Vince Cable’s essay in the 17 January issue of the New Statesman (“Keynes would be on our side”) is the first, and very welcome, sign of a senior coalition politician being willing to engage in a serious public debate on economic policy. It is in a different intellectual league from the jejune meditations of the Chancellor, George Osborne. Cable has written a well-argued – but ultimately unconvincing – defence of the coalition’s economic strategy.
His first, and perhaps least interesting, argument is that the parties are in agreement about a deficit reduction policy: the only question is the speed of reduction. This may be so, but a consensus is not the same thing as the truth. Cable argues that it is appropriate to begin to pay off the deficit “over five years”. It is important to point out, however, that there is no basis in economics for the imposition of a time period. This choice of five years is entirely arbitrary, as, indeed, was the time frame of the Labour government’s less austere fiscal tightening plan.
The only sensible course was – and still is – to commit to reducing the deficit at a speed and by an amount determined by economic circumstances. This would have the benefit of allowing decision-makers to avoid taking a premature view on the size of the “structural deficit”. Cable says it would have been 6 per cent of GDP even with “full recovery”, but readers should know that there is considerable doubt about this number, which the Business Secretary brandishes so confidently.
“Look after unemployment and the Budget will look after itself,” was John Maynard Keynes’s advice. This may not always be true but it is better than the coalition’s current stance of: “Look after the Budget and unemployment will look after itself.”
Paying off the deficit too quickly, on the basis of projections that even Cable concedes are highly uncertain, carries a far greater risk of a decade or more of lost output and social unrest and dislocation than a more measured path that is dependent on, for example, the economy hitting unemployment targets. When unemployment is far above any plausible “natural” rate, longer is likely to be better than shorter.
Cable seems to place a great deal of faith in the confidence-boosting effect of fiscal contractions. But the empirical evidence for this is far from convincing. An important study by Vincent Hogan (Scandinavian Journal of Economics, 106(4), 2004) finds that the increase in private consumption produced by fiscal contraction is not sufficient to offset the direct effect of the reduction in public consumption.
Another study, by Rita Canale and others, published by the University of Naples in 2007, concludes that fiscal contraction may be consistent with an expansion of aggregate demand if monetary policy concurrently leads to devaluation. But it is the monetary loosening, not the fiscal contraction, which has this effect.
In such cases it would be more accurate to say that economic recovery is possible despite fiscal consolidation. The question then is whether recovery might have been faster and more durable had fiscal and monetary policy both been expansionary. Cable argues that, had the coalition not acted decisively to reduce the deficit, Britain would have faced a “crisis of confidence” similar to that of Greece, which would have forced up the yield on government bonds. This is frequently asserted, but it is far-fetched. Even before the coalition’s deficit reduction plan, the British government was able to borrow at historically low rates. Moreover, the US treasury bond rate is even lower than ours, without a deficit reduction plan. There are many reasons for these low bond yields, but one of them is surely the diminished appetite for risk, itself a product of economic stagnation.
In any case, Britain is not Greece. For one thing, Greece has spent more than half the years since independence, in 1829, in default; Britain has not defaulted once in that period (see Carmen M Reinhart and Kenneth S Rogoff’s This Time Is Different, Princeton University Press, 2009, page 99). In addition, the UK has its own central bank and a floating exchange rate, while Greece is stuck in monetary union.
Greece is characterised by endemic tax evasion, a poor tax collection infrastructure, parochial patronage policies, corruption and huge delays in the administrative courts dealing with tax disputes. This clearly does not resemble developments in the UK. Granted, there was always a risk that “contagion” would spread from Greece to Britain. But the Conservatives had planned to slash public spending before the Greek crisis flared up, as a matter of ideological conviction. Greece was the excuse, not the reason.
Cable then embarks on the foolhardy project of enlisting Keynes on behalf of the coalition’s policy. First, some clearing of the air: Keynes never denied that economies would recover from depressions without help from governments. What he argued was that countries would not regain full employment without an exogenous injection of demand. Without it, the business cycle would go on, but at a lower level of activity.
In short, without sufficient “stimulus”, the employment and growth effects of a deep recession are long-lasting and likely to be large.
History bears this out. The UK and US did recover from the Great Depression, which reached its peak between 1929 and 1931, but the recovery was not strong enough to take them back to full employment for another eight years, when significant war spending started. Think, too, of the effects in the 1980s of the recession under Margaret Thatcher. UK unemployment was 5.3 per cent in May 1979 and remained above that level every month for the next 21 years until July 2000. There was another big collapse in output in 1937-38, as there was in 1987-89.
It is not enough to cite recoveries now in progress, or to chalk up growth rates, which recently have started to slow sharply. The question is whether current and projected growth rates will be strong and sustainable enough to restore full employment within some relatively short period, such as the life of this parliament. That seems unlikely.
Moreover, Cable severely underestimates the costs of prolonged underactivity. We need to take into account not just the output lost during the slump but the potential output lost in the subsequent periods of mediocre recovery. By 2015, the loss of output in the British economy from these two sources might well be in the order of 10 per cent. That is, the British economy might well be 10 per cent smaller than it would have been, had proper Keynesian policies been followed. This needs to be thought of in terms of the rusting away of human skills through persisting unemployment and failure to build the necessary infrastructure. As such, the knock-on effects go beyond 2015.
Cable is right to say that Keynes thought that the reduction of long-term interest rates had a vital role to play in sustaining any recovery. But he denied that it could happen naturally on its own, because, contrary to Cable’s interpretation, he did not believe that there was a “pool of excess saving” in a slump. There are no “excessive savings” during a slump because the excess saving that caused the slump has been eliminated by the fall in income. That means there is no “natural” tendency for the interest rate to fall: the fall has to be brought about by central bank policy. This was the main goal of the Bank of England’s recent £200bn quantitative easing (QE) policy.
More importantly, Keynes doubted whether the lowering of long-term interest rates would be enough to produce a full recovery. Again, the experience of the 1930s bears this out. “Cheap money” started a housing boom, which pulled the economy upwards, but it was never sufficient to restore full employment. The reason is that if profit expectations are sufficiently depressed, it might require negative real interest rates to produce a full-employment volume of investment. This is Keynes’s liquidity trap.
Although we are not yet in this situation, bank lending remains limited despite QE, especially to small firms that are unable to issue bonds. Hence the velocity of circulation has not recovered to pre-crisis levels because the banks are limiting their lending so that they can rebuild their balance sheets and firms lack confidence to invest.
So, what are the prospects for strong recovery in the present policy regime? Cable notes, correctly, that the Office for Budget Responsibility has produced the reassuring estimate that, by plausible assumptions, there should be improving growth, falling unemployment and fiscal consolidation to safe levels over the five-year life of this parliament. This forecast is considerably more optimistic than the consensus and is probably subject to marked downside risks, both externally, from further unravelling of the sovereign debt crisis, and domestically, where demand looks weak.
The latest economic data shows a big increase in the size of the national debt and in the debt-to-GDP ratio. GDP growth is slowing, unemployment has started to rise again – youth unemployment is approaching a million once more – and real wages are falling. Job creation in the private sector in the most recent quarter was exactly nil, while the public sector culled 33,000 jobs. In our view, under present policies, unemployment is likely to rise over the life of this parliament.
Furthermore, business and consumer confidence has collapsed since May 2010. This is illustrated in the two charts (see left). The first shows Markit’s purchasing managers’ indices (PMIs) for manufacturing, services and construction. Despite the recent jump in the manufacturing PMI, the overall index for the month dropped sharply, with big drops in services and construction. Commenting on the figures on 6 January, Markit suggested: “Worryingly, the slide in the PMI all-sector output index from 54.0 in November to 51.4 in December (the largest fall in points terms since November 2008) signals a slowing in GDP growth to near-stagnation in December.”
The second chart shows the Nationwide Consumer Confidence Index, which has collapsed since the coalition took office. It now stands at its lowest point since March 2009, and well below its long-run average. The strong rally in sentiment that took place from the middle of 2009 into the first quarter of 2010 has been almost completely reversed. An equivalent EU consumer confidence survey follows a similar path. So much for the improvement in “animal spirits” supposedly brought about by the coalition government’s policies.
We see no evidence currently that the UK economy is on course to “liberate new and sustainable investment”. Cable agrees, and so do we, that the priority is to get the investment engine restarted. He cites the government’s puny “green bank”, which is bound to have minimal impact, as it has no money. We need a national investment bank that is committed to spending at least the equivalent of the planned cuts in current spending and ideally more than this. Cuts in payroll taxes – as the US has implemented recently – also look like a sensible way to raise employment.
In short, though Vince Cable’s mind is working, the coalition is not.
David Blanchflower is economics editor of the NS and professor at Dartmouth College, New Hampshire, and the University of Stirling
Robert Skidelsky is the author of “Keynes: the Return of the Master” (Penguin, £9.99)
Read Vince Cable’s essay for the NS at http://www.newstatesman.com/economy/2011/01/investment-keynes-essay