The new chancellor will find himself in the worst starting position of anyone new in that job since the Second World War. According to the Treasury, we are just starting to limp out of the “most severe and synchronised downturn since the Great Depression in the 1930s”. Recovery is not secure. With the Greek crisis as the trigger, the world monetary system is starting to disintegrate. The historically minded will recall that the international financial crisis of 1931, two years after the start of the Depression, aborted an incipient recovery and forced Britain off the gold standard. A double-dip recession is a distinct possibility today.
Once a new government is in place, the chancellor will have to face the situation as it is, not as his party claimed it would have been had it been in power. The government’s finances are dire. The £163.4bn that the Labour government borrowed in the fiscal year 2009-2010, representing 11.6 per cent of GDP, is the biggest deficit in the postwar period. Public-sector net debt at the end of March was at £890bn, or 62 per cent of GDP – an increase of almost 10 percentage points over last year.
The worsening of the public finances is mainly the result of the deterioration in the economy. This has two aspects. The British economy is 5.4 per cent smaller than it was two years ago. But in addition, the fiscal forecasts at that time assumed that the economy would continue to grow to trend, reckoned to be 2.5 per cent a year – a growth that failed to occur. As a result, the British economy is 8.2 per cent smaller than it would have been had it continued to grow at that trend over the past two years. This, and not the actual shrinkage of the economy, measures the true deterioration in economic performance and the resulting deterioration in the public finances. Perhaps the forecasts were over-optimistic. But hindsight is the easiest form of virtue.
Such poor private-sector performance has inevitably had severe effects on the public finances. Tax revenues dwindle and social expenditure goes up. Of the total deficit of 11.6 per cent of GDP, 70 per cent is “structural”, representing a continuation of pre-recession spending. The £14.4bn tab for the fiscal stimulus in 2009-2010, plus the “automatic stabilisers” representing increased spending on the unemployed, amount to almost 5 per cent. This spending will shrink automatically as the economy recovers: the government saves £1bn a year until 2012 for every 200,000 people who leave claimant count unemployment. The most recent projections for this year’s deficit are already £13bn, lower than projections for the same period made 18 months ago.
However, even if the economy now resumes “growing to trend” – the 2010 Budget projects steady GDP growth in the next few years reaching between 3.25 per cent and 3.75 per cent in 2012, while inflation is expected to converge on the target rate of 2 per cent – there will remain
a “structural” deficit of between 7 per cent and 8 per cent of GDP, which will have to be filled by increases in taxes and cuts in expenditure. The Labour government promised to launch a programme next April aimed at cutting the deficit to £74bn or 4 per cent of GDP by fiscal year 2014-2015. The Tories promised to start cutting sooner and more, but how much sooner and how much more would depend on George Osborne’s promised emergency Budget.
If the recovery falters, even this drastic fiscal consolidation plan will seem inadequate. Although the stock market has recovered, the “real” economy is still struggling. In the first quarter of this year, GDP increased by only 0.2 per cent (half the figure in the last quarter of 2009), hardly the catch-up recovery some were hoping for. In February, unemployment figures rose by 43,000 to 2.5 million in total – or 8 per cent of the workforce. The US has started to grow more strongly, but Europe is flat. And, as already remarked, there is a not negligible risk of a double-dip recession.
Stimulating facts
In the pre-election period, there was a “war of economists”, in which I myself took part.
To the outsider, the engagement might have seemed to be on too narrow a front to be interesting. It was about how soon fiscal consolidation should start. However, behind this technical issue lay two contrasting theories, or models, of the economy. The first, which we may call “classical”, is highly sceptical about fiscal stimulus under any conditions. The argument is that when the government issues bonds or debt to pay for its spending, this is bound to be at the expense of private lending and borrowing. The stimulatory effect of a government deficit is therefore bound to be zero, or very small.
The second, or Keynesian, view is that this is not true when there is a lot of slack in the economy. The reason for the slack is that the private sector is not spending enough to employ all those seeking work – whether because investment prospects are too uncertain, or because it is paying off debt. In these circumstances government spending is not at the expense of private spending: it compensates for its absence. If the government were to economise on its own spending at the same time as the private sector was spending less, the result would be a slide into even greater recession. Keynes called this the “paradox of thrift”.
Those in the first camp do not deny the need for some stimulus when the economy is depressed, but they think this should not be at the expense of existing private spending. The only type of stimulus that meets this requirement is printing extra money. “Monetarists” put their faith in so-called quantitative easing (QE); Keynesians are happy with printing money, but deny that it is enough. The extra money has to be spent, and only the government can ensure that it is. (There is another way: the government can give all households time-limited spending vouchers – that is, special pounds, perhaps printed red, valid only for three months, and to be spent on buying British goods – and could issue successive tranches of these until the economy revives. This move would bypass the frozen banking system, but no political party has advocated it, and we can be sure that the incoming chancellor will put the horrendous thought to one side.)
The monetarists believe that the level of aggregate income is directly proportional to the amount of money in the economy. If the money supply goes up by 10 per cent, money income will go up by the same amount, and aggregate spending by the same amount. As the British monetarist Tim Congdon explains (using a more carefully defined notion of money): “large-scale creation of new bank deposits by the state can stop any recession”.
Printing money has an additional advantage. As the Chicago economist Robert Lucas remarked, monetary expansion “entails no new government enterprises . . . and no government role in the allocation of capital . . . These seem to me important virtues.” Except for one thing: it doesn’t do the job.
Keynesians argue that the demand for real cash balances (the amount of “ready command” or liquidity that people want) varies with the state of confidence. In the old days people would start hoarding gold when confidence fell. Now they add to their cash reserves or buy liquid securities. Building up cash or liquidity buffers, however, means that the new QE money is not spent, and therefore does not contribute to increasing output. While the Keynesians accept that an increase in the money supply is a necessary condition for an increase in national income, they deny that it is a sufficient condition. With increased preference for liquidity, the injection of cash into the banking system by the Bank of England may not lower the rate of interest sufficiently to restore a full-employment level of aggregate spending. As Keynes put it, if money is the drink that stimulates the system to activity, “there may be several slips between the cup and the lip”.
The numbers bear this out. From early 2009, the Bank of England started printing money with which to buy back government debt (as well as some high-grade corporate bonds) from the public. Over the year, roughly £200bn – or 15 per cent of GDP – worth of gilts and bonds was exchanged for cash. The monetarists expected a cash injection of that size would allow Britain to leave the recession with a bang.
Yet, as the 0.2 per cent GDP growth in the first quarter of this year is telling us, there was very little bang for quite a lot of buck. So what happened? Already at the first evaluation of the QE policy in August, six months into the programme, the Treasury and the Bank had noticed that something was not working. By then £144bn had been injected, yet UK bank lending had not picked up. Money from bond sales remained stuck in the banking system. The commercial banks held on to the cash, either in the form of reserves at the Bank of England or by buying new gilts or corporate bonds for the cash. Overall, in the 11 months between the launch of quantitative easing and its suspension, broad money supply (which includes bank deposits) actually fell by almost 10 per cent. And if we consider what John Slater calls “effective money” – a measure that, by including credit in the shadow banking system, is broader still – this fall is likely to have been even steeper.
The injection of money may have caused a stock-market boom in the financial economy, but on the real economy – the target of the policy – it had little effect. In short, damaged expectations may cause the credit crunch to outlast the circumstances that gave rise to it.
In such circumstances government spending needs to be the main agent of recovery – and that means fiscal policy, however it is financed.
We learn from experience nonetheless. If flooding the banking system with money doesn’t do the trick, there is a big problem with fiscal policy as well. The nature of this first emerged in an enthralling exchange between Keynes and the Treasury official Richard Hopkins before the Macmillan committee on finance and industry in 1930. Keynes was arguing for a big expansion of the public works programme; Hopkins countered that the effects of any government programme would depend on its effects on business confidence.
Fear of Labour
Hopkins did not disagree that government work programmes could, in principle, cure unemployment, but went on, “if you had to get [the loan] taken up at a very high rate of interest and accompanied by an adverse public sentiment you would very quickly lose what you gained by that from the number of people who would think it better to invest the next lot of money they had in America”. In other words, “psychological crowding-out” would cause the government to have to pay more for its debt. Extra government spending would cure unemployment only if it did not spook the markets.
Keynes himself was fully alert to the importance of confidence. He acknowledged that “economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average businessman. If the fear of a Labour government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent; it is the mere consequence of upsetting the delicate balance of spontaneous optimism.” He would even accept a “conservative Budget . . . if this would be helpful as a transitional measure”.
Keynes wrote his General Theory of Employment, Interest and Money (1936) not just to change the minds of economists, but to persuade the business world that government intervention to rescue failing economies would be in its interest. But he tended to the view that the root of “lack of confidence” was lack of demand for goods and services and that confidence would automatically revive with the revival of spending, however engineered. In all this, he underestimated the visceral business hatred of big government. By 1939, however, even he had come to doubt whether a “democracy would ever have the courage to make the grand experiment necessary to prove my case outside the conditions of war”.
In fact, that grand experiment has never been made outside war or other than under a totalitarian state, in the sense of Keynesian policy being used to rescue an economy from a slump. Franklin D Roosevelt’s “New Deal” gave Americans hope and important reforms, but achieved only a modest recovery from the Depression – largely, Keynes thought, because the scale of government spending was insufficient. Full employment in democracies was restored only in the Second World War, when the government started spending 70 per cent of the national income, with the national debt rising above 200 per cent.
The one experiment that did prove Keynes’s case was undertaken in Hitler’s Germany,
under the aegis of the Führer’s economics minister Hjalmar Schacht, though not in conditions that encouraged democratic emulation. The Schachtian system consisted of three main elements: a) controls on capital exports, b) bilateral payments agreements, whereby Germany’s trading partners were only allowed to sell as much to Germany as they brought from Germany, and c) huge state credits to German
industry (“printing money”), which over four years reduced unemployment from six million to near zero, with inflationary pressure being repressed by wage and price controls.
Gilt trip
Given the potentially conflicting requirements of “confidence” that he will face, what should the incoming chancellor do? He should choose the path dictated by economic reason, refuse to be spooked by what Samuel Brittan calls the “teenage scribblers”, and continue to pump money into the economy, counting on this advantage: that the markets do not expect the UK government to go bankrupt.
While Greece is paying close to 11 per cent for its ten-year bonds, the UK Treasury is still paying less than 4 per cent, and the UK coupon is not even 100 basis points higher than the German. In fact, the bid yield on the ten-year gilt is roughly 50 basis points lower now than at the start of September 2008. Unless and until confidence runs out, running a Budget deficit is far less costly than a return to recession. If we fear market reactions to sluggish growth and large deficits, imagine market reactions to no growth and much larger deficits.
To ensure that the policy of continued macroeconomic stimulus does not lead to the capital strike that Richard Hopkins feared and his modern successors predict, the chancellor should make a few simple promises. He should promise (and prepare) sharp fiscal cuts the day the government’s credit rating comes into serious doubt; he should promise to withdraw support for QE in the quarter that annualised inflation exceeds, say, 3 per cent; and he should promise to reconsider any type of stimulus measure once annualised GDP growth exceeds, say, 2.5 per cent for two quarters in a row. These promises could be part of a new fiscal constitution, adherence to which would be independently monitored. Spelling out precise conditions for the continuation of the fiscal stimulus would reassure the markets and shorten the period necessary to have one.
Beyond this, we cannot continue to run an economic system in which there is such a large gap between the beliefs of ordinary people and the beliefs of the business and financial worlds about the properties of the economy and the requirements of a decent economic life. Keynes rightly thought that ordinary people are instinctively more reasonable economists than economists and financiers. It is to them that the chancellor is ultimately responsible.
Robert Skidelsky 