Sunday, June 30, 2013
Osborne's slow march to a smaller state
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Gathered in a single room were several former chancellors, as well as the current one and his shadow, the only surviving former Bank of England governor, and very many current and former Bank and Treasury officials, including most who have served on the monetary policy committee.

The occasion, of course, was Sir Mervyn King’s retirement, and if you wanted to put together a collection of people who have tried to manage the ups and downs of Britain’s economy over the past three decades, last week’s would be hard to beat, though Gordon Brown, surely invited, would have been a useful addition.

I feel I have lived with these people during the rollercoaster ride. We have held hands, though usually not literally, during the scarier moments. All the economic expertise assembled in that room would, however, struggle to explain fully the economy now.

New gross domestic product figures from the Office for National Statistics have deepened the puzzle. They showed the double-dip recession of late 2011 and early 2012 was revised away, as long predicted here. The bigger story, however, was that as things stand the economy is even further below pre-crisis levels of GDP than we thought.

The ONS now believes, thanks to what it regards as more accurate corporate data, the economy’s plunge off the cliff in late 2008 and early 2009 was even more dramatic than it seemed at the time.

So GDP fell by 7.2% from peak to trough (compared with the 6.3% previously estimated), and in the first quarter was 3.9% below its level in the first quarter of 2008, compared with the previous estimate of 2.6%.

Think about that 3.9% for a moment. Let us round it to 4%. The five years of deep recession and modest recovery from the first quarter of 2008 to the first quarter of 2013 have left the economy 4% smaller than it was. Though its composition has changed, employment is up by nearly 1% over the same period, hence the sharp drop in productivity: output per worker.

Had the economy grown in line with its 3.2% average in the 10 years before the crisis, it would now be 17% bigger than it was in early 2008. Had it grown at a more modest 2% rate, it would be over 10% bigger. It did not, and the gap between what might have been and what is - equivalent to as much of a fifth of GDP or more than £300bn - is enormous.

We are where we are, or at least until the next big set of ONS revisions, so what does it tell us? The people gatrhered in that room have seen pretty well all variations of economic policy. The current mix of very loose monetary policy and tight fiscal policy is not unprecedented, but the extent of it, on the monetary side at least, is.

George Osborne’s spending round did not contain anything that will affect the short-term economic outlook. It confirmed, however, that the road back to fiscal health is a long and difficult one.

The spending round, with its additional £11.5bn of cuts, covered only the 2015-16 fiscal year. Even that year, when public spending is set at £745bn, it will be the equivalent of 43.1% of GDP. The 40% of GDP target that any Tory chancellor would normally regard as the maximum acceptable level of spending, will not even be achieved, on present plans, by 2017-18, when the level will be equivalent to 40.5% of GDP.

By then, even on these figures (which will surely change), a decade of austerity will have only got us back to where public spending was in 2007-8, the eve of the crisis, 40.7% of GDP. For 10 years, Britain will have been spending more than, on any reasonable estimate of the tax base, the country can afford, hence the big rise in public sector debt. Some of that spending has been hard to avoid, but it is still a sobering thought.

How sobering is it? There were three things in Osborne’s statement that could make a difference over the long run: the annual cap on welfare spending, from April 2015, to be policed by the Office for Budget Responsibility; the merging of health and long-term care and the ending of automatic, so-called progression payments in the public sector.

Each of these provides the opportunity, in the next parliament rather than this one, to exercise proper long run control of spending, in the way that countries like Canada have done but Britain has so far failed to manage. The weakness of the welfare cap is that it excludes most pensioner benefits, but it still leaves the possibility that the failure in this parliament to make serious inroads into the overall level of spending will not be repeated in the next one.

There is another consequence of the latest decisions. They mean the government is already well on the way to achieving a smaller state in the non-ringfenced areas of spending: most departmental spending excluding health, schools and overseas aid. If a combination of stronger growth and the new welfare cap were to mean that this huge element of spending is controlled or cut, it is possible that Britain’s public finances could look healthy in a few years’ time, with a smaller and more affordable state and borrowing under control. There are a lot of “ifs” in that but it is something to hope for.

What about that loose monetary policy? Should it, under the new Bank governor Mark Carney, be even looser. Some City economists have seized on the new GDP figures as evidence that there is more room for the Bank to act with additional quantitative easing (QE) than was thought.

After all, an economy languishing 4% below pre-crisis levels has an enormous amount of catching-up to do, and a lot of spare capacity. The output gap, a measure of that capacity, is bigger than we thought.

Tie that to the fact that in the past three months, the yield on 10-year gilts (UK government months) has risen from 1.7% to roughly 2.4% - and the one proven effect of QE is to get those yields down. You could make the case, on these two factors, for restarting the QE programme this week.

It is possible but it would make me very uneasy. The ONS revisions represent a change in our view of economic history, not the pace of the current recovery, which is unaffected. A monetary policy change driven by a revised view of what happened 4-5 years ago would be odd, and we are many years away from the last official word on what is happening now.

As for the rise in gilt yields, I repeat what I said last week. That rise is due to the markets’ reaction to Ben Bernanke’s very broad hints that the Federal Reserve will taper its asset purchases in the coming months. Bond yields have to normalise at some stage. As long as it does not get out of hand, that process should be encouraged, not artificially halted.