Sunday, September 13, 2009
Spending cuts won't stop the recovery
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Recessions usually end with a whimper rather than a bang. They peter out as downward momentum fades and the levers turn from negative to positive. What was a torrent of bad news becomes matched, then bettered, by good news.

That is the process we have been going through for a few weeks, as I noted a fortnight ago in my piece on the stock market. The National Institute of Economic and Social Research estimates that the economy hit bottom in May, which chimes with surveys such as those from the purchasing managers.

Industrial production figures from the Office for National Statistics (ONS) gave a solid hint that it will declare the recession over next month, when releasing its first estimate of third-quarter GDP.

You cannot rule out the ONS bowling another googly, as it has a few times recently, but the evidence is against it. Industrial production, on which it has the fullest information at this stage, is significantly above its second-quarter average and service-sector surveys have been upbeat.

A return to growth now will tell us a few things. On currently available information, the recession has been twice as bad as in the early 1990s but not as severe as in the 1980s. The proviso, which I repeat, is that recent figures are likely to be revised up.

A positive GDP number this quarter will also mean that, despite everything, the recession will have been of normal length five quarters. Its unusual feature was the "falling off a cliff" moment between October and April, for Britain and many other economies, as global trade collapsed. UK GDP fell 4.2%, a record over two quarters.

For many months I have been talking of the battle between the banking shock and the aggressive policy stimulus, particularly big cuts in interest rates but also quantitative easing. I thought the stimulus would win out in the end, and it has.

Now the question comes on to how sustainable the upturn will be. That is worth a series of articles and I shall return to the banks and what happens when the monetary policy stimulus comes off.

This week, however, let me address it in the context of the topic of the moment, public spending. The government's tone on spending has shifted, thanks to the efforts of Alistair Darling.

Instead of Gordon Brown's "investment versus cuts", the debate is "our cuts will be less damaging to services than yours". The chancellor, giving the James Callaghan Lecture in Cardiff, made the point that the state's enabling role in the economy does not apply only in times of crisis. On spending, though, he used the "c" word: "more efficiency, continuing to reform, cutting costs", which is a step in the right direction.

In the Treasury, the public-spending division is working at full pelt, going through programmes. There will be no comprehensive spending review and all that is certain in the autumn pre-budget report is that the spending "envelope" will be extended for another year until 2015. The official machine, however, stands ready to cut.

David Cameron promised a 120m cut in the cost of parliament, neither here nor there in the grand scheme of things but designed to show intent. George Osborne, shadow chancellor, has promised to learn lessons from councils that have cut spending without undermining services.

The shift in the political debate is welcome, and makes the loss of Britain's AAA sovereign debt rating even less likely. Outside government, meanwhile, the spending debate is intensifying. The Institute of Directors, with the Taxpayers' Alliance, have proposed more than 30 measures that would cut public spending by 50 billion.

It does not sound much when public spending is 671 billion but it shows how tough the choices may become. Labour sacred cows such as Sure Start and Building Schools for the Future would go and spending on private consultants would be halved, something that might not go down too well with all members of the Institute of Directors.

This week the Institute for Fiscal Studies will set out options involving tax rises, general reductions in spending and specific cuts in welfare to reduce the deficit. Robert Chote, its director, points out that the battle between the Tories and Labour over who will tighten first is rather phoney.

Even without further surgery, Treasury plans imply departmental spending will rise only 3.2 billion, or 0.7%, in 2010-11. Allowing for inflation, that means real cuts. The government needs recovery to be established or risks being accused of cutting when the economy can least take it.

This raises a general point. Can public spending be tightly restrained without seriously undermining recovery? Has not Britain become so dependent on the government that once the taps are turned off the economy will be becalmed?
The answer is no and, indeed, periods when public spending has been held down have tended to be times of good economic growth.

Looking back on the recent past, the arithmetic tells us that even when public spending is rising strongly, it makes a modest contribution to growth. 2000 to 2008 was Gordon Brown's "splurge" period, when public spending grew roughly 4% annually in real terms, well above the economy's overall rate of about 2.5%.

Over that period, GDP rose 224 billion, just over 20%, in real terms. Government spending rose by just over 50 billion. It contributed only just over a fifth of growth even when ministers were spending fit to bust. This kind of static comparison, more-over, probably overstates the public contribution. Had spending not risen, and the taxes needed to pay for it, private-sector growth could have been stronger.

This is the way to look at it for the future. A paper by Goldman Sachs, called Fiscal Consolidation and the Exchange Rate, argues that in an open economy like Britain's, public-spending cuts affect the composition of economic growth but not its pace. This is because sterling is a safety valve.

A tightening of fiscal policy, accompanied by a weak currency, means that what you lose in government spending, you gain in exports. Sterling is well below fair value against the euro, so this effect is ready to roll as the global economy picks up.

Nor is this just theory. "It is worth looking at what happened to the economy the last time the UK tightened fiscal policy aggressively, during the mid-1990s," write Ben Broadbent and Adrian Paul of Goldman Sachs. "It performed well.
Coming out of deep recession, and aided by a small acceleration in eurozone activity and a big decline in the currency, investment and exports bounced strongly. Aggregate demand grew by 3.5% a year."

This time it may be different, for other reasons. But we should not worry unduly that putting the brakes on public spending will kill recovery.

PS: The reviews were mixed but I enjoyed last week's BBC2 drama The Last Days of Lehman Brothers. While it featured a lot of British actors playing Americans, and doing so rather well, I did not spot any British characters. The nearest was when Hank Paulson rang Alistair Darling to check whether Barclays would be allowed to buy Lehman, but we only got the former US Treasury secretary's side of the conversation.

This may have been because the casting challenges were too great. Who would you get to play convincingly Gordon Brown, Mervyn King or Darling? Even Rada's finest would struggle. Unless, of course, you know better. Suggestions welcome, and I have some crunch-related books as prizes.

From The Sunday Times, September 13 2009