There’s not a lot left of the plan George Osborne had for the economy when he arrived at the Treasury in May 2010. Growth is lower, borrowing higher, the hopes of pre-election tax cuts dashed.
All that remains of the original vision is that long-term borrowing costs remain low and the UK’s status as a AAA-rated country. On Friday, one of the three ratings agencies â€“ Standard & Poor’s â€“ said that despite Britain’s deepening double-dip recession, there was no immediate threat of a downgrade.
Osborne welcomed this news, seeing it as a vindication of government strategy. In reality, a debt downgrade by S&P, Moody’s and Fitch would be a boon for Britain, since it would remove the policy straitjacket that has prevented an effective response as the economy has steadily weakened over the past two and a bit years.
Throughout this period, the chancellor’s mantra has been that only by sticking to his deficit reduction plan will Britain keep the ratings agencies sweet. If he were to shows signs of losing his nerve, a downgrade would follow that would send long-term interest shooting up. This, the chancellor says, would harm the country’s growth prospects.
Forget for a moment that the ratings agencies forfeited their right to give advice to governments when they gave AAA ratings to the toxic waste spewed out by Wall Street and the City of London in advance of the financial crisis. Ignore the evidence that the sky has not fallen in when other countries have been downgraded. While these are important points to bear in mind, the real problem with allowing policy to be dictated by the ratings agencies is that it is so clearly at odds with the government’s vision. This can be summed up quite simply: get the economy moving; meet the targets for deficit reduction; win the 2015 election. As things stand, none of these objectives will be achieved.
Osborne is, of course, not the first chancellor to find himself stuck in a policy trap from which he can only escape by losing personal credibility. Harold Wilson’s 1964-70 government arrived in power with an ambitious National Plan to boost Britain’s growth rate, but by setting its face against a devaluation of the pound from day one ensured that the plan would fail.
Twenty years ago, in the summer of 1992, the UK was part of the European Exchange Rate Mechanism, under which the pound’s value had to be maintained against the German mark. Interest rates were kept at 10% to achieve this, a level far too high for an economy suffering from record home repossessions and bankruptcies, and with unemployment close to three million.
Major and his chancellor, Norman Lamont, insisted there was no alternative to the ERM. They issued blood-curdling warnings that changing course would lead to disaster. In the end, on Black Wednesday, policy was changed for the government by George Soros. Britain was blown out of the ERM, interest rates came down to levels that allowed the economy to grow, the pound sank to levels that enabled firms to export, and a vigorous recovery began almost immediately.
The noose around the neck of the economy is not as tight today as it was two decades ago. Then, the disciplines of the ERM meant the government had little freedom to set monetary policy (interest rates and the level of sterling) and it was left to the Treasury to support growth through fiscal policy (tax and public spending). Today, the Bank of England can run an ultra-loose monetary policy by keeping interest rates low and pumping money into the economy through quantitative easing. Osborne believes it has been his deficit reduction strategy that has allowed Sir Mervyn King to keep bank rate at 0.5% for more than three years and to announce Â£375bn of quantitative easing. Yet this policy mix is clearly not working because even on the most generous interpretation of the official data the economy has flatlined for the past two years. Households remain debt-saturated and are slowly reducing their borrowing. That means a policy based around making credit cheap and more freely available has severe limitations.
Yet the outlook is for more of the same. The City believes that QE could reach Â£500bn before the Bank is done, and that there is a chance that bank rate will be cut to 0.25% this autumn. At the same time, Osborne plans to intensify his fiscal squeeze. The yardstick used by the Treasury to assess the success of its deficit reduction plan is the cyclically-adjusted primary balance, which means borrowing excluding interest payments on the national debt, adjusted for the state of the economy. In the 2012-13 financial year, the plan is to tighten policy by 0.3% of national output, rising to about 1.5% of gross domestic product in 2013-14 and 2014-15.
Let’s assume for a moment that the government no longer felt constrained by the need to keep the credit rating agencies sweet. Would it be sticking to its fiscal strategy and its current policy mix? That hardly seems likely, given the worst double-dip recession in history and a slower recovery than that which followed the Great Depression. Osborne is in the unenviable position of being attacked for his passivity from all sides. Last week he was lambasted from the left by David Blanchflower, a former member of the Bank’s monetary policy committee, by Mark Littlewood, the director general of the free-market Institute of Economic Affairs, by Brendan Barber, general secretary of the TUC and by Sir Richard Lambert, the former director general of the employers’ organisation, the CBI.
It is not that difficult to sketch out an alternative economic approach. The government can borrow cheaply so it could give the green light to infrastructure projects, particularly small-scale projects such as schools and local transport initiatives, where work can begin quickly. It should tackle youth unemployment by scrapping national insurance contributions for all those under 25 and bring in lower NICs for the northern regions. Learning from the big retailers, there should be additional time-limited spending vouchers for those on benefits to stimulate consumer spending. Consideration should be given to a temporary cut in VAT, which would bring down inflation, and increase spending power. For the longer term, there should be a national investment bank.
As Michael Saunders of Citigroup puts it: “The ultra-low level of gilt yields is practically an invitation for the government to borrow more”. He notes that Osborne could implement temporary tax cuts and extra public investment worth 1% of GDP (about Â£15bn) while maintaining the squeeze on current spending, which would still result in fiscal tightening of nearly 0.5% of GDP in 2013-14.
The International Monetary Fund has provided the political cover for the government to re-think its bone-headed adherence to a failed strategy that is making the deep-seated problems of the economy worse, not better. The change, of course, should happen immediately, although it may take a debt downgrade to remove the self-imposed shackles. For now, Osborne is digging the economy â€“ and himself â€“ deeper into a hole.