Sunday, January 27, 2013
Financial hangover is Britain's biggest growth headache
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.

Thanks to Friday’s figures, gross domestic product once again dominates the agenda. The GDP numbers, showing a 0.3% drop in the fourth quarter of 2012, completed a year in which Britain’s GDP was exactly flat, both comparing 2012 with 2011 and the fourth quarter of 2012 with the corresponding quarter of a year earlier.

Squaring that with another measure of how the economy is doing, the 552,000 rise in employment over the past 12 months, the biggest since the late 1980s’ boom, is hard to do. Squaring it with a 113,000 rise in full-time employment in the September-November period is as challenging.

The fact that GDP fell owes a lot to energy shutdowns, which reduced it by 0.2% over the quarter and a drop in "sporting activities" (you can't have the Olympics every quarter) which had a similar effect. Even so, when the economy is weak enough to be pushed off course by such factors, it is weak.

So GDP it is. Does its weakness mean, as Olivier Blanchard, chief economist at the International Monetary Fund has suggested, the government should re-think its austerity plans by the March budget?

No. The IMF is a strange body. Christine Lagarde, its managing director, has been something of an international cheerleader for the coalition’s fiscal strategy.

Last month the IMF published a working paper by three of its economists, Anja Baum, Marcos Poplawski-Ribeiro and Anke Weber, showing that the impact of tax increases and spending cuts on Britain’s economy, so-called fiscal multipliers, is very small.

Blanchard has a different view, which the Treasury is not taking too seriously because, though he is chief economist, his is not the IMF view. Whether or not the IMF does recommend a change of strategy we will not know until May, and its next detailed consultation, known in the jargon as an Article IV consultation.

It looks unlikely, not only because that work on the multipliers suggests austerity is not to blame, but also because the government has not tried to stick to deficit reduction willy-nilly. In the face of weaker growth it allowed borrowing to take some of the strain, allowing what economists call the automatic stabilisers to operate.

So why is GDP growth so weak? A paper by economists from Liverpool and Manchester universities, to be presented at the Royal Economic Society’s annual conference in April, argues strongly for a financial rather than a fiscal explanation for the slow recovery.

The most striking result from the research, which chimes in with the IMF’s detailed work, is how little difference the coalition’s austerity has made to growth. You cannot raise taxes and cut spending without some impact on growth. The point is that this impact has been small.

The economy has grown by roughly 0.5% a year since the coalition took office. In the absence of austerity, it would have grown only a little more strongly, perhaps 0.75%, the research suggests. The unemployment rate would have been a fractional 0.1 points lower annually.

Given the risks Britain faced if there had not been a programme to cut the deficit - the danger was of a full-blown fiscal crisis - this is a small price to pay.

The paper, The Impact of Stock Market Illiquidity on Real UK GDP Growth, by Chris Florackis, Gianluigi Giorgioni, Alexandros Kostakis and Costas Milas, focuses on the key role of liquidity - the availability of funds in the banking system and elsewhere - in Britain’s recent performance.

The drying up of liquidity in 2007, when the financial crisis hit, was a key factor in the severity of the recession. By the same token, it has been a significant constraint on recovery.

The Bank of England, responding to the crisis by providing liquidity to the financial system, and through quantitative easing, has tried to offset the liquidity drought and credit crunch. It has not, however, been able to eliminate the financial hangover.

Sir Mervyn King, in Tuesday’s final regional speech as Bank governor, in Belfast, barely mentioned fiscal policy as a factor in the slow recovery. Instead, as well as the high-inflation squeeze on real take-home pay and the eurozone, he focused on another financial factor.

The problem, he said, was “the extent to which the balance sheets of the major UK banks had grown before the crisis hit, and had been financed primarily by borrowing.

“So the subsequent reduction in bank lending – the deleveraging – was greater here than in many other countries. That deleveraging has as its counterpart a reduction in the amount of (broad) money in the economy and a reduced willingness on the part of banks to expand lending.”

These effects - the financial hangover - were predicted in one of the most important books of recent years, This Time is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Kenneth Rogoff.

It demonstrated that not only are banking and financial crises more common than we think but that they also lead to far deeper downturns and slower recoveries than normal cyclical recessions.

Rogoff is a former chief economist at the IMF who speaks sense. There is a debate among economists, particularly Americans such as Robert Gordon, about whether the West has reached the end of growth, because the technological progress that has driven living standards for 250 years has, no pun intended, run out of steam.

Rogoff does not believe that, though does think there is a risk the malaise we are suffering after the financial meltdown undermines long-run prospects. One danger is if new businesses that typically drive innovation and new products are strangled at birth by lack of credit.

When I asked him about the dilemma of economies such as Britain caught in a Reinhart-Rogoff slow recovery, he was clear that the solution does not lie on the fiscal side, or at least not with a fiscal stimulus.

The government, he said, could to shift resources to those areas of spending which boost long-term growth, such as infrastructure and education, and away from what he describes as entitlements. George Osborne has been trying to do a bit of this.

What the government also has to do is avoid getting to what he describes as the “rarefied air” of government debt rising above 90% of GDP. Britain has passed an important milestone, according to figures released last week, with public sector net debt rising from 69.3% of GDP in November to 70.7% in December, thus rising above 70% for the first time since the early 1970s.

Get above 90%, says Rogoff, and you get lower growth on a sustained basis that can last for decades. The financial hangover would be compounded by a fiscal millstone. That has to be avoided.