Budget 1999: You shouldn't be so complacent, Mr Brown
Wednesday 10 March 1999
The rapid slowing of the economy, with manufacturing industry near or in recession, the biggest deficit - pounds 20.6bn - on the balance of trade in goods for a decade, and the possibility of zero growth this year, or even recession, will all return to haunt us as the year rolls on.
This situation was entirely predictable and avoidable. But the Treasury, the International Monetary Fund and the Chancellor radically misunderstood the dynamics of the international economy and, as a result, their projections for growth in the world economy proved to be over-optimistic. Wrong policies inevitably followed.
In the year after slump struck East Asia in the summer of 1997, the Bank of England merrily raised short-term interest rates. As a result, the pound was held at an exchange rate at which British industry could not compete, while East Asia and the rest of the European currencies were devaluing. The interest-rate cuts since last summer are a case of too little, too late, with their effects taking 12-18 months to reach the real productive economy. The current economic slow-down is the result, and will be made worse because 40 per cent of the world economy is already in recession.
While it is true that the Bank of England, and other central banks, are reducing short-term (three-month) interest rates, they have no control over long-term interest rates. Productive investment is affected by long- term interest rates, not short-term ones. Long-term interest rates, in turn, are set by the supply of and demand for capital.
There is now an international rise in interest rates. This started in Japan with long-term rates doubling between September last year and January 1999. It then spread to the US from last October, and began to affect Europe in February. Since inflation during this period has not risen, real long-term interest rates have gone up in the last period.
This means that the world economy is slowing sharply - with recession in Japan, slow-down in Europe and various degrees of financial crisis in East Asia, Brazil and Russia. Under those conditions the rising long- term interest rates reflect a decline in the supply of capital rather than excessive demand.
The exception to slowing growth is the United States, but it is running up against the limits of the supply of capital - the chief external supplier of which has been Japan.
The key point in Europe is that at the beginning of a slow-down or recession, real long-term interest rates have risen, whereas they would normally be expected to fall. Such an increase in real interest rates during the downswing of the business cycle increases recessionary pressures. Indeed, the German economy contracted in the last quarter of 1998. The German Finance Minister, Oskar Lafontaine, recently said that if the European Central Bank refuses further to reduce interest rates, then governments will need to use fiscal policy to stimulate economic growth.
This is advice that Gordon would have been well advised to follow in his Budget, particularly as his growth predictions are likely to be over- optimistic. Rising long-term interest rates will further reduce investment and growth. In these circumstances monetary policy alone cannot be relied upon to prevent a recession.
Gordon should therefore have taken the opportunity of this Budget to use a big increase in taxation on high incomes and dividends in order to fund a sharp increase in public spending, particularly investment. Instead of cutting corporation tax to 30 per cent it should have been increased to 40 per cent, with a 100 per cent rebate to cover the full cost of all firms' investment in increasing their productive capacity.
Such a policy would lead to a real expansion of investment and employment and lay the foundation for an investment-led upswing in the business cycle, joyfully coinciding with the next general election.
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