Economists are famous for disagreeing – as, of course, are politicians. And there is a lot of disagreement around at the moment. George Osborne is determined to cut Britain’s large public-sector deficit, and cut it quickly. This, argues the Coalition government and many economists, is necessary to maintain the UK’s AAA sovereign credit rating. This, in turn, will allow interest rates to be kept down and the international confidence will encourage investment. In short, the cut in aggregate demand by government would be more than compensated by a rise in aggregate demand elsewhere in the economy, and especially from investment and exports. By contrast, not cutting the deficit rapidly would undermine confidence. This would make it more expensive to borrow and would discourage inward investment.
Not so, say the opposition and many other economists. A contractionary fiscal policy will achieve just that – an economic contraction. In other words, there is a real danger of a double-dip recession. Far from encouraging investment, it will do just the opposite. Consumers, fearing falling incomes and rising unemployment, will cut back on spending. Businesses, fearing a fall in sales, will cut back on investment. Economic pessimism, and hence caution, will feed on themselves.
So who are right? The first two blogs by Stephanie Flanders, the BBC’s Economics Editor, look at the arguments on both sides. The third attempts to sum up. The other articles continue the debate. For example, the link to The Economist contains several contributions from commentators on either side of the debate. See also the earlier posting on this site, The ‘paradox of cuts’.
Articles
The case for Mr Osborne’s austerity BBC News Blogs, Stephanomics, Stephanie Flanders (7/9/10)
The case against Mr Osborne’s austerity BBC News Blogs, Stephanomics, Stephanie Flanders (8/9/10)
Austerity plans: Where do you stand? BBC News Blogs, Stephanomics, Stephanie Flanders (10/9/10)
Are current deficit reduction plans likely to boost growth? The Economist debates, various invited guests
Debt and growth revisited Vox, Carmen M. Reinhart and Kenneth Rogoff (11/8/10)
Leading article: Mr Osborne should prepare a Plan B Independent (13/9/10)
Shock fall in UK retail sales adds to fears of double-dip recession Guardian, Larry Elliott (16/9/10)
Chancellor accused of £100bn economic growth gamble by Compass Guardian, Larry Elliott (18/9/10)
Double-dip recession: bulls and bears diverge over future economic prospects Guardian, Phillip Inman (16/9/10)
Speech by Mervyn King to TUC Congress TUC (15/9/10)
Barber, Blanchflower and the fake debate on double dip The Spectator, Ed Howker (14/9/10)
Confidence data
Consumer confidence Nationwide
ICAEW / Grant Thornton UK Business Confidence Monitor (BCM) ICAEW
Business and Consumer Surveys Economic and Financial Affairs, European Commission
Questions
- Summarise the arguments for the Coalition government’s programme of rapidly reducing the public-sector deficit.
- Summarise the arguments against the Coalition government’s programme of rapidly reducing the public-sector deficit.
- What factors are likely to determine whether there will be a double-dip recession as a result of the austerity programme?
- Why is it very hard to predict the effects of the austerity programme?
- How effective is an expansionary monetary policy likely to be in the context of a tightening fiscal policy?
- How important are other countries’ macroeconomic policies in determining the success of George Osborne’s policies?
- How similar to or different from other recessions has the recent one been? What are the policy implications of these similarities/differences?
Every three months, the Bank of England produces its Inflation Report. This includes forecasts for inflation and economic growth for the next three years. The forecasts are presented as fan charts. These depict the probability of various outcomes for inflation or growth in the future. “In any particular quarter of the forecast period, GDP is expected to lie somewhere within the fan on 90 out of 100 occasions.” Each coloured band represents a 10% probability of occurrence. “Although not every member will agree with every assumption on which our projections are based, the fan charts represent the MPC’s best collective judgement about the most likely paths for inflation and output, and the uncertainties surrounding those central projections.” The broader the fan the less confident are the forecasts. The fans have tended to get broader in recent Reports, reflecting the greater uncertainties in the UK and global economies since the credit crunch.
Since the last Report, the forecast for economic growth in 2011 has been adjusted downwards from 3.4% to 2.5%. Inflation, while still being forecast to be below the target of 2% in two years’ time, is forecast to rise in the short term, thanks to higher commodity prices and the rise in VAT from 17.5% to 20% in January 2011.
So what impact, according to the Report, will various factors such as the Coalition’s emergency Budget in June, rising commodity prices, falling consumer confidence and improving export performance have on the economy? And how much credence should be put on the forecasts? The following articles address these questions
Articles
Bank chief warns of ‘choppy recovery’ Independent, Russell Lynch (11/8/10)
King warns of ‘choppy recovery’ for economy Channel 4 News, Faisal Islam (11/8/10)
Bank of England warns UK recovery will be weaker than hoped Telegraph (11/8/10)
Bank of England lowers UK growth forecast Telegraph, Angela Monaghan (11/8/10)
Bank of England cuts UK economic growth forecasts Guardian, Katie Allen (11/8/10)
Bank of England forecasts ‘choppy’ economic recovery BBC News, Katie Allen (11/8/10)
Bank of England Cuts Outlook for Economic Growth Bloomberg, Jennifer Ryan (11/8/10)
Why is the UK heading into choppy waters? BBC News Analysis, Hugh Pym (11/8/10)
Bank of England overhauls forecast model after errors Telegraph, Philip Aldrick (11/8/10)
The Bank’s impossible balancing act Independent, David Prosser (11/8/10)
How uncertain exactly is the uncertain BoE? Reuters Blogs, MacroScope (11/8/10)
‘Slowflation’ – the combination the Bank of England fears most Independent, Sean O’Grady (11/8/10)
The Bank is right to paint a mixed picture Independent, Hamish McRae (11/8/10)
Sterling falls, gilts rally after Bank of England cuts growth forecasts Guardian Blogs, Elena Moya (11/8/10)
Report
Inflation Report
Inflation Report Press Conference
Questions
- Do the Bank of England’s forecasts suggest that the UK economy is on track for meeting the inflation target in 24 months’ time?
- How much reliance should be put on Bank of England inflation and growth forecasts? You might want to check out the forecasts made one and two years ago for current (2010) rates of inflation and growth (see Inflation Reports (by date)).
- What are the factors that have persuaded the Bank of England to reduce its forecast for the rate of economic growth in 2011? Are these factors all on the demand side?
- According to the fan chart for economic growth, what is the probability that the UK economy will move back into recession in 2011?
- Will the rise in VAT in January 2011 cause inflation to be higher in 2012 than in 2010 (other things being equal)? Explain.
- Why did the FTSE fall by 2.4% on the day the Report was released?
- If commodity price inflation increases (see Food prices: a question of supply and demand), what impact is this likely to have (a) on the rate of economic growth; (b) on the rate of interest chosen by the MPC?
- What policy should the Bank of England adopt to tackle ‘slowflation’?
Under its terms of reference the new Office for Budget Responsibility is required to provide updated forecasts for the economy and the public finances at the time of each Budget in order take into account the impact of those measures contained in the Budget. Here we consider those economic forecasts contained in the June 2010 OBR Budget Forecast relating to economic growth. In particular, we consider the OBR’s interpretation of how growth is likely to be affected by the policy measures unveiled by George Osborne in his first Budget as Chancellor of Exchequer on 22 June.
The OBR forecasts that the UK economy will grow by 1.2% in 2010 and by a further 2.3% in 2011. These estimates are lower than those published by the OBR in its Pre-Budget Forecast published on 14 June. The Pre-Budget Forecasts predicted growth of 1.3% in 2010 and 2.6% in 2011. The downward revisions reflect the OBR’s assertion that the Budget’s measures to meet the Government’s fiscal mandate and, hence the resultant fiscal consolidation package, will weaken aggregate demand.
In terms of the components of aggregate demand, the fiscal consolidation will mean restraints on government spending (G) and, if the OBR is right, lower growth in household consumption (C). Lower consumption growth is expected as a result of reduced growth in household incomes and the rise in the standard rate of Value Added Tax next January from 17½% to 20%.
The OBR now forecasts that real household consumption will grow by just 0.2% in 2010, following last year’s contraction of 3.2%, and by 1.3% in 2011. General government final consumption – the Government’s expenditure on current goods and services – is forecast to grow in real terms by 1.7% this year before falling by 1.1% next year. The forecasts for general government capital spending are for a real fall of 4.9% this year, following last year’s rise of 15.7%, followed by a sizeable 19% decline in 2011.
A more positive note emerging from the OBR forecasts relates to capital expenditure by businesses. The measures to reform corporation tax, which include a reduction in the main rate of corporation tax from 28 per cent to 24 per cent over four years beginning with a one per cent reduction from April 2011, are predicted to have a favourable effect on investment. Business investment is forecast to rise in real terms by 1.4% this year, following last year’s fall of 19.3%, and to rise again in 2011 by 8.1%.
The projections for growth from 2013 are now stronger than in the OBR’s Pre-Budget Forecast with the economy portrayed as adjusting more quickly at this point towards its potential output. Potential output is the level of output level when the economy’s resources are operating at ‘normal capacity utilisation’. But, in 2015, which is at the end of the OBR’s five year forecast period, the UK economy is still forecast to be experiencing a negative output gap. In other words, actual output will still be less than potential output.
To help paint a picture of how the economy’s output will adjust towards its potential level consider the OBR estimates for the output gap. The OBR estimates that in financial year 2009-10 the economy’s output was 4.1% below its potential. This negative output gap is now expected to be reduced to 3.7% of potential output in 2010-11, to 2.8% in 2012-13 and to 0.9% of potential output in 2015-16.
Office for Budget Responsibility
OBR home page
Office for Budget Responsibility Terms of Reference
Documents
Budget Forecast June 2010 OBR (22/6/10)
Pre-Budget Forecast June 2010 OBR (14/6/10)
Budget 2010 HM Treasury (22/6/10)
Articles
OBR endorses Budget but faces questions over its own predictions Telegraph, Philip Alrdrick (23/6/10)
UK growth forecasts could be revised again, says Sir Alan Budd Citywire, Deborah Hyde (23/6/10)
OBR says growth will take bigger hit Financial Times, Norma Cohen (22/6/10)
Budget 2010: Government cuts will slow economic recovery, says watchdog Telegraph, James Kirkup (23/6/10)
Highlights from the Budget BBC News (22/6/10)
Budget statement: George Osborne’s speech in full BBC Democracy Live (22/6/10)
Questions
- What do you understand by the concept of aggregate demand?
- What are the component expenditures of aggregate demand? Which of these do you think is the largest in value terms?
- The OBR is forecasting the household sector’s disposable income to grow in real terms this year by 0.2% and by 1.2% next year. Why then is the OBR identifying weaker consumer demand as a result of the Budget measures as a major reason for revising down its predictions for economic growth?
- The OBR argues that the fiscal consolidation measures will have a ‘direct effect’ on household incomes and so on spending, but that this will be ‘partially offset by a decline in saving’. Why might the OBR be arguing that a fiscal consolidation will lead to a decline in saving? Evaluate the OBR’s arguments.
- What do you understand by the concept of an output gap? What does a negative output gap signify?
- To see the sorts of problems that forecasters commonly face, try identifying reasons why the output gap could be eliminated more quickly or less quickly as a result of the Budget measures.
In 2008 and 2009, as the global recession deepened, so governments around the world turned to Keynesian policies. Aggregate demand had to be boosted. This meant a combination of fiscal and monetary policies. Fiscal stimulus packages were adopted, combining increased government expenditure and cuts in taxes. On the monetary policy front, central banks cut interest rates to virtually zero and expanded the money supply in bouts of quantitative easing.
The global recession turned out not to be a deep as many had feared and the Keynesian policies were hailed by many as a success.
But how the tide is turning! The combination of the recession (which reduced tax revenues and increased welfare spending) and the stimulus packages played havoc with public finances. Deficits soared. These deficits had to be financed, and increasingly credit agencies and others were asking how sustainable such deficits were over the longer term. These worries have been compounded by the perilous state of the public finances in countries such as Greece, Portugal, Ireland and Hungary. The focus has thus turned to cuts. In fact there is now an international ‘competition’ as to which country can wear the hairiest hair shirt. The new Coalition government in the UK, for example, is busy preparing the general public for deep cuts to come.
We are now seeing a re-emergence of new classical views that increased deficits, far from stimulating the economy and resulting in faster growth, largely crowd out private expenditure. To prevent this crowding out and restore confidence in financial markets, deficits must be rapidly cut, thereby allowing finance to be diverted to the private sector.
But if the contribution to aggregate demand of the public sector is to be reduced, and if consumption, the largest component of aggregate demand, is also reduced as households try to reduce their reliance on borrowing, where is the necessary rise in aggregate demand to come from? We are left with investment and net exports – the remaining two components of aggregate demand, where AD = C + G + I + (X – M).
But will firms want to invest if deficit reduction results in higher taxes, higher unemployment and less spending by the government on construction, equipment and many other private-sector goods and services. Won’t firms, fearing a decline in consumer demand, and possibly a ‘double-dip recession’, hold off from investing? As for export growth, this depends very much on growth in the rest of the world. If the rest of the world is busy making cuts too, then export growth may be very limited.
The G20, meeting in Korea on 4 June, wrestled with this problem. But the mood had definitely turned. Leaders seemed much more concerned about deficit reduction than maintaining the fiscal stimulus.
The following articles look at the arguments between Keynesians and new classicists. The disagreements between their authors reflect the disagreements between economists and between politicians about the timing and extent of cuts.
Articles
Time to plan for post-Keynesian era Financial Times, Jeffrey Sachs (7/6/10)
The Keynesian Endpoint CNBC Guest Blog, Tony Crescenzi (7/6/10)
Keynes, Recovered Boston Review, Jonathan Kirshner (May/June 2010)
How Keynes, not mining, saved us from recession Sydney Morning Herald, Ross Gittins (7/6/10)
The verdict on Keynes Asia Times, Martin Hutchinson (2/6/10)
The G20 Has Officially Voted For Global Depression Business Insider, Marshall Auerback (7/6/10)
Deficit disorder: the Keynes solution New Statesman, Robert Skidelsky (17/5/10)
Hawks v doves: economists square up over Osborne’s cuts Guardian, Phillip Inman (14/6/10)
Reports and data
OECD Economic Outlook No. 87, May 2010 (see)
Economics: Growth rising faster than expected but risks increasing too, says OECD Economic Outlook OECD (26/5/10)
Economy: responses must reflect governments’ views of national situations OECD (26/5/10)
Editorial and summary of projections OECD (26/5/10)
General assessment of the macroeconomic situation OECD (26/5/10)
Statistical Annex to OECD Economic Outlook No. 87 OECD (10/6/10)
Communiqué, Meeting of Finance Ministers and Central Bank Governors, Busan, Republic of Korea G20 (5/6/10)
Questions
- Summarise the arguments for and against making rapid cuts in public-sector deficits.
- What forms can crowding out take? Under what circumstances will a rise in public-sector deficits (a) cause and (b) not cause crowding out?
- Assess the policy measures being proposed by the G20.
- How important is confidence for the success of (a) fiscal stimulus packages and (b) deficit reduction policies in boosting economic growth?
In the UK, we have an inflation target of 2% and it’s the Bank of England’s job to use monetary policy, in particular interest rates, to keep inflation within 1 percentage point of its target. However, with rising commodity prices and the onset of recession back in 2008, interest rates had another objective: to prevent or at least lessen the recession. Bank Rate fell to 0.5% and there it has remained in a bid to encourage investment, discourage saving and increase consumption, as a means of stimulating the economy.
However, at such a low rate, interest rates are not acting as a brake on inflation, which is now well above target. This rise in inflation, has been largely brought about by cost-push factors, such as the restoration of the 17.5% VAT (up from the temporary 15%), higher oil and commodity prices, and a fall in the exchange rate. But part of the reason might be found in the increase in money supply that resulted from quantitative easing.
There are concerns that the UK may lose its credibility on inflation if action isn’t taken. The OECD has advised the Bank of England to raise Bank Rate to 3.5% by the end of 2011. The following articles consider this issue.
Articles
Time to worry about inflation? BBC News blogs, Stephanomics, Stephanie Flanders (28/5/10)
UK must not fall for the false promise of higher inflation Telegraph, Charles Bean, Deputy Governor of the Bank of England (4/6/10)
Reports and documents
General Assessment of the Macroeconomic Situation OECD Economic Outlook, No. 87 Chapter 1 (see especially pages 53–4) (May 2010)
United Kingdom – Country Summary OECD Economic Outlook, No. 87 (May 2010)
Statistical Annex OECD Economic Outlook, No. 87 (available 10/6/10)
Inflation Report portal Bank of England (see May 2010)
Questions
- Explain the relationship between interest rates and inflation. Why have such low interest rates caused inflation to increase?
- In 2008, the UK moved into recession, but was also suffering from inflation. This was unusual, as AD/AS analysis suggests that when aggregate demand falls, growth will fall, but so will prices. What can explain the low growth and inflation we saw in 2008?
- What is the difference between real and nominal GDP?
- What are the causes of the current high inflation and what solutions are available and viable?
- Why are expectations of inflation so important and how might they influence the Bank of England’s plans for interest rates?
- Do you think the OECD should have advised the Bank of England? Will there be any adverse effects internationally if the UK doesn’t heed the OECD’s advice?
- Is the OECD’s assessment of the UK in the above Country Summary consistent with its view on UK interest rates contained in pages 53 and 54 in the first OECD link?