How could the deficit reduction plan 'work'?
Like a pint of bitter, the Spending Review 2010 has taken a little time to settle down and become clear. Its claims to fairness were attacked by the IFS within 24 hours - and the debate on housing benefit rages.
But I've been taking a closer look at the big macroeconomic questions, which have caused both the FT and the Economist to call it "an experiment":
-Will it flatten the economic recovery?
-Does the labour market story hold water - of 490,000 job losses replaced by 2m private sector jobs over the same timescale?
-How does its impact interact with monetary stimulus, global currency war and still frozen credit conditions?
And I want to ask a possibly heretical question for those who are against the austerity package: what would you have to do to make it work? JM Keynes famously said don't wish for the failure of the anti-crisis measures, even if you consider them imperfect. So...First: what is the likely impact on GDP?
-Public spending will fall from 48% of GDP to 41% in 2014-15 (according to SR2010)
-So the private sector has to rebalance the economy, filling a 7% gap.
-The OBR in June published estimates of how it would do this, namely that there would be a switch - achieved by 2013 - from public spending to export led, investment led growth.
Here's a pie chart of GDP growth in 2008.
And here's one as projected by the OBR for 2014. Overall growth is the same, but its components massively different.
Starting next year, spending cuts create a 0.7% of GDP headwind against growth, so they disappear as a contributor to the pie chart. Business investment - which averaged 0.3% between 1999-2008, has to contribute 1.1% in 2012, 2013 and 2014. Net trade - which has been on average negative since 1999 - has to be contributing 0.5% by 2014 and indeed 0.9% in the next two years. (Source: OBR Supplementary Material to June 2010 Budget, Table 1.2)
So the conceptual shape of the rebalanced economy, at this level is clear: private investment flows in, stimulated by changes to corporation tax; Britain switches from a trade deficit to a strongly export led economy by the end of FY2011.
It is worth remembering why these projections were done by the OBR: if growth does not remain strong in FY 2011 and beyond, the tax take falls, the deficit rises. Unemployment places further pressure on the welfare bill, which in CSR 2010 was made to take £18bn of strain out of an £81bn cuts package.
The theory of "expansionary fiscal austerity" supports the OBR's projections - but it is only a theory. Its poster children are Canada and Sweden after the 1991 recession. Its theorists - most notably the October 2009 Policy Exchange report "Controlling Spending and Government Debts", look at three scenarios for the impact of a high budget deficit.
-In a "normative" economy, where information flows transparently and everybody acts rationally, a deficit does not produce a stimulus to the economy because consumers rationally react to the future tax hike implied by saving. This is the so-called Ricardian equivalence model. Its critics believe it has no relevance to a modern economy.
-Next, in times of crisis, because rationality goes out the window, a "right sized" deficit/stimulus can work - and therefore reversing it can cause a second recession. This is the common ground between Keynesians and neo-liberals.
- Finally there is a situation of a "too big" deficit: "When deﬁcits are too large and/or spending levels too high, instead of providing a boost to demand large deﬁcits actually impair growth, and so ﬁscal consolidations, far from driving additional contraction or limiting recovery, actually promote faster growth and more rapid recovery." (Policy Exchange, op cit, p26)
This is the essential theory behind the Coalition's strategy. The PX document states a preference for 80:20 cuts/tax rises and says:
"Providing spending cuts predominate over tax rises tightening is more likely to promote recovery than impede it." (p103) adding the caveat that this is especially true if fiscal tightening can be accompanied by monetary easing.
The IMF, in its World Economic Outlook this month, has issued a pretty thorough refutation of this theory. The IMF's position is not based just on a historical survey but on the most developed model of the world economy in existence - the GIMF.
Running its model, and the historical data the IMF finds:
"The idea that fiscal austerity triggers faster growth in the short term finds little support in the data." (WEO, IMF October 2010)
It does support the idea that deficit reduction has a benign long-term effect, but issues a caveat, of which more later.
The IMF sets out its model for what usually happens. They do not draw a distinction between "exceptionally large" deficits and right sized ones: for them the main distinction is whether a country is at risk of default - in which case cutting the deficit supercedes worries about austerity.
They calculate as follows:
-A 1% fiscal tightening brings 1% cut in demand plus a 0.3% rise in unemployment. But GDP only falls by 0.5% - due to the mitigating factor of a 1-for-1 percentage fall in value of currency, facilitating a rapid switch to exports.
-Without a boost from currency depreciation, higher exports and lower interest rates, the impact on GDP is worse.
-In particular if you are already at zero interest rates and cannot lower them any more "the output cost of fiscal consolidation doubles to about 1% after two years". (p109)
-It gets worse, because the IMF economists then model a global fiscal tightening scenario (using Canada as the guinea pig) where one country cuts the deficit but so do several others. This shows for every 1% of tightening, Canada - a small, open, globalised economy - suffers a 2% fall in GDP a year later.
-The IMF accepts that cuts-based tightening stimulates growth faster than tax-based tightening - because the absence of increases in VAT and other indirect taxes leads to the central bank being able to slash interest rates. So it implicitly supports the Coalition line on the mix of cuts to tax rises.
Applying all this to the UK, what it shows is that there is a large theoretical variability to the outcome of a 7% fiscal tightening. What are the variables:
Is the interest rate 0%? Yes it is.
Does everybody else cut? In many places yes.
Does the currency depreciate to boost exports? Yes it has done by 18% - but now needs to fall at least another 7% in the next 4 years.
Does everybody else attempt depreciation? You bet - we're in the middle of an undeclared currency war.
Without a massive monetary policy boost, the IMF's model would indicate the UK faces at least 1% reduction of GDP for every percentage point of tightening. Of course it's only a model, and an abstract one at that.
Both the IMF and Policy Exchange believe there are beneficial long-term outcomes from reducing the size of the deficit relative to GDP. This is because the long-term real interest rate falls, pulling in private sector investment. However the IMF is clear on the limitations of this, and the timescales:
-It believes the long-term interest rate effect takes place about 5 years into the cuts.
-It believes there is a stronger positive impact of deficit cutting in countries at risk of sovereign debt default. Hence the debate about the real or imagined nature of Britain's sovereign risk is important there (see Kaletsky, Wolf etc)
Here too it is important to understand the IMF's model is global, and depends on interaction between economies, not just the domestic impact of deficit reduction. In the global model, the developed world can make a one-off long-term cut in the size of budget deficits, and this can boost growth, but only if there is a one-time rebalancing of world trade so that the entire developed world improves its export performance while China, India, Asia, South America consume more.
But the complicating factor - the crucial factor - is quantitative easing (QE). Since we can't cut interest rates much further, the monetary stimulus relies on QE being effective. George Osborne has already signalled he will allow for more QE - but will it work? To work it has to get real interest rates down.
Whether it is because of QE or merely a signal of long-term stagnation, inflation-protected bond yields are currently at their lowest ever. Here is the indexed yield on a 10-yr gilt:
As you can see it is extremely low. One bond-market source told me:
"Credit risk is not being reflected in real yields today. Or rather, if there is credit risk in UK real yields, then the 'risk-free' real yield is a deeply negative number. Real yields can only fall in the UK due to market concerns that the long-term sustainable growth is falling, or because they see the stock of Gilts evaporate, and in this way what we see is no longer a 'market price'."
So while it is true, and welcome, that deficit reduction plans - even before implemented - are able to lower the cost of borrowing for government considerably, and hike its credit rating, you have to have some long-term view of what's going to happen in this combined world of QE, deficit reduction and currency depreciation.
And the starting point is, the risk-free rate is historically low: if my bond-market source is right, it is the credit system, not the perceived risk of a UK default, that is strangling the recovery.
In summary. To answer the question - how could the deficit reduction plan "work".
-It needs the maximum possible assistance from monetary policy. If it is the case that 12% of GDP spent on QE suddenly switches through from bank balance sheets into the money supply, then you will see QE supporting the austerity programme and the conditions for success will be in place. However then comes the moment where the monetary authorities have to decide what to do if this boosts core inflation.
-Real credit conditions would need to change. The risk-free rate is, as I say, already low: it is the margin between that and real business credit rates that is too high for recovery to take place. My hunch is that much of what "worked" in Labour's fiscal stimulus was micro-economics: the grants to businesses, the instructions to the banks to avoid foreclosure; the rapid return of A8 migrants to East Europe. Micro-strategy is important in the austerity phase as well.
-Then there is the labour market. Actually the labour market is crucial in these situations. Policy Exchange notes, inter alia, that it was the Invergordon Mutiny that finally pushed Britain off the gold standard and thus onto a softer path through the Depression after 1931. Likewise, the theory that if Britain pegged its currency to gold, wages would fall in line with global market forces, ran up against that ultimate example of wage stickyness, the 1926 General Strike.
Today wages are sticky for a number of reasons:
-The minimum wage: impossible politically to abolish, or to cut without sustained inflation.
-During the boom there was already downward pressure on wages at the lower end. The problem is at the salariat level. You cannot place mid-term downward pressure on wages without this showing up as a new stress in the property and personal credit market.
-The 490,000 estimate of public sector jobs lost was reduced from 750,000 on the understanding that public sector pension cuts would mitigate the public wage bill. We already know the scale of increased pension contribution in the public sector: it's about 1.5bn. But we also know the government's strategy is to encourage public sector workers to trade wages, pensions and hours for job security. We will have to wait for the OBR's assessment of the impact of SR2010 on 25 November. The OBR is now "under new management" and its new boss Robert Chote may want to revisit the methodology used in June.
-The longer term issues remain: do the new jobs created go to A8 migrants, does the Universal Credit succeed in getting millions of Brits back to work, and does it do so in time?
On currency: according to the IMF theory you would need a massive boost from sterling depreciation. Having fallen 18% you now need a 7% depreciation. But the USA is depreciating - despite its doctrine of strong dollar. So is Japan. QE should help depreciate but it is not yet a done deal at the Bank of England.
Of course, the real economy has a habit of defying all theories and models. But it is striking how overtly the IMF's view clashes with the underlying assumptions of the UK government - despite the fact that the IMF gave the June budget a nod of approval.
Another striking thing is that, while academics and journalists are locking horns at this theoretical level, the two front benches seem keen to skirt around the deep detail.
It leaves me asking the question - to make the austerity work the way it's intended to, will they have to adopt a vigorous modern form of protectionism, aggressively promoting trade, tanking the currency, printing money and manipulating the cross-border labour supply?