Sunday, September 25, 2011
Which pump to pull to rescue the recovery?
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Scary. The International Monetary Fund, determined not to get caught out as it was when the crisis hit three years ago, has been daily sounding the alarm. The global economy, it says, is in “a dangerous new phase”, while Christine Lagarde, its managing director, warns that the path to continued recovery is narrower than three years ago.

The IMF thinks chances of a new recession are as high as 38% in the US, 18% in France and 17% in Britain. Purchasing managers’ surveys point to a eurozone on the brink of recession. Resolving its crisis in a climate of growth was hard. Doing so in recession is much harder, notwithstanding George Osborne’s warning that its leaders have six weeks to save the euro.

The economic solution, in the form of “shock and awe” from the European Central Bank and an enlarged European Financial Stability Facility, recapitalisation of Europe’s banks and medium-term restructuring of the eurozone (including an eventual Greek exit), is not hard to envisage. The politics of it, however, are horrendously difficult. The eurozone, it goes without saying, is the biggest threat facing the world.

There are caveats. The IMF’s forecast for global growth, 4% this year, and 4% next, is a long way from recession. That figure is not as perky as last year’s 5.1% expansion but is in line with the global economy’s long-run trend. The IMF thinks there is only a 1 in 10 chance of new global recession, which it defines as global growth of less than 2%.

So there is growth. The trouble is that it is not in countries like ours. Western economies will grow by 1.6% this year, 1.9% next, the IMF says, while emerging economies will grow by 6.4% and 6.1% respectively. Rarely has the growth gap been so wide.

Britain’s projected growth rates, 1.1% and 1.6%, are not the worst in the advanced world but are clearly not the best. The question is, what should be done about it?

Three things have happened to spice up the debate. The first is that, as a result of some detective work by the Financial Times and speeches by Robert Chote and Spencer Dale, respectively chairman of the Office for Budget Responsibility and chief economist at the Bank of England, doubts have grown about the amount of spare capacity in Britain’s economy.

The “output gap” is not something they talk about at the Dog and Duck but is meat and drink to policymakers, and worrying if it has got smaller. The FT’s assessment, an attempt to anticipate the OBR’s fiscal verdict on November 29, was that it has and that a £12 billion black hole has opened up.

The second development was that talk emerged at the Liberal Democrat conference of a £5 billion capital spending boost by government. While stamped on by the Treasury, the debate is opening up.

The third thing was that, short of Sir Mervyn King standing atop 1 Threadneedle Street with a loud-hailer, the Bank of England gave the clearest signal it is moving to another round of quantitative easing.

Let me take fiscal policy first. A £12 billion black hole followed by talk of a £5 billion stimulus is confusing, particularly when followed by record August public borrowing and a big downward revision, to £136.7 billion, in the 2010-11 borrowing total. As Geoffrey Dicks oif Novus Capital pointed out, this is £40 billion less than the Treasury was predicting two years ago.

Why is spare capacity, the output gap, important in this context? Because George Osborne’s main fiscal rule is to eliminate the so-called structural current budget deficit. That is a mouthful but, put simply, if you believed there was no spare capacity now, the actual budget deficit would be the same as the structural deficit. The bigger the output gap, the more the deficit reflects the economy’s temporary weakness.

The issue has arisen because productivity, which fell sharply in the recession, has failed to recover. The economy has lost its mojo. It is good firms are hiring workers rather than squeezing more out of existing staff, but it points to an economy that has less spare capacity than thought.

The OBR’s Chote, whose job it is to adjudicate on the fiscal rules, said he had expected the output gap to be 3.9% of gross domestic product now, or more. But the evidence is that spare capacity is less than this. If the OBR becomes pessimistic on the output gap, it could find itself in November telling the chancellor he has to raise taxes or cut spending further to meet his rules.

I don’t think that will happen. Chote, as I think he was hinting, is not going to bet the ranch on very uncertain estimates.

The upshot, however, is that there is also no room for Osborne to offer any stimulus in tax cuts and extra current spending. Is there room to boost capital spending? The argument here is that the government can do this because its fiscal target is set in terms of current spending and revenues, not capital spending. Sadly it is not so easy.

The government’s other rule is that debt is falling as a percentage of GDP by the end of the parliament. This means getting borrowing to around about 2% of GDP from 9% now. You might get away with a bit more capital spending and achieve that, but not much.

I repeat that the way to boost infrastructure spending is to recycle savings on debt interest and anything else that can be extracted from current spending. There is an argument for issuing dedicated infrastructure bonds but problems over the private finance initiative suggest the government will not grab at that.

So, in terms of pressing the growth levers, we come back to the argument in favour of targeted capital spending, not a broad-based fiscal stimulus, unless Osborne abandons his rules.

What about quantitative easing, the case for which has “significantly strengthened”, according to the Bank’s minutes? A research note in its quarterly bulletin suggested the first £200 billion of easing, mainly buying gilts, (government bonds) was equivalent to cutting Bank rate by 1.5 to 3 percentage points and boosted GDP by between 1.5% and 2%.

If £200 billion can do that, how much would £400 billion, £500 billion or £1 trillion do? Osborne is in favour, as is Vince Cable. So is Sir Richard Lambert and other ex-MPC members. With an economic impact like that, it looks like a no-brainer.

But not to me. As well as boosting GDP, the Bank says quantitative easing boosted inflation, by between 0.75 and 1.5 percentage points. That was okay when the fear was deflation, not when it is 4.5% and heading for 5%. The Bank’s chief economist, remember, is worried about spare capacity, which should argue for monetary as well as fiscal caution.

So I shall continue to stand, Canute-like, against the rush to more easing. It is less a magic bullet than a tool to inflate your way out of trouble. It does not boost bank lending. Growth is slow. Sometimes you just have to live with that Of course if the eurozone implodes, all bets are off and every policy option will have to be considered. But we are not quite there yet.