Despite strong evidence to the contrary, the Treasury says there is still time to turn the economy round before the next election
George Osborne has had a long, tough summer. It started with a series of U-turns after a badly received budget and it has ended with a deficit that is bigger than it was this time last year. Critics say that Bradley Wiggins and Usain Bolt have done more to boost the economy than the chancellor.
The Treasury, unsurprisingly, says that this is not the time to hit the panic button, that despite strong evidence to the contrary everything is going to plan, and that there is still time to turn things round before a general election in 2015. This view is built on a number of assumptions.
Assumption No1 is that Britain’s problems are deep and structural, rooted in a culture of excessive borrowing and a narrow productive base. Osborne is right about that.
Assumption No2 is that any respite from bad economic news will be short-lived because rising activity in the third-quarter will be the result of a bounce back from the lost production caused by an extra bank holiday in June and a modest boost from the Olympics.
The reason for this sombre assessment is that Greece is now in limbo until after the US presidential election in early November, prolonging the uncertainty caused by the crisis in the eurozone. Osborne is making contingency plans for a single currency reduced from 17 to 16 countries but believes that Barack Obama’s influence with Angela Merkel means there is no immediate prospect of the plug being pulled on Athens.
Like Obama, the chancellor is far from convinced that Europe could prevent contagion in the event of a Greek departure and wants reassurance that the return of the drachma would be accompanied by swift action by the European Central Bank to buy bonds of other vulnerable countries in unlimited quantities. On past form, the chances of it all going wrong are worryingly high.
UK business surveys suggest that the next few months are going to be difficult for manufacturers, construction firms and the services sector alike. Although the revisions to the second-quarter growth figures painted a slightly less gloomy picture than the original estimates, the underlying performance of the economy is extremely weak. Consumer spending is down. Investment is down. And trade is a drag on growth.
The third assumption is that Europe is to blame for Britain’s flatlining economy over the past 18 months, with fears over a break-up leading to mothballed investment decisions, higher funding costs for banks and fewer export opportunities.
This is a questionable interpretation of recent events since it skates over the impact of government decisions on the domestic economy – infrastructure cutbacks on the construction sector and the increase in VAT on consumer spending, for example – but Osborne’s intends to stick to his story that his attempts to remedy the ills of the structurally flawed economy he inherited from Labour have been hampered by events on the other side of the Channel.
Blaming Gordon Brown for 50% of his troubles allows the chancellor to reject calls from the Keynesian left for a package of tax cuts and spending increases to tackle the economy’s demand deficiency and weak investment. Osborne is convinced that this would be simply a sugar rush and that firms, fearful of an even tougher deficit-reduction plan in the future to pay for the fiscal stimulus, would continue to hunker down and that the financial markets would exact a heavy price for the backsliding on deficit reduction.
Blaming the other half of his woes on the eurozone enables Osborne to deflect criticism from those on the right demanding that he respond to the stagnation of the economy with even deeper spending cuts. The Treasury divides the deficit into two parts: cyclical and structural. The cyclical bit should disappear when the economy finally recovers from the recession; the structural bit will remain even when growth has returned to its long-term trend. His fourth assumption, therefore, is that the damage caused to the economy from the double-dip recession is temporary rather than permanent.
There will be no big stimulus package this autumn, although the Treasury is looking at ways of making public spending “growth rich” while leaving the deficit-reduction plan unchanged. This idea has been backed by the International Monetary Fund and involves saving money on the running costs of government (current spending) and allocating it instead to public investment projects (capital spending). Housing, the sector that helped drag the UK out of the recession in the 1930s, will be targeted.
Assumption No5, therefore, is that the Bank of England will do the heavy lifting when it comes to stimulating the economy. Even though Threadneedle Street has already bought up a third of UK gilts (government bonds) through its quantitative easing programme, Osborne does not think monetary policy is now “pushing on a piece of string”. The mix of policy will continue to be fiscal conservatism and monetary activism, which raises the question of whether the Treasury will grant the Bank powers to buy up a wider range of assets, including corporate bonds.
Sir Mervyn King has always said that this is a political decision since it would involve deciding which companies should benefit from actions designed to drive down borrowing costs, but that if Osborne wants to sanction such a move the Bank would act as the Treasury’s agent.
Would the chancellor be prepared to take this step? Well, attention is being paid to the debate raging in the economics profession about the merits of replacing inflation targets with nominal GDP targets. This sounds esoteric but actually has big implications for the conduct of monetary policy, with its supporters saying it provides a way of recovering the output lost since the start of the crisis and its opponents warning that it will lead to inflation raging unchecked.
In normal circumstances, the value of all the goods and services produced by the UK economy increases by around 5% a year. Part of this is a real increase in output and part of it is inflation. The Bank of England has a target of keeping inflation at 2%.
Under a nominal GDP target of 5%, the split between real output growth and inflation would be of no consequence for the Bank’s monetary policy committee. It would follow expansionary policies if nominal GDP growth were below 5% – and contractionary policies if it were above 5%. Over the past year, the Bank would have been under pressure to ease monetary policy more aggressively because nominal GDP growth has been 3%. That would have meant more quantative easing sooner and the purchase of a wider range of assets.
Osborne is not about to ditch the inflation target, even though it would be perfectly justifiable to look at the monetary policy regime given its failure to prevent the buildup of dangerous imbalances in the economy in the runup to the crisis. But the interest in nominal GDP targeting suggests monetary activism will be stepped up as early as this autumn. Why? Because Osborne’s final assumption is that there needs to be solid evidence of recovery by this time next year if David Cameron is to avoid being a one-term prime minister.