Risky behaviour

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