Paul Mason has an interesting blog arguing that the 2011 Autumn Statement has destroyed the argument for “expansionary fiscal contraction” — i.e. the view that the economy would grow faster as the deficit was cut.  He says that this did not work, partly because key channels through which private demand was supposed to be stimulated under the theory proceed via the banking sector, and the banking sector transmission mechanism is bust.

Paul notes the key role a number of Policy Exchange papers played in setting out what he has previously described as the “essential theory behind the Coalition's strategy”.  On this occasion he describes it thus:

The theory says if you rapidly reduce the cost of government borrowing, this channels private investment into productive business; on top of that, by signalling a rapidly shrinking state, you signal lower future taxes and generate behaviour changes that stimulate growth.

This seems to me to be a perfectly fair description of the theory.  Paul says that if the government had really believed in the Policy Exchange arguments, in the way it appeared to in May 2010, the correct response to the current downwards revision in the growth outlook would have been to cut spending deeper and faster, providing money for either temporary or permanent tax cuts — a strategy alluded to by the IMF in its June statement on the UK economy.  Instead, the government has chosen additional deficit cuts — fearful of a ratings downgrade and aware that Britain is not immune to technocratic imposition either by markets or by sovereign lenders.

I agree with almost all that Paul says and the way he sets out the issues.  However, I do have the following observations:

a). I always urged that there should be QE to accompany the fiscal contraction

b). The first two years of the fiscal contraction involved around half of the work being done by tax rises, not spending cuts.  I always argued that tax rises could have some a short-term negative impact on growth.

c). The proportion of tax rises early on reflects political constraints, the fact that some early work was announced by Labour, that the Lib Dems rejected front-loading spending cuts, and that the Conservatives made the central argument the deficit, not spending.

d). I always argued that the key priority was cutting spending, not cutting the deficit.  I had, for example, favoured a temporary tax cut in late 2008 (not making myself terribly popular in Conservative senior circles).

e). My view is that subsequent events suggest that those that were more concerned about the deficit than I was were right, not wrong — I should have been more concerned about the deficit, per se, than I was.

f). The Policy Exchange reports always carefully argued that a heavily spending-cuts-based deficit reduction programme could be expected to raise growth, relative to what would have happened otherwise — for example, that might be true if the economy neither grew nor shrank, but would have shrunk has the deficit reduction not taken place.  The argument does not imply that the policy has succeeded only if growth accelerates.  We floated the possibility that fiscal contraction might raise growth per se, but stated explicitly that this should not be relied upon and there should be additional QE.

g). I always urged that the sustainable growth rate of the economy was much lower than forecast by the Bank of England and OBR.  My contention was always that average growth over the next decade is unlikely to be much more than about 1-1.5%.  But what I also contended was that this could not, in the UK, take the same form as in Japan – of quiescence.  Why not?  Well, my claim was that if we had extended stagnation in cash wages, households would default on their mortgages, dragging down the banking sector and plunging us into an early 1930s-US-style scenario.  Instead, I said there would be boom-and-bust through the 2010s, like in the 1970s.

h). One illustration of that was my August 2010 note, where I argued that if 2011-12 growth came in as the Bank of England and OBR hoped (which I considered possible provided that QE2 was launched in 2010, as I predicted it would be) then there would be rapid rises in inflation.  That reflects precisely the point above: because the UK’s sustainable growth rate is only about 1-1.5%, growth of 2.5-3% would be inflationary, taking CPI to around 6%.  Interest rates would need to shoot up in response, triggering another recession by 2014.  I said that achieving such growth, inflation, and later recession was the “best-case scenario”, if all went well and policy was ideal.  (I do urge people to read my actual note, rather than the press reporting of it.  Some press reporting gives the impression that it is an argument that the economy would be strong from 2010-12.  But the note sets out, straight from the off, to counter the claim that the UK is unlikely to have a double dip recession.  Instead, it suggests that it is very likely that there is at least an initial blip in late 2010 or early 2011, and that there will be another significant recession by 2013-14.)

i). Unfortunately policy was not ideal, and all did not go well (as the August 2010 note said could well be the case — when I said my sketch was of the “best-case scenario” many people didn’t take me seriously).  There was not QE2, and I was (as usual) too conventional in accepting the Bank of England and OBR growth figures as my point of departure.

j). I wish it had been possible for the government to be more flexible on the merits of temporary tax cuts, maintaining some wriggle room on the use of macroeconomic fiscal policy.  Alas, the UK’s political debate finds it so difficult to accept any spending cuts that any slippage on deficit reduction could well – disastrously – lead to slippage on spending reduction.

k). I agree with Paul that a key issue is the bust banks undermining the transmission mechanism.  As regular readers will know, I regard that as a direct consequence of government bailouts.  Also, it is the effect of government bailouts upon the government’s balance sheet and hence its creditworthiness that creates the greatest threat of UK sovereign default – not the deficit per se.

l). If anything, in my view events of the past year strengthen the case for rapid and large deficit reduction, rather than weakening it.  Britain could easily have gone the way of France – and may yet do so.

m). My major concern about the government’s programme is that it has so little public focus upon the need to achieve a rise in the medium-term sustainable growth rate.  The OBR provides false comfort suggesting that the sustainable growth rate will be 2.0% by 2013 and 2.3% by 2014.  It has now converged to my own figure of 1.1% for the present sustainable growth rate (it says 1% since 2009 and 1.2% for 2012).  I expect to see it revised down later years in a similar way.  Growth will eventually rise back above 2% as households repay their debts, government spending falls back to about 40% of GDP, and public sector productivity growth rises (if only under the pressure of spending control – though the government should be seeking to go further in enhancing public sector productivity).  But whether that will be before 2015-6 is yet in the balance.

n). Furthermore, if the euro blows up totally, the numbers in the government’s programme will, in themselves, be rendered irrelevant.  Its key merit will have been in establishing something of the spirit of the UK political debate.  We have been willing to take measures early, and to agree to cut spending rather a lot.  That should, hopefully, give markets some reason to believe that, if matters deteriorate further (as they probably will – it’s mainly a question of how much further they deteriorate) the UK political system will prove equal to the task, in cutting yet deeper and embracing the pain.

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