Stephen King: More Keynesian than Keynes was – and more wrong than right this time
But George Osborne's numbers are also based on some very optimistic assumptions regarding a pick-up in trade
Monday 04 April 2011
What have Britian's liberal press, Paul Krugman and George Osborne got in common? Well, the first two – the liberal journalists and a Nobel Prize-winning economist– see eye-to-eye on quite a lot of things.
In a recent column telling George Osborne that if the facts change, "it's OK to change your mind", one writer made use of Professor Krugman's recent musings to declare that "the confidence fairy has flown, even before these tougher cuts and job losses kick in".
The recipe, and indeed that of Professor Krugman's, is for the Government to scrap its plans, borrow a lot more for a lot longer and invest in housing and jobs. By doing so, Britain will be able to avoid "George Osborne's rerun of the depression years". (For the record, and to underscore the degree to which hyperbole often clouds the argument, the peak rate of unemployment in the 1930s was well over 20 per cent: today's unemployment rate is 8 per cent).
So what on earth is the link? The answer is that, despite their differences, they are all, in their own idiosyncratic ways, optimists. They all believe Britain's economic problems can be fixed. The journalists love a good increase in public spending, Professor Krugman loves a big dose of government borrowing and Mr Osborne loves a private sector, supply-side, renaissance. Each thinks Britain's economic problems are resolvable. They merely disagree on the measures required.
For Keynesians, aggressive deficit reduction will simply send the UK economy back into recession. Indeed, they worry that any attempt to reduce the deficit on the scale proposed by Mr Osborne will ultimately be self-defeating: another recession would leave the Government both short of revenue and with a bigger bill for unemployment benefit, thereby making the deficit bigger, not smaller.
Instead, they suggest the UK should wait for a vibrant recovery to come through before taking the axe to the deficit. Such is their optimism that they doubtless rather hope that, in the event of a recovery, the axe would never have to be used at all: a strong cyclical rebound would automatically boost tax revenues, removing the need for the surgeon's knife. It is, if you like, money for free.
Mr Osborne sees things differently. He thinks the Government has, for too long, borrowed far too much. He worries that continued excessive borrowing will ultimately damage the UK's international credit rating, in the process driving up borrowing costs and thus scuppering the recovery. For him, the only way for the UK economy to recover is for us to live within our means: and if that means near-term spending cuts, so be it. To regurgitate a phrase, he believes "there is no alternative". That might sound bleak but Mr Osborne believes that surgery on the deficit now will reduce fears about higher taxes in the future, leading to a private sector supply-side revolution delivered by an entrepreneurial hunger. See what I mean about optimism?
So who is right? I'm not sure that any of them is. I argued last week that Mr Osborne's numbers are based on some very optimistic assumptions regarding a pick-up in trade. If this doesn't happen – and the evidence from history suggests it won't – there's every chance that the economy will end up weaker than Mr Osborne's advisors at the Office for Budget Responsibility (OBR) have suggested. Indeed, in response to the sogginess of the recovery so far, the OBR has already revised down the projected level of economic activity over the medium term, pointing to either a bigger deficit or, if the deficit targets are to be hit, bigger spending cuts.
It may simply be that the entrepreneurial kick-start that Mr Osborne craves simply won't materialise, partly because the UK, like other industrial nations, is now having to cope with much higher food and fuel prices, a consequence not just of the political upheavals in the Middle East but also the enhanced buying power of China and India (the OBR conveniently steers around its economic downgrade by suggesting that the reduction in projected levels of economic activity is a reflection of cyclical rather than structural factors, leaving the fiscal position intact over the medium term: this, however, may be an assumption of convenience than of reality).
Yet the idea that the UK's economic problems can be cured simply by leaving the deficit higher for longer is absurd. Ed Miliband agrees that surgery is required, even if he wouldn't be advocating quite such aggressive cuts over the next few months. On either side of the political spectrum, no one is seriously advocating an increase in government borrowing. Put another way, everyone accepts that hard choices have to be made.
The reason is simple. On current projections, the ratio of debt to GDP – a cumulative measure of the borrowing made by governments of all hues since time began – will rise further. According to the Government's numbers, it will peak at a little over 70 per cent of GDP in 2013/14 before heading lower – and that depends on the release of Mr Osborne's entrepreneurial spirits. You may recall Gordon Brown's desire to keep the debt ratio below 40 per cent so, clearly, something has gone badly wrong.
The simplest way to explain all this is to consider the path projected for the UK economy prior to the financial crisis compared with where we are today.
The 2008 Budget - before sub-prime and Lehman had become part of day-to-day conversation - was relatively upbeat regarding prospects for the UK economy, pointing to growth of between 2 and 3 per cent per annum in the years ahead. The oncoming crisis was either not spotted or, if it was, completely ignored. The recession that followed basically ripped up the previous fiscal projections. All those high hopes for public spending had to go into the bin: the economy was now incapable of generating the necessary revenues to support such generous ambitions, as the chart suggests.
The numbers are startling. In 2010, the level of economic activity was more than 10 per cent lower than had been projected in 2008. Whether economic growth over the next few years is at 2 per cent, 3 per cent or 4 per cent, the UK economy will be a long way from operating at a level of activity which would enable past promises to be met. Those promises were made on expectations which were hopelessly wrong. The nation now has to adjust.
To suggest that this is all the result of a temporary demand shortfall is hopelessly naive. No amount of fiscal stimulus will be enough to return the UK to the conditions that prevailed before the financial crisis, dependent as they were on excessive credit growth and a build up of systemic financial risks. It's up to our political leaders to work out where the axe will fall but there is no escaping the years of austerity which lie ahead.
And it would be good if those of an "extreme Keynesian" disposition admitted the need for hard choices, rather than pretending there is an easy way out of this mess.
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