As Chancellor, George Osborne faces a considerable problem, and it’s far from clear there is any politically feasible way he can get through it. The central problem facing the British economy since 2008 has been this. During the 2000s, households took on massive debts, especially in the form of mortgages. That increase in household debt would have made sense had the economy been going to grow faster in the future than in the past — e.g. if, instead of the around 2.5% real-terms growth per year we had from the late 1970s until the mid-2000s, underlying growth by now had increased to 3%, those high mortgages would have made perfect sense.
Unfortunately, the evidence suggests that, far from underlying economic growth accelerating from the mid-2000s, it has actually dropped dramatically. Over the decade starting 2008, the UK will be lucky to grow by more than 1% per year. If it does indeed grow as slowly as that, households will, more and more over time, find they cannot service their mortgages and they will default, bankrupting the banks that lent them the money.
In 2008, the UK government (supported by Cameron and Osborne) chose to stand behind the British banks, and now has three nationalised or quasi-nationalised banks – Northern Rock, Lloyds and RBS. If those mortgages go bad enough and those banks go bust again, that could bankrupt the British government, much as bust banks have bankrupted the governments of Ireland and Spain.
Because the British government was at such risk, through its banking commitments, it was very unwise of the outgoing Labour government not to have a credible planning for controlling the accumulation even more government debt, in the form of government bonds.
Furthermore, there seemed to be little comprehension of the real danger. By enormously increasing government, as a proportion of GDP, between 2007 and 2010, Gordon Brown’s government damaged the medium-term growth rate even further, increasing the risk of escalating mortgage defaults and banking failure. By contrast, by cutting government spending relative to GDP, George Osborne had some scope to increase the medium-term growth rate. If the government’s plans are all implemented, the sustainable growth rate might be back to 2.5% by 2017.
But that is a big “if”. Past experience, internationally and historically in the UK, with major deficit-reduction programmes is that after about two years austerity fatigue sets in and governments find themselves unable to take further action until there is another crisis. We have seen that this year. Whilst in 2010 there was debate about Osborne’s Emergency Budget and spending cuts announcements, there was a general resignation and sense of inevitability. But two years later, in the 2012 Budget, Osborne was forced into u-turn after u-turn, all in respect of attempts to raise taxes. He probably has no political capital left to raise any taxes now for the rest of this Parliament. If he is to cut spending any further, he would need some crisis as an excuse. Perhaps a crisis will emerge – maybe the euro might yet collapse. But absent that, the best we can hope for in terms of deficit reduction is that the scheduled massive spending cuts programme, just now starting, is implemented as scheduled.
And to be clear, so far the spending cuts that have taken place have been virtually only those cuts to capital spending (e.g. roads and schools) that were scheduled by Alistair Darling before he left office. Taxes have risen substantially – both Darling’s scheduled rises and some new ones from Osborne. But Darling had not detailed any large cuts to consumption spending (e.g. public sector salaries, the numbers of public sector employees, consultant fees, and so on). Osborne has scheduled large cuts to consumption spending, but they have only just started.
Once those consumption spending cuts get going properly, there is a good chance that the medium-term sustainable growth rate will at least stop falling and may rise back, a little. By itself that wouldn’t mean we got strong growth in the short term, but it would help address the medium-term danger.
For the shorter-term, some think they can see hope in the statistical tea-leaves. The recession this year has been a bit of a statistical illusion, driven by lots of bank holidays (not to mention half the country’s staff spending much of their days pressing “refresh” on the BBC Sport web-site, instead of working, and staying in in the evenings watching TV instead of spending money). Now that our five-month 2012 party is over, there is a decent chance that the economy will return to some growth in the last two quarters of the year. Furthermore, developments in the EU suggest that policymakers are finally grasping that if they are to save the euro they need to have a fully-fledged political union and are taking the necessary steps to put that in place. The Eurozone crisis has been a great mill-stone upon confidence – a total euro collapse could have led to 5-10% more recession in the UK. Few businesses would be willing to invest with such uncertainty.
If the risk of total euro collapse starts to fade, there is a good chance investment could be released. But that will bring new challenges. Since 2007 we have seen that whenever the UK is not actually contracting, CPI inflation rises to 5% and up. Rapid investment growth, leading to the kinds of growth figures Osborne might hope for, e.g. 3% per year, could well be associated with much higher inflation. The Bank of England has not attempted to prevent inflation rising to 5% twice in the past four years. But if it went much beyond that 5%, the Bank would eventually have to react by raising interest rates.
Rapid inflation and interest rate rises would present a new and unwelcome challenge to Osborne, on top of the difficulties of implementing spending cuts and consistently missing his deficit reduction targets. The early phase of recovery might well also be associated with a rise in unemployment, as recoveries often are (e.g. the early 1980s). Rising interest rates could also lead to even bigger house price falls. House prices are already down 33% in real terms since 1997. Even a 2% rise in interest rates would put a large number of households with excessive mortgages into distress.
The bottom line, then, is that although there is a chance that we shall soon see the end of the period of stagnation we’ve had since mid-2010, faster growth may well herald a new phase of economic crisis, with inflation, unemployment and rising interest rates, rather than the sunlit uplands.
Many are already urging Osborne to change course. In truth he will be very lucky if he can stick to the course he’s on. But we must hope he does, and although we should be willing to offer helpful fine-tuning ideas, the Party should give him strong support as he struggles, not always successfully (and I have not agreed with everything), with matters not of his making that could well get tougher and tougher. For though Osborne’s Path is unpleasant, almost every other plausible route from here would risk being much much worse.