Hamish McRae: What happened in the Eighties shows the cuts were right and we will recover

Economic view
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The Independent Online

It has been, for obvious reasons, a troubling week, and that is true whatever your judgement on the need for and impact of the spending cuts. So it is perhaps helpful to step back and put a bit of perspective on all this.

The best starting point is to ask where we are in the world recovery, because if the world does pull up sharply we will be pulled along with it. The point that the emerging world has continued to grow throughout this cycle and that the recession has been a developed-world phenomenon has been made so often that there is no reason to labour it here, save for one small point. Most people probably now know that Britain's largest manufacturer is Tata of India. But I heard another fact the other day. India is the third largest market for Jaguar Land Rover, the vehicles produced by Tata. We are benefiting directly from growth in the emerging world.

Come back to the old developed world and there still seems to be reasonable growth, albeit slower than in the spring. But it is uneven. The US economy does seem to be faltering but the Germany economy is still growing strongly and the rest of Europe, bar the most indebted fringe countries, is not doing too badly either. This has led to a different perception of what should happen to policy. In the US there is a strong call for more quantitative easing, while in Europe the prevailing view is that if the countries hang on in there it will all be all right.

So the US will try to give another monetary boost to the economy in the coming weeks. There are a number of justifications for this. One is that it will make funding the fiscal deficit easier and cheaper and will nudge down the dollar, thereby boosting US competitiveness. The real economy is certainly hitting a soft patch. Manufacturing output is still climbing but the forward surveys have been wobbling and unemployment is stuck at around 10 per cent. Another and slightly different justification is that asset prices in the US, particularly property prices, had apparently bottomed out but may be falling back again. Until there is a floor under property it is going to be hard to rebuild consumer confidence. Mortgage applications, housing starts and building permits are all weak.

By contrast, the growth in Germany is impressive. Business confidence jumped in October and is close to its peak at the top of the last boom in 2006. Unemployment has been falling and employment rising. Consensus forecasts for GDP growth this year are around 3.3 per cent. Retailers are their most optimistic since the post-unification boom in the early 1990s. As a result, it seems likely that Germany will again be the locomotive for the eurozone, pulling its neighbours with it.

You can catch a feeling for this general message in the main chart: a recovery in the developed world that is slowing a little but still positive. This has relevance to us. As spending is cut the private sector must take up the slack, in terms of employment and output. You can see from the right-hand graph that the projected decline in public spending as a percentage of GDP is not so dissimilar to the two previous periods of fiscal consolidation in the 1980s and 1990s.

At the end of this period, public spending will still be higher as a proportion of GDP than in the early Gordon Brown years. But – and this is a real concern – during the previous periods of fiscal squeeze the rest of the world economy was growing strongly, so it was easier for the private sector to take advantage of that. Now, given that governments in the developed world are cutting deficits, that prospect is not so certain.

There are two arguments against this. One is the oft-made one that the alternative would be worse; that the country would be faced with a collective loss of confidence at home and abroad; and that the boost to confidence already evident in the gilt market will spread through the business community to consumers.

The other is that we are an open, medium-sized economy and cannot but benefit from the global cycle. If we have learnt one lesson from the past two years, it is that there is an economic cycle with an amplitude of seven to 10 years, though that says nothing about the depth of the downturns or the pace of the recoveries. Experience from the 1930s onwards tells us that eventually growth returns. Back then, after four years, output in the UK returned to its peak. The shrill "back to depression" voices ignore this self-correcting mechanism.

Besides, this really does feel like the early 1980s. There has been mismanagement of the economy similar to that of the 1970s, though this time more of the mistakes have been on the fiscal rather than the monetary side, and the incoming government has to correct the errors. Back then, the fiscal squeeze imposed by Sir Geoffrey Howe was similarly criticised, famously by 364 economists in a letter to The Times. There was indeed a recession similar to this one and the cuts were made a little earlier in the cycle. Yet the economy grew strongly through the 1980s – too strongly as the boom got out of control. This is not to claim that the policies then were optimal, simply that the opposition to them proved wrong.

It is always hard to prove the counter-factual: what would have happened had policies been different. But the early 1980s do give one clue to what might have happened. France carried on with a fiscal boost just as the UK was pulling back. But after 18 months France had to reverse its policy and ended the 1980s with higher unemployment than the UK, a situation that has persisted to this day.

None of this should be taken to mean that the coming four years will be easy. It is difficult to cope with cutbacks in any walk of life and the numbers are so huge that some things will happen that could and should have been avoided. My point is a broader one. It is that notwithstanding this probable pause, the developed world almost certainly is in the early stages of a growth phase that will last several years. We have a window to sort things out.

Canadians have a lot to teach us about how to get out of an economic hole

If you want a model for successful financial management – or rather recently successful management – Canada is as good as any. During the 1990s, the country faced a similar situation to the UK now, including public spending reaching 50 per cent of GDP. Then it successfully cut back to less than 40 per cent during the boom, when the country was running a fiscal surplus. Even now, its public spending is only about 44 per cent of GDP.

The fiscal deficit did climb to about 6 per cent of GDP last year but is now falling and is forecast by the IMF to disappear by 2015. Overall, debt is now lower than in the US, whereas it has been higher. There was no banking boom or bust, thanks to a culture of caution in its banks. There has been no house-price crash, just a little dip and prices are now past their previous peak. The list goes on.

The experience has not been perfect nor is it directly applicable to the UK. One of the reasons the central government was able to cut back was that it pushed responsibilities towards the provinces, leading to severe cutbacks there. And one reason for its success has been the fact that Canada remains to a fair extent a resource-driven economy, with a hungry neighbour to the south. But it is hard to quarrel with the thrust of policy. If you run a surplus in boom years you can safely allow the deficit to climb during a slump. If you have a cautious banking industry, you find it easier to avoid an asset bubble.

Sound fiscal policy buys you options, whereas letting things rip closes those options. Indeed my main worry, looking at comparative data between Canada and the US, is just how alarming the US deficit and debt numbers appear. But that is another story, to be concluded when the markets decide that US debts are reaching a level where even the Chinese start to baulk.