It was John Maynard Keynes who first pointed out its importance, and its consequences for policy. Keynes said that policies which are sound and necessary when the economy is fully employed, are unsound and destructive when the economy is shrinking.
He knew what he was talking about. He had lived through the Great Depression of 1929-32 when governments did what they were supposed to do in normal times: balance the budget and hold fast to sound money. The result was the greatest economic disaster in modern history.
Keynes’s crucial distinction between full employment and subnormal employment was totally ignored by George Osborne in his speech “The Conservative Strategy for Recovery” last week. At no point in his speech did Osborne mention that UK output has fallen by 5pc since last October and unemployment has risen by over one million. The gap between what we can produce and what we do produce has grown to more than £70bn. This is because, as a nation, we are spending £70bn too little.
Almost all that Osborne said is right and sensible in conditions of full employment; most of it is wrong and wrong-headed when there is heavy and persisting unemployment. Although he understands that we have been in the deepest recession since the war, his strategy for recovery assumes that there is nothing to recover from – except a Labour government!
His sole policy to counter recession is low interest rates to reduce “our enormous private and public debt burden”. Low interest rates require “tight fiscal policy”. Tight fiscal policy requires cutting government spending now.
What is the argument? Osborne is right to say that low interest rates are necessary to fight a recession. But they are not enough. They reduce the burden of existing debt; but, even when combined with the recapitalisation of zombie banks and guarantees on old debt, they may not lower the cost of borrowing enough to stimulate new investment.
For the volume of investment depends not just on the cost of borrowing but on the expectation of profit. Recessions are the result of a collapse in profit expectations. And it may be that no feasible reduction in interest rates can revive profit expectations sufficiently to produce a robust recovery.
Today depressive forces are rampant both on the lending and borrowing sides. Commercial banks have seized the opportunity offered by the lower Bank of England rate to rebuild their balance sheets by increasing the margins on their own lending. Since October last year profit margins measured as the spread between swap rate and the mortgage rate have more than tripled. The volume of private investment has also shrunk. Not only has it decreased in absolute terms by almost £60bn but, crucially, by 2010 we are projected to invest 25pc less than before the crisis relative to GDP. We’re investing a smaller portion of a smaller cake.
This is the context in which a fiscal stimulus – deliberately increasing the size of the budget deficit – becomes not just relevant but necessary. Osborne’s main argument is that Britain couldn’t, and can’t, “afford” a fiscal stimulus because the Government’s finances were already deranged before the recession started.
Criticism of Gordon Brown’s handling of the public finances in his 10 years as Chancellor is certainly valid: like home owners who banked on the prices of their properties going up for ever, he banked on permanent boom to bring his budgets back into balance and like them, was caught short when the boom collapsed. But Labour’s fiscal record from 1997-2007 has no bearing on the question of what we can “afford” today. We couldn’t afford not to have had a stimulus in the past year and we can’t afford not to continue with it now.
The reason is quite straightforward. If output is falling, the Government’s revenues fall automatically and its social spending rises automatically. If the Government tries to reduce the deficit by cutting its spending, it reduces total spending in the economy still further. This causes the recession to deepen and makes the deficit even larger. It is like a cat chasing its own tail.
In these circumstances a discretionary increase in the deficit – the deliberate injection of extra spending power into the economy large enough to reverse the fall in output – is the best way of reducing the deficit in the medium term. The logic of this seems to have escaped Osborne.
He is on sounder ground in criticising some of the actual measures taken. The temporary cut in VAT was useless. Further, some forms of fiscal stimulus, like spending on infrastructure programmes, take a long time to work their way into the economy. But this is an argument for a quicker-acting stimulus, not for no stimulus.
Had the Government given everyone a spending voucher of £500 last Christmas, the chances are we would have had no output gap and full employment today! And we would be facing a much smaller prospective budget deficit.
The idea that, in present conditions, a rising budget deficit is bound to drive up long-term interest rates is moonshine. Increased household spending, diffused through the economy, would multiply the volume of bank deposits, which would have the effect of reducing the rates banks charge on loans. So a policy of expanding the budget deficit is perfectly consistent with low interest rates when aggregate spending is severely depressed.
The Osborne effect – to coin a phrase – would occur only if there is a fixed money supply. Then, it is true that if the Government borrows more money from the public the banks will have less to lend the public. However, the Bank of England can always create the money for additional government spending by printing more money This is the meaning and purpose of “quantitative easing” – to enable interest rates to stay low even as the Government is increasing its own spending, and thus avoid “financial crowding out”.
At full employment, “printing money” is the royal and pretty immediate road to runaway inflation. But one cannot repeat too often that when there is heavy unemployment the injection of additional money into the economy will arrest the economic slide and bring about a recovery in output and employment. This will increase the resources available to the banks for lending, and enable the Bank of England to reverse the “quantitative easing” in due course.
The dodgiest part of Osborne’s argument is that “fiscal tightening” (during a recession) does not reduce output because “what you lose in government spending, you gain in exports”. But you gain in exports only if the exchange rate depreciates. Osborne does not explain why “fiscal tightening” should cause the pound to sink against other currencies (the usual argument is that it is fiscal loosening which has this effect), and he does not begin to consider how far, in the absence of a stimulus, the pound would have had to depreciate to plug the output gap. To fill a 6pc output gap with increased revenues from exports, British exports would have to grow by about 25pc.
Between January 2007 and December 2008 the trade-weighted value of the pound depreciated by 27pc. In the same time exports only grew by 13pc. By this reasoning, and keeping everything else constant, the pound would have to lose another 50pc against its major trade partner currencies for exports to fill the output gap. In fact, the pound has recovered by 7pc since January 2009.
All the arguments for a stimulus go into reverse when the economy ceases to need stimulating.
Then, as Osborne rightly says, fiscal responsibility is the condition of low interest rates. And it is more than just a party point to say that Labour mismanaged the national finances before the recession, and that as a result the “size of the fiscal adjustment” needed to get the budget under control will be greater than it need have been. But as a guide for what needs doing now his analysis is way off target. By contrast, the TUC general secretary Brendan Barber was spot on when he told the Congress at Liverpool that to “try and cut a deficit during a recession and you make it worse… But in the medium and long term it must start to come down. And that is going to mean some hard choices.”
Yes, our Government, like all governments, should have an exit strategy. But it is too early to take our currently traumatised economies off their life-support systems just because bank profits have started to recover. That should be the message Gordon Brown takes to Pittsburgh for Thursday’s meeting of the G20.
Robert Skidelsky 