by the lecture concerns the relationship between government finance and the economy, and how this should respond to “the slings and arrows of outrageous fortune”. Mr Osborne quotes from a Bank of International Settlements report that “persistently high levels of public debt will drive down capital accumulation, productivity growth and long-term growth potential”. This is true, provided the economy is running at or near full capacity. In such a situation, a high and persistent level of public debt would “crowd out” more profitable private investment. But this is not our situation.
Our public debt – unlike, perhaps, that of Greece – is not “persistently high”. It has gone up from a low of 36 per cent to 62 per cent in 2009 to cope with an unprecedented emergency. Moreover, when national output is 6 per cent – possibly more – below potential, as measured by prior trend, an increase in the public debt does not come at the expense of capital accumulation. It replaces the investment that is not taking place because the economy has shrunk. The government is spending so much because the private sector is investing so little: figures show that private investment has declined by a quarter since 2008.
Mr Osborne asks: why is private demand so weak? His answer is that private demand depends on “expectations and confidence”, and that immediate fiscal consolidation will be good for confidence. But an IMF paper last month warned that premature cuts in public spending could lead to a sterling crisis. The truth is that we do not know how the markets will assess the balance of risk between cutting off the life-support system and the government defaulting on its debt.
In any case, Mr Osborne is ignoring the pressure to rebuild private sector balance sheets, which has pushed the household savings ratio up from about 1 per cent at the start of 2008 to about 9 per cent in the third quarter of 2009. Experience of Japan’s recession of the 1990s will confirm that if the private sector is de-leveraging – reducing spending to reduce its debts – then public sector de-leveraging – cutting its deficit – will deepen, not lighten, recession. This is what Keynes dubbed the “paradox of thrift”.
Mr Osborne recommends an independent Office for Budget Responsibility to oversee the public finances. This has its attractions: governments can too easily become addicted to deficit finance. But it is no use having Three Wise Men monitoring the Treasury’s adherence to its fiscal rules until one knows what the fiscal rules will be. In the present circumstances, the risk is that these rules might be designed to reincarnate and reinforce the “Treasury view” of balanced budgets as it operated at the time of the Great Depression.
The shadow chancellor sets out the argument for the Bank of England to re-absorb the responsibilities of the Financial Services Authority. This proposal deserves to be considered on its merits. But the focus on “institutional design” of the regulatory framework risks masking the flaws in regulatory philosophy that stemmed from the belief that the banks could safely be left to regulate their own risks.
Now is not the time to be scoring party-political points on the conduct of economic policy. It is a time for a radical reappraisal of the regulation of finance, so that the creativity of the industry can be harnessed to serve the needs of society, and not to generate transfers to those who can gamble with the nation’s resources. It is a time to design an “exit strategy” that allows the public sector – and the Bank – safely to remove the life support that was extended to the private capital markets in their hour of need.
We cannot return to the status quo ante. Get the reforms right and the private sector can get back on its feet without the crutch of public sector support and wholesale guarantees. Get them wrong and the present recession, for which Mr Osborne so castigates the government, could look like a success story.
Lord Skidelsky is emeritus professor of political economy and Marcus Miller professor of economics at the University of Warwick