Written evidence submitted by Professor
David Blanchflower
I believe this ill-advised budget is a major
gamble. I suspect it will turn out to be the biggest macro-economic
mistake for a century.
All too soon the government, in my view, is going
to have to reverse course as it becomes clear that the package
of measures will push the UK back into recession. A particular
concern is that no Plan B seems to be ready, if and when the austerity
measures backfire, as they surely will.
I do welcome though reductions in corporation
tax and taxes on SMEs, to get firms investing, and National Insurance
cuts for firms outside the south-east, to aid new hiring. But
these will be cancelled out by additional public spending cuts
of £32 billion a year by 2014-15, plus £8 billion in
tax increases over and above those to which Labour had already
committed itself. It is time to provide the private sector with
much bigger incentives, through tax cuts and subsidies, for additional
hiring and investing, especially in the most disadvantaged regions.
It is the public sector that is doing the work,
crowding in the private sector right now. There is zero evidence
that the public sector is crowding out the private sector as the
government appears to believe. The fragile recovery we are observing
is being driven primarily by fiscal and monetary stimulus. There
is no crowding out, period. The private sector is in no fit state
to enter into the vacuum that would be left by public sector withdrawal.
Monetary policy of course is playing a large
part, with interest rates at 0.5%. Over four million households
on tracker mortgages have ridden out the storm pretty well as
the payments on their mortgages have dropped substantially. Increases
in interest rates would be extremely harmful to the economy in
general and to home owners in particular. There is no room to
cut rates further and it is unclear what impact additional amounts
of quantitative easing would have.
But the MPC should be doing a lot more QE right
now, perhaps by as much as £50 billion immediately. It may
well have to do a lot more than that if this government proceeds
with its cutting programme. The effects of such a large scale
increase in QE remain uncertain though.
Previous examples where countries have made
major cuts in public spending do not seem relevant especially
when bank lending is impaired. Canada implemented smaller cuts
than are being proposed for the UK. That occurred though at a
time when the its neighbour to the south, the United States that
was experiencing the Clinton boom. Plus there was room to cut
interest rates. There is little room to cut rates in the UK as
they are at the zero bound and our major trading partner, the
Euro area, is in danger of slipping back into recession.
There are even signs that the US and China are
also slowing. The Baltic Dry index, which reflects the cost of
shipping dry bulk cargoes has fallen sharply since the end of
May suggests that demand is falling for dry commodities such as
iron ore and coal. Shipping prices continue to fall. The global
recovery appears to have reached a turning point.
GDP GROWTH, EXPORTS
AND IMPORTS
The latest GDP data suggest that the recession
was much deeper than previously thought, with output declining
by 6.4% from peak to trough. The latest data from 2010Q1 show
that household consumption fell while the share of government
spending rose sharply. These downward revisions to the past will
inevitably result n lower output in the future and result in downgrades
to forecasts.
The IMF downgraded its forecast of growth in the
UK based on the budget cuts. The IMF said that Britain would grow
by 1.2% this year, the second-slowest growth rate in the G7 group
and 0.1 points lower than its previous estimate in April. Next
year, it expects growth to pick up to 2.1%, 0.4 points down on
its April forecast and below the 2.3% predicted by the Office
for Budget Responsibility (OBR). Olivier Blanchard, the IMF's
chief economist warned that, "downside risks have risen sharply".
Also last week the Institute of Directors (IOD)
produced its own forecasts of GDP growth, which were even lower
than those of the IMF. The IOD forecast GDP growth of only 0.9%
in 2010 and 1.8% in 2011. Commenting on the economic outlook,
Graeme Leach, their Chief Economist said: "after a very abnormal
recession it would be foolish to rule out the possibility of a
very abnormal recovery as well. A whole host of reasons support
the idea of one L of a recovery."
Fathom Consulting in its most recent forecast
predicts GDP growth of only 0.8% in 2010 and 1.6% in 2011 with
unemployment rising to 8.4% in 2011. The risks to growth however
in their forecast are heavily skewed to the downside, much more
so than elsewhere. In their downside scenario, to which they attach
a 40% probability, UK GDP growth next year is -1% (and a further
¸0.2% in 2012); and unemployment rises to 10% and stays there
through 2012. This is the nightmare scenario that the government
has brought into play. I fear this is where we are headed.
Adding to the worries that downside risks are
starting to come to fruition the new data on exports and imports
are worsening. The OBR in its forecast assumes that net trade—the
balance between exports and imports—will make a big positive
contribution to GDP growth in 2011 and onward. Data on exports
and imports published last week by the ONS suggest this is probably
not going to happen. The trade in goods and services gap widened
unexpectedly to £3.8 billion in May, the worst since July
2008. Exports went up less than £100 million, or 0.2%, while
imports climbed £700 million, or 2.4%.
This is consistent with the most recent Markit/CIPS
manufacturing survey, which showed that export orders dropped
sharply last month. The strengthening pound and weakening of growth
in our major export market, the Euro area, reduce UK exports.
The OBR made it clear that there are considerable
downside risks to its original forecast,
"A major uncertainty relates to developments
in credit and financial markets, in particular whether the banks
are able or willing to supply credit in the amount that is normally
required in the recovery phase of the economic cycle; and, if
not, whether that credit can be obtained elsewhere."
As if on cue, the Bank of England subsequently
reported that the flow of net lending to UK businesses remained
negative in April. The major UK lenders reported that demand for
credit remained subdued. Total net consumer credit flows also
turned slightly negative in April, with the stock of lending little
changed from a year earlier. To put it simply, the banks are not
lending, just as the OBR feared, which will inevitably constrain
growth.
The OBR went on to warn that "another major
area of uncertainty is whether, and to what extent, private-sector
spending and employment are able to fill the gap that the cuts
in public spending in our forecast leave. The prospects for external
demand are also uncertain since the outlook for the euro area
is particularly opaque at this time."
The euro area appears to be heading back into
recession and the austerity measures being introduced in certain
Eurozone countries, especially those in Germany, will inevitably
lower UK growth, too. It is extremely unlikely, therefore, that
net trade will leap to our rescue.
BUSINESS INVESTMENT
AND CONSUMER
CONFIDENCE
In the months leading up to the financial crisis
in 2008, UK data on business and consumer confidence turned well
before other more quantitative measures such as output or employment.
These data were good predictors of the coming decline, especially
in late 2007 and early 2008. This data has the great benefit that
it is timely and not subject to revision.
Monthly reports from the Bank of England's regional
agents show that, from mid-2007, investment intentions across
the UK collapsed, hitting their lowest points in spring 2009.
In their latest report, for June 2010, the agents said that investment
intentions had picked up, "but remained consistent with a
gradual recovery from a low level, rather than a robust pick-up
in spending. Intentions continued to be depressed by uncertainty
about future demand and by the existing margin of spare capacity."
Business investment in the first quarter of
2010 is estimated to be 6% higher than in the previous quarter.
In spite of the quarterly rise, business investment was 11% lower
than in the same period in 2009. Investment in private-sector
manufacturing was down by 1% on the quarter and by 29% on the
corresponding quarter of the previous year. The OBR is forecasting
that business investment will grow by 1.3% in 2010, 8.1% in 2011
and nearly 10% a year on average from 2012-15. It is unclear whether
firms will increase investment, but for the government's Budget
to succeed, it is vital that they do.
As for consumer confidence, it is again
on the wane. The chart plots data from the Nationwide Building
Society's consumer confidence and expectations indices, which
are available monthly. In a survey, respondents are quizzed on
five areas: (1) appraisal of current economic conditions; (2)
expectations regarding economic conditions six months hence; (3)
appraisal of current employment conditions; (4) expectations regarding
employment conditions six months hence; and (5) expectations regarding
total family income six months hence.
The consumer confidence index takes the average
of all five questions, while the expectations index averages questions
2, 4 and 5. Both indices began to fall from around September 2007
and recovered through early 2009, but have since fallen back.
The latest survey, conducted between 19 April
and 23 May, covered the period after the general election and
the announcement a £6 billion spending cut. The consumer
confidence index fell sharply by 10 points to 65. The expectations
index fell even more, by 12 points to 93. This index has now fallen
by 26 points since February. Respondents expected the economic
climate to worsen, which implies lower consumer spending, which
is negative for growth. Other surveys are also downbeat.
WE ARE
NOT GREECE
The government have argued that they need to
implement these draconian spending cuts because (a) the markets
are demanding it and (b) because the UK is Greece.
As Nobel Laureate Paul Krugman has argued, there
is no evidence that the markets are demanding such action and
called such arguments "utter folly dressed up as wisdom".
Countries such as Ireland and Greece that have implemented such
measures have actually seen the markets turn against them as the
measures compromised growth.
The main danger to the UK's credibility is when
ministers spread fear in the markets and talk down the economy.
Harsh cuts in public spending have the potential to scythe growth
and increase unemployment.
Over the last two years the governments have
responded to the financial meltdown by loosening monetary policy,
lowering interest rates, providing extra liquidity, introducing
quantitative easing measures, alongside expansionary fiscal policies.
Yet a number of these countries, mostly in the
euro area, are following Greece and announcing fiscal austerity
measures to tackle rising public debts and lower fiscal deficits.
The IMF has warned against such precipitate action.
Proposing the same medicine in the UK as in
Greece, though at a lower dose, seems a priori absurd, as the
problems are fundamentally different because the two countries
suffer from different pathologies.
The Greek crisis is the result of a steady loss
of competitiveness, reflected in a ballooning trade deficit and
relatively high inflation, and a rapid expansion of public sector
spending.
Greece is characterised by endemic tax evasion,
a poor tax collection infrastructure, parochial patronage policies,
corruption and huge delays in the administrative courts dealing
with tax disputes. This clearly does not resemble developments
in the UK.
The recent increase in the debt burden of the
British economy is driven not by structural inefficiencies, as
in Greece, but from the 2007 financial crisis, the immediate economic
contraction, and the government's expansionary response.
Public debt in Greece is the highest in the
euro area at about 120% of GDP. The country also has one of the
highest fiscal deficits in the OECD, at 14% of GDP. The UK's is
11%.
In contrast, government debt to GDP in the UK
in 2009 was 68%—much lower than the euro area average of
79%. While UK debt/GDP has increased over the past two years by
about 20 percentage points, during the past decade it fluctuated
around 40%-50%. The recent increase mainly reflects a rational
Keynesian counter-cyclical policy in response to the global economic
crisis.
These differences are reflected in government
bond yields. Yields on long-term UK bonds are quite low, 3.32%,
very similar to US Treasury bonds. German bund yields are lower,
at 2.59%, reflecting the lower inflation expectations on the euro
area.
In addition, only 20% of UK debt matures in
the next three years compared with 34% for Greece. The ratio for
the US is around 50% and 40% for Germany. So in contrast to Greece,
the UK does not suffer at all from roll-over risk.
The forecasters' consensus suggests that Greece
will suffer negative GDP growth of at least 4% in 2010 and ¸1%
in 2011. So even if Greece succeeds in its fiscal consolidation
plan the debt burden as a share of GDP will keep rising for the
next couple of years, while the debt to GDP for the UK has already
started falling.
While Greece would surely benefit from the recent
slide of the euro, Greece does not have control of its monetary
policy, which is decided in Frankfurt. In contrast the UK has
exchange rate flexibility, which could prove quite useful in the
adjustment.
Greece also has deep structural problems, mostly
in product markets with oligopolies in almost every industry,
closed professions, administrative and bureaucratic impediments
to entrepreneurship alongside barriers to trade and exporting.
In contrast, the UK economy is flexible, with fewer administrative
burdens.
The diagnosis above suggests that the two countries
are plagued with different diseases. There is zero chance that
the UK will default on its debt. So each country needs a different
treatment.
The UK is demonstrably not Greece.
THE IMPACT
OF THE
BUDGET ON
EMPLOYMENT AND
UNEMPLOYMENT
There has been a debate over the last few weeks
over the potential impact of the Budget on employment and unemployment.
The credibility of the OBR is in question given that its forecasts
appear to have severely underestimated the likely impact on jobs.
In my view their forecasts are overly optimistic. Unemployment
will rise substantially as a result of this ill-considered budget.
Leaked Treasury analysis revealed that George Osborne's
Budget will result in the loss of at least half a million jobs
in the public sector and 600,000-700,000 in the private sector
by the end of this parliament. This was closely followed by an
indication, in a letter to ministers from the Lib Dem Chief Secretary
to the Treasury, Danny Alexander, that the job losses could be
even greater. Alexander ordered government departments (with the
exception of Health and International Development) to identify
possible spending cuts of up to 40%. He also asked departments
to show how they would cut day-to-day administrative costs, excluding
salaries, by 33% at the lower end and 50% at the upper end.
The loss of jobs in the private sector is partly
the result of much private-sector employment being dependent on
spending in the public sector. So cuts in public spending make
people in the private sector redundant—or seriously reduce
the incomes of, say, consultants, many of whom depend on the public
sector for a significant proportion of their work. And yet, the
OBR says, employment will grow from now on. Despite the Budget's
expected destruction of 1.3 million jobs, the OBR projects that
employment will rise by an astonishing 1.2 million between 2010
and 2014. Hence, according to the OBR, the private sector is going
to create about 2.5 million jobs.
Subsequently the Financial Times reported
that the OBR had also put a positive gloss on the employment numbers
by trimming its forecasts for public-sector job losses by about
175,000. The OBR pre-empted the results of the Pensions Commission
by assuming lower pension contributions and reduced promotions
for public servants, even though the government hasn't announced
such a plan. Both assumptions cut the job-loss figure. Meanwhile,
policy initiatives that would lower long-term growth and increase
unemployment were excluded.
Let's look at why the OBR's forecast is overly
optimistic. First, job growth of this kind is unprecedented in
the private sector. According to the Office for National Statistics,
between the first quarter of 2000 and the first quarter of 2008,
when the latest recession began, the private sector created 1.6
million jobs, at a time when the economy was booming.
Most of the job growth up to 2008 was in financial
and business services and construction, along with the public
sector. This seems highly unlikely to be repeated over the next
five years. (Note that RBS and Lloyds are included in the public-sector
estimates from December 2008 onwards.)
The coalition's austerity measures have already
hit business confidence, according to the Chartered Institute
of Purchasing & Supply's latest services survey. Business
expectations dropped to a 15-month low in the single biggest month-on-month
fall ever recorded. It is hard to see which industries all of
these new private-sector jobs are supposed to come from.
Second, with all G20 members tightening fiscal
policy at the same time, it will be "hard to deliver on improving
growth for all, or possibly any", as the chief economist
at Goldman Sachs, Jim O'Neill, has warned. Adding to that worry,
O'Neill notes, is growing evidence that both the US and Chinese
economies are slowing.
Third, it is unlikely that people fired from
the public sector, such as care assistants, police officers and
local authority workers, can simply jump to jobs in the private
sector. Occupational differences between any new jobs and jobseekers
will be a problem—a skills mismatch.
Fourth, the chances are that most people who
lose their jobs in the public sector will live in regions that
are heavily dependent on the public sector, such as the north,
while any new private-sector jobs are likely to be in different
regions—especially the south, where access to housing will
be a problem—a regional mismatch.
Fifth, many companies have managed to retain
staff during the downturn by reducing their hours of work. In
any upswing, firms are likely to increase hours rather than create
jobs. This will be especially bad for young jobseekers.
Sixth, any increase in jobs will lure back workers
from eastern Europe, who left Britain when job opportunities began
to disappear. In such circumstances, measured employment will
not rise as the OBR expects.
Seventh, there is no intellectual basis for
believing that the public sector is crowding out the private sector.
In a letter to the Times on 1 January 1938, John Maynard
Keynes argued: "Examples abound in all parts of the world
where public loan expenditure has improved employment: and I know
of no case to the contrary." That seems right. Public spending
is keeping many private firms from bankruptcy.
Eighth, plans for building new schools and hospitals
are to be scrapped under a review of capital spending, and private-sector
construction jobs will fall as a result. Even the CBI thinks these
cutbacks are a bad idea.
CONCLUSION
In my view the Budget that the Chancellor announced
in June is misguided and wildly dangerous. No reputable economic
theory justifies such precipitate action as cutting spending and
increasing taxes by this amount at any time, but certainly not
in the depths of the most serious financial crisis of our lifetimes.
This is what happened in 1937 in the United States when Roosevelt
tightened policy too quickly, which plunged the United States
into, double-dip, recession. Re-armament expenditure—a classic
Keynesian fiscal stimulus—prevented the UK doing the same.
I have every expectation that this austerity programme
will generate widespread industrial and social unrest, worsen
well-being and mental health, widen regional disparities and cause
increases in crime and poverty. Social divisions, as a result,
will widen. All for what?
Sadly, it appears that the poorest individuals
in society are going to be hit hardest. VAT is a regressive tax.
Inequality will inevitably rise Cuts in free school meals, and
in benefits will hit the weak and the vulnerable. Reducing the
number of university places at a time when applications are up
by over a hundred thousand appears to be a major mistake. Freezing
public sector hiring hits the young hardest as they try to enter
the labour market. Spells of unemployment while young leave permanent
scars. Evidence from the Prince's Trust suggest that the young
unemployed are unhappy and depressed. Cuts in programmes to help
the young are also misguided and will result in rapid increases
in the youth unemployment rat, which is already close to an alarming
twenty percent. And long-term unemployment is rising fast for
all age groups.
Far from boosting confidence this government
has worsened it. The OBR's forecasts for the likely impact of
these measures on output, employment and unemployment in particular
are flawed. Unemployment is going to rise.
During the 1980s recession output also fell
by around 6%. The unemployment rate increased from 5.4% in 1979
and peaked at 11.8% in 1984 but didn't return to 5.4% for over
20 years.
My concern is that this Budget, alongside the
earlier efficiency savings of over £6 billion will push the
UK back into a double-dip recession at best. Fed Governor Ben
Bernanke, argued in testimony to the House Budget Committee "This
very moment is not the time to radically reduce our spending or
raise our taxes because the economy is still in a recovery mode
and needs that support." This also applies to the UK.
This is not the time to pull my punches. It
is time for this government to reverse course and stimulate growth
and jobs before it is forced to do so by the very markets it so
reveres. This rash and ill-judged Budget will lower growth and
destroy jobs and will be a disaster for the British economy.
12 July 2010
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