Taking the wrong road to recovery

Investment, not cuts, is the key to rebuilding the nation’s finances and creating jobs, says Michael Burke

The opposition parties have been attempting to outdo one another in their fervour for “savage cuts” in public spending. Nobel Prize winner Paul Krugman is right to state that such policies will make the recession worse. They are also deeply unpopular electorally. Yet this thinking now appears to be part of a growing consensus that includes the Labour frontbench.

The economic debate in Britain has become dominated by the budget deficit – that is, the gap between government revenues and expenditure. This is a grave mistake. The deficit is a symptom of the current economic crisis, not its cause. To reverse the widening of the deficit, policy should be aimed at reviving economic activity. Only an increase in activity – and the taxes that come with it – can revive the economy and restore government finances.

The recession just ending is the sharpest one in Britain in the post-Second World War period. Even now, many commentators continue to fret over the possibility of a “double-dip” recession – a return to economic contraction after a brief interlude of growth. This is a genuine concern as the effects of lower interest rates wear away and stimulus measures are withdrawn. Worse, the emerging political consensus in favour of spending cuts, which is almost unique to this country, is certain to depress activity once more.

The driving force of the recession has been the slump in investment (gross fixed capital formation). Investment has fallen at a rate more than three times as fast as the aggregate decline in gross domestic product. Actual GDP peaked at £1,343 billion (annualised) in the first quarter of 2008 and has fallen by £81 billion since. Investment peaked one quarter earlier, at the end of 2007, and has since fallen by £47 billion. In addition, business inventories have fallen by a cumulative £13 billion over the course of the recession. Taken together, the decline in investment and in inventories amounts to £60 billion – or three-quarters of the entire decline in GDP.

Of course, other areas have been hit hard, notably household spending – down by

£31 billion. But the decline in this category is 3.7 per cent and is dwarfed by the 19.1 per cent decline in investment. At the same time, government spending has also slightly offset the ferocity of the recession. However, the real increase in expenditure has been minimal, at £6 billion, compared to the £81 billion fall in aggregate output.

Investment forms the basis of all future prosperity. The recession is an investment-led slump in activity. Therefore, both Britain’s immediate and medium-term economic outlook depend on a revival of investment.

The yawning gap in the budget deficit is caused by the severity of the downturn and is overwhelmingly related to the decline in taxation revenues. Since 1997, taxation revenues have grown at an average annual rate of over 5.6 per cent a year. Without a recession, on this trend, tax revenues would be £612 billion in the current financial year, compared to a projection from the Treasury of £498 billion. The difference between the trend level and the Treasury projection for this year amounts to £114 billion. This represents the overwhelming bulk of the Treasury’s projection for the entire budget deficit of £128 billion.

In the clamour to cut public sector spending – including jobs and pay, as well as services – this key fact has been overlooked. The rise in the deficit is almost entirely due to the slump in taxation receipts, not some allegedly reckless increase in government spending.

It is clear that a sharp increase in government investment could tackle the twin problems of the recession and the deterioration in government finances.

In fact, public investment is set to be 3.5 per cent of GDP in the current financial year, a cumulative rise equivalent to 1.8 per cent of GDP since the recession began. This modest level is actually the highest level under this Government. But it is a wholly inadequate response, as it is less than half of the decline in private investment. It is also planned to fall back to 2.7 per cent next year and back below 2 per cent in subsequent years.

Thatcherism saw a decline in the growth of government investment to 1 per cent. The increase under this Labour Government has been 1.5 per cent – barely above the rate of depreciation. Yet, from 1963 onwardsuntil Thatcherism, growth in government investment averaged 5.25 per cent per annum. A return to something like those levels is currently required.

Businesses do not have a magic wand. When they invest, it is to achieve a higher return than the capital deployed and usually much higher than the initial capital outlay. Government can do the same. In the jargon, these are called the “fiscal multipliers”. According to the Treasury model, government spending is the most effective of these – nearly three times as powerful as cutting VAT, which was itself a useful initiative. The Treasury analysis shows the effect of the multipliers rising in the second and third years, so that a £1 billion rise in government spending raises total economic activity by £1.4 billion in each of those years.

The impact of the stimulus can often persist over a great many years. In addition, these Treasury estimates are only averages derived from long-term experience. Most research is agreed that the effectiveness increases when any of the following conditions apply: when there is large unused capacity in the economy, when interest rates are low and when access to credit is hampered. All these conditions currently apply, so the effectiveness of any stimulus measures currently would be significantly increased.

All this increased activity provides increased taxation revenues. Again, the Treasury has estimates of how much. Over two years, every 1 per cent increase in GDP will lead to an improvement in both the level of public sector borrowing and the budget deficit of just under 0.75 per cent of GDP. To take the year two effect alone, government spending equal to £1 billion produces an increase in activity of £1.4 billion, which in turn produces a reduction in the budget deficit of £1.05 billion (1.4 multiplied by 0.75). It should be stressed these are only averages. In current crisis conditions, the returns are significantly higher.

Investment not only revives economic activity, by doing so it reduces the cause of the deficit, the slump in taxation revenues. Reflationary policies have been adopted by countries all across the world. According to the International Monetary Fund, Britain is the only G20 economy that has not announced discretionary stimulus measures for 2010.

A crucial fact is that these multipliers also work in reverse. That is, spending cuts depress economic activity even further and so push taxation receipts down. This was the experience of the 1930s, where a policy of public spending cuts was a contributory factor in the Great Depression. This is why Paul Krugman says David Cameron’s policies are “just wrong”. They are wrong and their adoption by Labour does not make them any less damaging.

The alternative is investment, which will revive economic activity, get people back to work and produce a sharp improvement in government finances.

http://www.tribunemagazine.co.uk/2010/01/29/taking-the-wrong-road-to-recovery/