Monday, October 25, 2010

The "confidence fairy" trumps Keynes in UK!

Even as a fierce debate rages about the policies required to address the Great Recession across the developed economies, among the major economies Britain has made a decisive choice to embrace fiscal austerity to restore market confidence. The land of Keynes appears to have blinked on the face of massive fiscal strains and chosen to break with Keynesian policies and follow the path of balancing government finances to revive economic growth.

In recent days, France has decided to raise the minimum retirement age to 62 from 60 and the age for a full pension to 67 from 65. Earlier Greece, Spain, and Ireland had embraced deep spending cuts in an attempt to avoid sovereign bankruptcies.

The Conservative Government in Britain last week followed its other European partners by annoucing the country’s steepest public spending cuts in more than 60 years in an effort to eliminate government deficits by 2015. This comes as Britain faces one the worst public debt problems among all developed economies - 11.5% public deficit and 61% public debt. It is hoped that these steep cuts will repair government's fiscal balance, improve market confidence, stimulate the private sector and restart growth.

The proposed measures include a reduction of expenditures in government departments by an average of 19% (£83 billion or about $130 billion) by 2015, sharp cuts in welfare benefits, increase in the retirement age from 65 to 66 by 2020 (saving $ 8 bn a year), and elimination of 490,000 public sector jobs (out of a total of 6 million jobs or 8% of the total) over the next four years. Further, payments to the long-term unemployed who fail to seek jobs will be cut saving $11 billion a year, and a new 12-month limit will be imposed on long-term jobless benefits, and measures will be taken to curb benefit fraud.

This follows an earlier decision to stop paying its hitherto universal child benefit payments ($32 a week for a first child and $21 for each subsequent one) to people earning more than around $70,000 a year. There is also a proposal to accept the findings of the Browne Review on subsidies for university education, which suggests dramatic cuts on university education spending.

The Browne review advocates scrapping of the present system that caps a year's tuition fee at £3,290 ($5,275) in favor of a free-market approach paid for by the students themselves — but only after they graduate and are earning more than £21,000 a year. It is being suggested that the government could then cut about 80% of the current $6.2 billion it pays annually for university teaching, and about $1.6 billion from the $6.4 billion it provides for research. To make up for the shortfall, universities would have to raise tuition to an average of more than $11,000.

On the revenues front, the British Government has already announced plans to levy a one-time 50% marginal tax on bankers' bonuses of more than £25,000 ($40,700). This would be levied not only British banks but also the London subsidiaries of Wall Street giants. The move is more symbolic than substantial since it would raise only £550 million.

Such a hair-trigger alarmist repsonse from Britain is surprising, and far from engendering market confidence may end up rousing market anxiety and even panic. Unlike fellow Europeans like Greece and Ireland, despite its high 11.5% fiscal deficit, Britain is nowhere close to bankruptcy or reeling from any bond-vigilantes. There were no bond-market panics and inteerest rates have remained low. Public debt at 61%, while high, is not so large as to press the panic button. And all these macroeconomic indicators are similar to that in the US (fiscal deficit of 10.7%), which is debating the extent of accommodation - monetary and fiscal - required. Further, there will be serious questions about the need to eliminate government deficits at all, and that too within such a short-time and starting from an aggregate demand shrinkage driven recession.

These dramatic measures carries with it considerable risks and even goes against the grain of historical record of countries which faced similar situations. In simple terms, the spending cuts are made on the assumption that the private sector will be able to able to make up for the 19% and 8% cuts in government spending and employment respectively, over the next four years.

However, this private sector growth in output and job creation to cover up for the government's exit would have to be a top-up on the regular growth. And regular growth itself will have to be large enough to bridge the yawning output gaps that shows no signs of narrowing. In simple terms, Britain will have to grow at its highest rate in the post-war era, close to double digits, just to return to normalcy. What makes this even more formidable is the fact that this momentum will have to get generated immediately and there appears nothing in the horizon among the private sector that could trigger off such a dramatic spurt in growth.

And all this has to start immediately, since any delays would only end up pushing the can further down the road and widening the output and employment gaps, necessitating even more higher rates of growth and job creation. There are serious and well-grounded fears that such optimism may be misplaced.

It is also hoped that these measures will restore market confidence and encourage the private sector to come forward with their investment and spending plans. However, as the evidence so far from Ireland, which has been similarly savage with its spending cuts, shows, such assumptions may fall through. After its initial round of spending cuts failed to enthuse the markets and trigger any recovery and make any dent on its stupendous budget deficit of 32% of GDP, Ireland is set to announce another round of cuts, which would take the total cuts to 14% of its GDP.

As Joseph Stiglitz wrote in response to the British decision, the excessive faith in the confidence fairy and attendant spending cutbacks "will weaken Britain, and even worsen its long-term fiscal position relative to well-designed government spending". He wrote,

"There is a shortage of aggregate demand – the demand for goods and services that generates jobs. Cutbacks in government spending will mean lower output and higher unemployment, unless something else fills the gap. Monetary policy won't. Short-term interest rates can't go any lower, and quantitative easing is not likely to substantially reduce the long-term interest rates government pays – and is even less likely to lead to substantial increases either in consumption or investment. If only one country does it, it might hope to gain an advantage through the weakening of its currency; but if anything the US is more likely to succeed in weakening its currency against sterling through its aggressive quantitative easing, worsening Britain's trade position...

The few instances where small countries managed to grow in the face of austerity were those where their trading partners were experiencing a boom... Lower aggregate demand will mean lower tax revenues. But cutbacks in investments in education, technology and infrastructure will be even more costly in future. For they will spell lower growth – and lower revenues. Indeed, higher unemployment itself, especially if it is persistent, will result in a deterioration of skills, in effect the destruction of human capital, a phenomena which Europe experienced in the eighties and which is called hysteresis. Lower tax revenues now and in the future combined with lower growth imply a higher national debt, and an even higher debt-to-GDP ratio."

It is being argued in some circles that the apprently contrasting responses (atleast till now) on both sides of the Atlantic to addressing the Great Recession comes from their respective different historical experiences and the attendant institutional memories. The memories of the Great Depression and the human sufferings and long-term damage inflicted to the economy is thought to inform the relative acceptance of fiscal and monetary accomodation in the US. In contrast, Europeans are driven by even more recent experiences with government deficits that have resulted in sovereign defaults and episodes of run-away inflation. In particular, it is being claimed that the Conservative Government's decision now is grounded in memories of Britain’s economic collapse in the 1970s, when the International Monetary Fund had to come to the rescue just as it has done recently in Greece.

Joe Stiglitz should have the last word,

"Austerity converts downturns into recessions, recessions into depressions. The confidence fairy that the austerity advocates claim will appear never does... Consumers and investors, knowing this and seeing the deteriorating competitive position, the depreciation of human capital and infrastructure, the country's worsening balance sheet, increasing social tensions, and recognising the inevitability of future tax increases to make up for losses as the economy stagnates, may even cut back on their consumption and investment, worsening the downward spiral...

Britain is embarking on a highly risky experiment. More likely than not, it will add one more data point to the well- established result that austerity in the midst of a downturn lowers GDP and increases unemployment, and excessive austerity can have long-lasting effects... it is a gamble with almost no potential upside. Austerity is a gamble which Britain can ill afford."

1 comment:

James Reade said...

Just to say: It's a Coalition government in the UK, not a Conservative one. At least theoretically. In practice it's very hard to tell the difference...