Thursday, September 15, 2011

The radical alternative to austerity

Today, the Guardian carried another one of their moanfests. This time, their target was Milliband and his lukewarm attitude to the trade union movement. The Guardian wanted " no more 'distancing' or posturing." They argued that the UK "urgently needs a radical alternative to austerity."

I read through the article searching for further information on this radical alternative demanded in the opening paragraph. My search did not yield much. It was only in the second to last paragraph that I found the following tantalizing sentence "We urgently need a more radical and stimulative alternative to cuts.

And then, nothing.

Let me step in where the Guardian and other leftists fear to tread. I will try an outline a radical and stimulative alternative to the "fiscal barbarism" of the coalition.

Lets start with a realistic assessment of our current difficulties. The UK economy is not growing. In fact, it looks increasingly likely that it is again slipping into recession. Unemployment is rising. Inflation has remained above the central bank target for almost 5 years. Real wages are declining. Asset prices, including property prices, are weakening. We have an external deficit, and if you add up all the debts and the economy it comes to about four times national income. The banking system is screwed and the private sector is starved of credit. Did I miss anything out?

Yes, I missed out something very important. I did not mention the U.K.'s current fiscal position. The radical alternative, if it is about anything at all, is about an alternative fiscal strategy. Again, it helps to talk plainly about the current situation. Last year, government spending accounted for about 47 percent of GDP, while revenues were only 37 percent. By the end of this fiscal year, gross general government debt is likely to be 80 percent of GDP. Government indebtedness has doubled in the space of four short years, and we haven't even added in the costs of the banking crisis.Those debts sit on the balance sheet of the Bank of England.

So this is the background that the radical alternative to austerity needs to confront. A stimulus package normally means increasing expenditures or reducing taxes. It follows therefore that this alternative strategy means a much larger fiscal deficit. Going forward, it also means that the coalition's deficit reduction plan will be abandoned. It follows that the radical and stimulative alternative to cuts must mean much a higher government debt level.

For how long can the government run double-digit deficits without running into a crisis? Based on recent international experience, there appears to be two answers. If you are a large global power like the US or Japan with an internationally important currency like dollars or yen, the answer appears to be that you can run up debt levels well above 140 percent of GDP. This is the current debt stock of Japan. The US is somewhat lower, but seems determined to get there as quickly as possible.

If you are a small European economy, the threshold is much lower. Based on the recent experiences of Greece, Ireland, Portugal, Italy and Spain, countries run into trouble when the debt level reaches anywhere between 90 and 120 percent of GDP. Once a country in the danger zone, bondholders start to panic and stop lending.

So, where would you put Britain? Are we one of the global players? Or are we one of the European minions?

If you think we're one of the minions, then another round of stimulus looks extremely risky. While the UK fiscal numbers are bad, government debt levels are just below the danger zone. It is also clear that two or three more years of double-digit deficits and we will have a debt ratio well above 100 percent of GDP.

To be fair, proponents of the radical alternative have a riposte. They argue that another round of stimulus will boost GDP growth dramatically. Nominal GDP will grow faster than nominal public debt; and the debt to GDP ratio will fall, In other words, the UK will enter a virtuous circle of improving fiscal indicators and rapid economic growth.

Are there any good reasons for thinking that the fiscal stimulus will lead to a surge in growth? The strongest argument is that unemployment levels are rather high at the moment. Presumably, all that spare capacity could be quickly re-employed leading to a surge in economic activity.

Sadly, the most recent experience of fiscal stimulus, which followed the financial crisis of 2007, doesn't offer much hope for an emerging virtuous circle. The UK economy contracted by around five percent of GDP, despite huge tax cuts and massive increases expenditure. The post-recession recovery was extremely feeble.

The best thing you can say about the radical alternative to austerity is that it looks like a highly speculative and risky strategy. Either you have to believe that the fiscal stimulus will provoke an economic miracle of extremely rapid growth or you have to believe that the bond markets will be exceptionally tolerant of a debt to GDP ratio well in excess of 100 percent of GDP.

What is the downside of the radical alternative? It would be a disorderly fiscal adjustment very much like we have recently witnessed in southern Europe. One day, we would wake up and find that nobody wants to hold UK government debt. Either we would have to go cap in hand to the Chinese government or the EU or we would have to cut that 10 percent of GDP fiscal deficit more or less immediately. This would be true fiscal barbarism. We would experience cruel expenditure cuts and horrifying hikes in taxation. Benefits would be slashed, the National Health Service would be decimated, and schools would be starved of cash.

And when all this was happening, we would doubtless wish that we could go back to the autumn of 2011 and continue with the difficult path of fiscal adjustment proposed by the coalition.

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