Economics

After new figures showed the UK emerged from the recession with unemployment over 2% lower than the European average, news and analysis is now coming thick and fast of the Budget’s threat to jobs.

The Guardian this week reported secret Treasury studies showing the Budget could cost 1.7million jobs, and the TUC’s Adam Lent argued that recoveries in the past simply didn’t point to the kind of job growth forecast by the Budget.

Why is this so serious – beyond the obvious?

It’s serious because at the heart of George Osborne’s budget is a big gamble that cutting back public investment this year will lead to private sector investment stepping forward.

This is of course pretty suspect because many firms – and households – are ‘deleveraging’ – that is paying off debt, rather than spending money, and the financial system isn’t ‘fixed’ enough for lending to oil the wheels. This week’s Bank of England Credit Conditions Survey says things are improving but worries about the economy’s recovery are now also acting as a drag. There are still reports of problems with firms accessing loans and the UK savings rate is now very high. The upshot is that although the ONS reported on 30 June that business investment in the first quarter of 2010 is up on the end of 2009;

Compared with the first quarter of 2009, total business investment (in the last quarter) fell by 7.7 per cent.

Exacerbating this risk is the imposition of new the VAT taxes will help depress consumption still further, adding to the risk that private sector investment doesn’t pick up at the speed we need to grow our economy.

The result is a Budget that is relying on an almost unprecedented growth in business investment and exports totalling some £190 billion over the next few years. As far as I can tell from House of Commons library research I commissioned this week, growth in business investment and exports have only once since 1966, hit the growth rate we’re relying on in each of the next three years.

Now, remember that growth in the UK needs to exceed around 2% before unemployment starts falling (to take account of the growing size of the labour market and productivity changes) and you can see there is a real risk that unemployment does not fall at the rate we need it too. That will make paying down the deficit harder, not easier.

Here’s what John Philpott, Chief Economist at the Chartered Institute for Personnel Development, had to say on Channel 4 News this week (Wednesday, 30 June 2010):

JP: If you take into account the fact that the public sector is going to be cutting hundreds of thousands of jobs and they are also going to be private sector job losses amongst firms that are dependent on the public sector you can see that the government faces a big challenge if it is going to prevent unemployment from rising much further, let alone seeing unemployment fall as it’s forecasts today suggest.

Finally, some will remember managers at bond fund Pimco warning earlier in the year for clear deficit reduction plans. Well, here’s Scott Mather at Pimco  today warning that the scale of cuts now proposed risks pushing us back into recession;

“There are parts of Europe where austerity wasn’t called for immediately,” said Mather, who mentioned Germany and the U.K. as examples.

Moody’s also warned today of “implementation risks” associated with the budget, including the potential impact on growth from the austerity measures.

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Last night was the final day of the Budget debate – and we saw the very first fracture in the coalition as a couple of Lib Dem MP’s voted against the coalition’s plan to raise VAT. The link to the Hansard of my speech is here.

One of the worst accusations thrown about by the Tories is that Labour had no plan for deficit reduction. This is total nonsense. Our plan was set out very clearly in chapter 6 of the March 2010 Budget. Below for those interested in a summary…. 

Our deficit reduction plan                                                            

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If you want a warning about the risks the government is embarked on, you could do well to study the lessons of Japan. Here’s Richard Koo’s interview on Newsnight, which is very good on the subject…

RICHARD KOO, ECONOMIST AT NOMURA INSTITUTE IN JAPAN
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Today’s public finance figures show the outlook for public finances is even better than projected by the Office of Budget Responsibility just last week (which itself said the outlook was £30 billion better than forecast in the Budget). So, this week we’ve had significant proof that the finances are better – not worse – than the new government tried to lead us to believe.

The great risk now is that next week, cuts are announced that are so large, that the recovery is choked off. This theme was well explained by Paul Krugman who today posts a very good piece from Germany about risky behaviour of those who want to cut back government support for the economy in a way that’s too big too soon. Here’s his conclusion;

The key point is that while the advocates of austerity pose as hardheaded realists, doing what has to be done, they can’t and won’t justify their stance with actual numbers — because the numbers do not, in fact, support their position. Nor can they claim that markets are demanding austerity. On the contrary, the German government remains able to borrow at rock-bottom interest rates.

No-one disputes the need to get on with the business of paying down the deficit – but not too much too soon. The dangers of the kind of approach we we may see in the UK next week from George Osborne was explained well by Christine Romer in a good piece in the Economist last year. Drawing on the lessons of the Great Depression, Romer argues;

The recovery from the Depression is often described as slow because America did not return to full employment until after the outbreak of the second world war. But the truth is the recovery in the four years after Franklin Roosevelt took office in 1933 was incredibly rapid. Annual real GDP growth averaged over 9%. Unemployment fell from 25% to 14%. The second world war aside, the United States has never experienced such sustained, rapid growth.

However, that growth was halted by a second severe downturn in 1937-38, when unemployment surged again to 19% (see chart). The fundamental cause of this second recession was an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy. One source of the growth in 1936 was that Congress had overridden Mr Roosevelt’s veto and passed a large bonus for veterans of the first world war. In 1937, this fiscal stimulus disappeared. In addition, social-security taxes were collected for the first time. These factors reduced the deficit by roughly 2.5% of GDP, exerting significant contractionary pressure.

Also important was an accidental switch to contractionary monetary policy. In 1936 the Federal Reserve began to worry about its “exit strategy”.After several years of relatively loose monetary policy, American banks were holding large quantities of reserves in excess of their legislated requirements. Monetary policymakers feared these excess reserves would make it difficult to tighten if inflation developed or if “speculative excess” began again on Wall Street…The Fed then doubled reserve requirements in a series of steps. Unfortunately it turned out that banks, still nervous after the financial panics of the early 1930s, wanted to hold excess reserves as a cushion. When that excess was legislated away, they scrambled to replace it by reducing lending. According to a classic study of the Depression by Milton Friedman and Anna Schwartz, the resulting monetary contraction was a central cause of the 1937-38 recession.”

For those interested in more recent parallels, take a look at the IMF paper on the lessons from Japan’s lost decade. It’s warning is not to move too fast at the first sign of recovery;

green shoots do not guarantee a recovery, implying a need to be cautious about the outlook. Second, financial fragilities can leave an economy vulnerable to adverse shocks and should be resolved for a durable recovery.

Bottom line: history tells us when a recovery starts,  take care – not risks

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