Herbert Hoover, you were right. That is the consensus of all right-thinking people on UK fiscal policy. This view, as my colleague, Chris Giles notes, has even become a much admired British intellectual export.
Interestingly, the Institute of Fiscal Studies, which is as right-thinking as can be, proffered an admittedly lukewarm version of the opposing view in its Green Budget this week. It states that “the case for a short-term fiscal stimulus package to boost the economy is stronger now than it was a year ago. Decisions made in the Autumn Statement are likely to have had a small but positive impact on growth. The case for taking this further is not clear-cut: ongoing uncertainty over the future fiscal situation and the importance of credibility argue against it, but the continued weakness of the economy and the low chance of monetary tightening offsetting it make a loosening look more attractive than a year ago. The case would be strengthened significantly were the outlook for the UK economy to deteriorate sharply”.
My only difference from this analysis is that economic performance is already dismal. It does not need to deteriorate further. How masochistic does one need to be? The task is to devise action that is effective and preserves credibility.
Fact one: in the fourth quarter of 2011, UK gross domestic product was 3.8 percent lower than at the pre-crisis peak in the first quarter of 2008. Fact two: the economy is now stagnant, with output in the last quarter of 2011 a mere 0.3 percent above its level in the third quarter of 2010. Fact three: as Jonathan Portes of the National Institute of Economic and Social Research notes, the UK “depression” – the period during which output is below its pre-crisis peak – is now longer than the Great Depression, let alone subsequent recessions. Fact four: it could be many years before this slump ends.
Ignore, for the moment, who bears responsibility for the disaster. Put to one side the question of whether external shocks were responsible for the weakness since the autumn of 2010. The question is whether anything should, or can, be done. My answer remains a definite yes.
Something should be done, because prolonged stagnation and high unemployment will permanently lower the economy’s potential, quite apart from the social costs they impose. Some believe the UK economy has little spare capacity. I find this too pessimistic. Goldman Sachs has estimated the slack at between 4 and 5 percent of GDP. That is quite a bit to play with.
The question, then, is about the “can”. Opponents of fiscal action would argue that monetary policy is effective on its own, that fiscal action would be disastrous, or both. The argument that monetary policy is effective on its own is at the very least unproven when interest rates are already so low. So far, the unconventional monetary policy chosen by the Bank of England – purchases of UK government bonds – does not look highly effective. I suspect that lower long-term rates, even if achievable, would amount to “pushing on a string”. Yet, with broad money and bank lending shrinking, the case for the Bank to do even more is also very strong.
This leaves fiscal action. The big argument against it is that it would destroy credibility and so lead to a Greek-style crisis. Never say never. But this argument looks quite weak. First, it looks increasingly clear that sub-sovereign euro zone borrowers are in a different position from a sovereign country, such as the UK. Second, a primary determinant of the ultimate debt position is how fast an economy recovers. Thus, the aim must be to adopt fiscal measures that are credibly temporary and promote additional demand, in the short run, and additional supply in the long run. This is not impossible. It just takes some imagination.
The starting point must be to stick to the announced cuts in current spending. If that is brought down to sustainable levels, even relative to a pessimistic view of potential output, credibility should be ensured. But temporary tax cuts could promote spending: national insurance charges and value added taxes are obvious candidates. This should be combined with long-term structural and fiscal reforms, with a view to creating a more dynamic economy, in addition to promoting spending on infrastructure. When the government can borrow at real interest rates of below zero, good, time-limited investment projects must make sense. Finally, co-ordinate with the Bank to make use of its willingness to create money, or “zero-interest, perpetual public debt”, to finance the temporary rises in deficits.
I do not expect any of this to happen. But it should. Of course, stagnation might be the best policymakers can do. But one has to be certain of this, given the evident costs. A little flexibility might make all the difference. Start now.