The price of Britain's fiscal follies

Britain's return to economic growth shouldn't justify the government's overwhelming focus on fiscal consolidation, which will have severe consequences in the long term.

FT.com

George Osborne is quite sure that “Britain’s economic plan is working”. Now, with growth returning, he argues for a “responsible recovery”. But the prior question is: what is the UK recovering? Policymakers have given up on recovering what the economy has lost. They believe the public will and must accept far less. Only those equally pessimistic should regard such an outcome as a vindication of government policies.

In 2013, six years after the start of the crisis, the UK economy is yet to recover its pre-crisis peak. According to the Office for Budgetary Responsibility, that will occur in 2014. Yet even then the economy will be a mere 0.6 per cent larger than seven years earlier – the slowest recovery in more than a century.

The longer-term picture is even more depressing. In 2013 the UK economy was 14 per cent smaller than if its 1955-2007 trend had continued. The independent OBR expects none of this to be recovered by 2018. Instead, it thinks the recent improvement has only brought forward the date at which the economy returns to full capacity. The deviation from past trends will grow wider: the 1955-2007 trend annual rate of growth was 2.8 per cent, while the OBR’s forecast of the growth rate of potential output is about 2 per cent.

Thus, while the economy has recovered growth and should soon recover pre-crisis output levels, it is forecast to recover neither its pre-crisis trend level nor its rate of growth. Under plausible assumptions, the present value of the output lost as a result of the crisis and its aftermath will be 500 per cent of annual gross domestic product.

Yet, while prospects for output remain depressing, those for employment have been cheering. As Osborne notes: “Unemployment is lower than in 2010, and is forecast to fall further, from 7.6 per cent this year to 7 per cent in 2015, before falling even further to 5.6 per cent by 2018.” Those who feared that the dismal recovery would mean soaring unemployment were wrong.

Unfortunately, this heart-warming performance on employment is a mirror image of the dismal performance on productivity. Ultimately, real wages have fallen because output per hour has fallen. That has softened job losses. The OBR assumes the past productivity losses, relative to the trend, will not be recouped. Yet it hopes growth of output per hour will recover to close to 2 per cent by 2015.

Little in recent economic performance encourages optimism about future dynamism. As the OBR notes, the principal cause of faster-than-expected growth is more dynamic consumption. The principal cause of that is “lower saving, not higher income”. This is unsustainable. Hopes that recovery will strengthen depend on surging productivity and real earnings. Alas, business investment is forecast to shrink by 5.5 per cent this year. It is forecast to rebound strongly next year. Let us hope. No improvement in net trade is forecast. Rebalancing remains a pipe dream.

The heart of the government’s plan is fiscal consolidation. Here, the position has improved because recovery has come earlier than expected. The OBR forecasts lower public sector net borrowing and public sector net debt, relative to GDP (now peaking at 80 per cent in 2015-16), than it did in March. Yet, since it is no more optimistic about the structural position, the fiscal pressures are unchanged.

Some implications are startling. The budget deficit is forecast to fall by 11.1 per cent of GDP over the nine years from 2009-10. About 80 per cent of this fall is a result of lower public spending. That would take government consumption of goods and services to its smallest share of national income at least since 1948. We should strongly doubt that this is going to happen, whatever the government promises. If it does happen, it will be reversed.

This government’s predominant response to the crisis has been to assume that its overwhelming priority was fiscal consolidation. It assumed that it was confronting a fiscal rather than a wider economic crisis. It did not focus on what policies it needed to return the economy as quickly as possible to its long-term trend levels and rates of growth. Work at the International Monetary Fund shows that huge financial crises do normally have dire long-term effects. But the staff note: “Economies that apply counter-cyclical fiscal and monetary stimulus in the short run ... tend to have smaller output losses over the medium term.”

The government had the room to sustain strong fiscal support, but reversed it prematurely. It is not hard to accept that this has affected investment and so potential (as well as actual) output. Furthermore, despite extraordinarily low borrowing costs in nominal and real terms, net public investment will average 1.5 per cent of GDP between 2013-14 and 2018-19 – about two-thirds of the share before the crisis, and surely vastly below what the economy needs and can afford. This is just one of many ways in which the obsession with public sector deficits and debt, rather than with the health of the economy and the public sector’s net worth, has led the government astray.

The government is not just another household. Particularly after a huge crisis, its job is to restore the economy to health as quickly as possible, thereby minimising long-term damage. It failed to do so. The fact that growth has returned is good news. But this cannot vindicate a strategy that has tolerated such large long-term losses.

Copyright The Financial Times Limited 2013.