Sunday, April 25, 2010
Recovery mountain is not as steep as it looks
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


There was something for everybody in Friday's gross domestic product figures. Growth of 0.2% was weak enough for Labour to say that the economy is too fragile to be entrusted to the Tories, while the opposition parties could retort that if this is the best upturn the government can achieve, it is pretty feeble.

The truth is that 0.2% was not bad in the context of weak, snow-affected January data, and the certainty that the Office for National Statistics will revise these figures. A double-dip recession has been avoided in the quarter when the risk was greatest.

Politicians love talking about growth, not least because it is a lot more palatable than the alternative. So in the past few days we have had Labour's growth strategy basically a rehash of the budget and the ongoing spat between the two main parties, if that is not now an obsolete expression, about which of them poses the biggest risk of a future double-dip.

More on that in a second, but it is clear from the International Monetary Fund's latest world economic outlook that the politicians who really have something to shout about on growth are a long way from here. The IMF has China growing 10% this year and next, India at 8.8% and 8.4% and Brazil 5.5 and 4.1%. But it is far from gloomy on Britain, despite a modest downgrade for 2011. Growth of 1.3% this year and 2.5% next is comfortably better than the eurozone and the average for advanced economies.

The Ernst & Young Item club predicts 1% and 2.7%, followed by 3.4% in 2012. The consensus among independent forecasters lags behind these and the Treasury and Bank of England, at 3% next year. Even so, forecasters see 2011 growth above 2%, and that consensus has been rising.

This, it should be said, is at odds with the more downbeat view many in business, and some in financial markets, have about recovery. Many fear a double-dip, or they worry that the economy will chug along, failing to achieve take-off speed.

The "no-growth" argument is straightforward: if the spending cuts do not get us, tax rises will. So public spending cuts will kick one important prop away from growth and employment, while higher taxes will squeeze household incomes more tightly, discourage businesses from investing, and leave the economy in the mire.

In the great non-battle over the economy in the election, though we are promised 90 minutes on it in this week's final leaders' debate, it has all come down to 6 billion. Economists and businessmen have locked horns on either side.

Thus, Labour peer Lord Layard and the former Tory peer Lord Skidelsky got nearly 80 economists to sign a letter warning that an additional 6 billion of spending cuts this year would be dangerous.

Against them have been the large group of businessmen backing Tory policy with Sir Terry Leahy, the highly successful Tesco chief executive, conspicuously not among them which warned that the real 6 billion threat was in 2011 when Labour's National Insurance (NI) rise comes in. The truth is that, while you would rather the fiscal pain occurs when the recovery is better established, this is a sideshow. Economists who predict the UK numbers expect growth of 1% or so this year even if the Tories manage to find their first-year cuts, and predict growth of more than 2% in 2011 even if the NI rise for employers and employees goes through in its entirety.

Where the Tories are right is to focus more of the deficit reduction on spending cuts rather than taxes. They would do it 80%-20%, whereas Labour's would be something like 66%-33%. All the evidence is that the greater the weight of deficit reduction that falls on spending cuts, the more durable and least economically damaging it is.

Are economists right to be so sanguine about recovery in the face of a fiscal squeeze of well beyond 6 billion?

One of the big fears is about jobs, an area where there is a lot of misunderstanding. On the face of it, the only thing that has stopped a much bigger rise in unemployment than the current 2.5m (widely expected to be 3m or 3.5m) has been public-sector employment, up nearly 350,000 to 6.1m during the recession, while private-sector jobs have declined by some 1m to 22.76m.

Two-thirds of the apparent rise in public-sector employment, however, is the reclassification of employees of state-aided banks such as RBS and Lloyds from private to public sectors. Adjusting for this gives a more modest rise in public-sector jobs and somewhat less of a private-sector fall.

What about a future in which, according to the Chartered Institute of Personnel and Development, 600,000 public-sector jobs could go in the next few years? All we can do is look at a little history. In the 1990s, public-sector employment was cut from 5.8m to 5.1m, yet this was more than compensated for by rising private-sector jobs. Taking the 16-year upturn that ended in early 2008 as a whole, all the net new jobs created, 4m, were in the private sector.

It will take time, because there is a lot of job slack within firms, but Britain is good at creating jobs, and recovery will see that happen, notwithstanding public-sector cutbacks. The first half of the 1990s saw the economy growing at a good pace in spite of significant tax increases and, as now, sluggish growth in what today is the eurozone.

So the recovery can cope with a significant fiscal tightening, particularly when the world economy is strong. That, however, is not the only risk. Kenneth Clarke is one of my favourite politicians and I have never really seen him as an attack dog. I am prepared to believe, when he warned a hung parliament could mean Britain calling in the IMF, it was with a twinkle in his eye. He was in the Commons in the 1970s and knows that when Britain did call in the IMF in 1976 we did not have a hung parliament and that the balance-of-payments support Britain required then is not needed now. Economic crises in Britain are no respecter of majorities. Sometimes, as in 1931, a coalition government was the political solution to the crisis.

That said, it is possible to sketch out a scenario in which there is a risk to the recovery. Inflation, at 3.4%, is higher than the Bank's monetary policy committee (MPC) is comfortable with. A further big fall in sterling, prompted by a long period of post-election political uncertainty, could be too much for the MPC to bear.

The economy can cope with a fiscal tightening. Adding a monetary tightening into the mix higher interest rates would be a different matter.

PS: Talking of the IMF, its proposals for new bank taxes raise challenging questions, one of which, plainly, is whether there will be agreement on this at the G20 leaders' summit in Toronto in June.

Another is where the money goes. The IMF proposed two new taxes, a "financial stability contribution", a levy to meet the cost of future bank bailouts, and a "financial activities tax", the Fat, on bank profits and remuneration.

This tax is intended to go into general revenue, to be spent as governments see fit, while the IMF's preference for the levy is that it go into a ringfenced fund to be used in the next banking crisis, though it concedes (as all UK political parties prefer) it could also go into general taxation. Either way, it would "pay for the fiscal cost of any future government support to the sector".

There was no such levy before the crisis but, to play devil's advocate, you could argue that the huge tax take from Britain's financial sector, poured into public services, could have been used in part to make sure the public finances were in good enough shape to cope with a crisis. Can we have any confidence that, even with new bank taxes, this will be the case in future?

To play devil's advocate again, the tax and regulatory backlash against bankers must not happen in a way that either provokes a new crisis or seriously undermines recovery. Revenge is sweet, but not when it rebounds in your face.

From The Sunday Times, April 25 2010