The UK economy is suffering from a lack of aggregate demand. Low spending in real terms is preventing the economy from growing. A simple solution would seem to be to stimulate aggregate demand through fiscal policy, backed up by even looser monetary policy. But this is easier said than done and could result in undesirable consequences in the medium term.
If increased borrowing were to be used to fund increased government expenditure and/or cuts in taxes, would any resulting growth be sufficient in the medium term to reduce the public-sector deficit below the initial level through automatic fiscal stabilisers? And would the growth be sustainable? The answer to this second question depends on what happens to the supply side of the economy. Would there be an increase in aggregate supply to match the increase in aggregate demand?
This second question has led many economists to argue that we need to see a rebalancing of the economy. What is needed is an increase in investment and exports, rather than an increase in just consumer expenditure funded by private borrowing and government current expenditure funded by public borrowing.
But how will exports and investment be stimulated? As far as exports are concerned, it was hoped that the depreciation of the pound since 2008 would give UK exporters a competitive advantage. Also domestic producers would gain a competitive advantage in the UK from imports becoming more expensive. But the current account deficit has actually deteriorated. According to the EU’s AMECO database, in 2008 the current account deficit was 1% of GDP; in 2012 it was 3.7%. It would seem that UK producers are not taking sufficient advantage of the pound’s depreciation, whether for exports or import substitutes.
As far as investment is concerned, there are two major problems. The first is the ability to invest. This depends on financing and things such as available land and planning regulations. The second is the confidence to invest. With not little or no growth in consumer demand, there is little opportunity for the accelerator to work. And with forecasts of sluggish growth and austerity measures continuing for some years, there is little confidence in a resurgence in consumer demand in the future. (Click here for a PowerPoint of the above chart. Note that the 2013 plots are based on AMECO forecasts.)
So hope of a rebalancing is faint at the current time. Hence the arguments for an increase in government capital expenditure that we looked at in the last blog post (The political dynamite of calm economic reflection). The problem and the options for government are considered in the following articles.
Articles
Budget 2013: Chancellor’s rebalancing act BBC News, Stephanie Flanders (11/3/13)
Why George Osborne is failing to rebalance the economy The Guardian, Larry Elliott (17/3/13)
Economy fails to ‘rebalance’ Financial Times, Sarah O’Connor (27/2/13)
Analysis – Long haul ahead for Britain’s struggling economy Reuters, William Schomberg (3/3/13)
Can banks be forced to lend more? BBC News, Robert Peston (12/3/13)
Budget 2013: What the commentators are saying BBC News (13/3/13)
Data
UK Trade, January 2013 (ONS) (12/3/13)
Business investment, Q4 2012 ONS (27/2/13)
Questions
- Draw a diagram to illustrate the effects of a successful policy to increase both aggregate demand and aggregate supply. What will determine the effect on the output gap?
- For what reasons has the UK’s current account deteriorated over the past few years while those of the USA and the eurozone have not?
- Using ONS data, find out what has happened to the UK’s balance of trade in (a) goods and (b) services over the past few years and explain your findings.
- Why are firms reluctant to invest at the moment? What policy measures could the government adopt to increase investment?
- With interest rates so low, why don’t consumers borrow and spend more, thereby aiding the recovery?
In a carefully argued article in the New Statesman, the UK Business Secretary, Vince Cable, considers the slow recovery in the economy and whether additional measures should be adopted. He sums up the current state of the economy as follows:
The British economy is still operating at levels around or below those before the 2008 financial crisis and roughly 15 per cent below an albeit unsustainable pre-crisis trend. There was next to no growth during 2012 and the prospect for 2013 is of very modest recovery.
Unsurprisingly there is vigorous debate as to what has gone wrong. And also what has gone right; unemployment has fallen as a result of a million (net) new jobs in the private sector and there is vigorous growth of new enterprises. Optimistic official growth forecasts and prophets of mass unemployment have both been confounded.
He argues that supply-side policies involving “a major and sustained commitment to skills, innovation and infrastructure investment” are essential if more rapid long-term growth is to be achieved. This is relatively uncontroversial.
But he also considers the claim that austerity has kept the economy from recovering and whether policies to tackle the negative output gap should be adopted, even if this means a short-term increase in government borrowing.
But crude Keynesian policies of expanding aggregate demand are both difficult to implement and may not take into account the particular circumstance of the current extended recession – or depression – in the UK and in many eurozone countries. World aggregate demand, however, is not deficient. In fact it is expanding quite rapidly, and with the sterling exchange rate index some 20% lower than before the financial crisis, this should give plenty of opportunity for UK exporters.
Yet expanding UK aggregate demand is proving difficult to achieve. Consumers, worried about falling real wages and large debts accumulated in the years of expansion, are reluctant to increase consumption and take on more debts, despite low interest rates. In the light of dampened consumer demand, firms are reluctant to invest. This makes monetary policy particularly ineffective, especially when banks have become more risk averse and wish to hold higher reserves, and indeed are under pressure to do so.
So what can be done? He argues that there is “some scope for more demand to boost output, particularly if the stimulus is targeted on supply bottlenecks such as infrastructure and skills.” In other words, he advocates policies that will simultaneously increase both aggregate demand and aggregate supply. Monetary policy, involving negative real interest rates and quantitative easing, has helped to prevent a larger fall in real aggregate demand and a deeper dive into recession, but the dampened demand for money and the desire by banks to build their reserves has meant a massive fall in the money multiplier. Perhaps monetary policy needs to be more aggressive still (see the blog post, Doves from above), but this may not be sufficient.
Which brings Dr Cable to the political dynamite! He advocates an increase in public investment on infrastructure (schools and colleges, hospitals, road and rail projects and housing, and considers whether this should be financed, not by switching government expenditure away from current spending, but by borrowing more.
Such a strategy does not undermine the central objective of reducing the structural deficit, and may assist it by reviving growth. It may complicate the secondary objective of reducing government debt relative to GDP because it entails more state borrowing; but in a weak economy, more public investment increases the numerator and the denominator.
He raises the question of whether the balance of risks has changed: away from the risk of increased short-term borrowing causing a collapse of confidence to the risk of lack of growth causing a deterioration in public finances and this causing a fall in confidence. As we saw in the blog post Moody Blues, the lack of growth has already caused one ratings agency (Moody’s) to downgrade the UK’s credit rating. The other two major agencies, Standard & Poor’s and Fitch may well follow suit.
The day after Dr Cable’s article was published, David Cameron gave a speech saying that the government would stick to its plan of deficit reduction. Not surprisingly commentators interpreted this as a split in the Coalition. Carefully argued economics from Dr Cable it might have been, but political analysts have seen it as a hand grenade, as you will see from some of the articles below.
When the facts change, should I change my mind? New Statesman, Vince Cable (6/3/13)
Keynes would be on our side New Statesman, Vince Cable (12/1/11)
Exclusive: Vince Cable calls on Osborne to change direction New Statesman, George Eaton (67/3/13)
Vince Cable: Borrowing may not be as bad as slow growth BBC News (7/3/13)
Vince Cable makes direct challenge to Cameron over economic programme The Guardian, Nicholas Watt (7/3/13)
Vince Cable Says George Osborne Must Change Course And Borrow More To Revive Growth Huffington Post, Ned Simons (6/3/13)
David Cameron and Vince Cable at war over route to recovery Independent, Andrew Grice (6/3/13)
Vince Cable: Borrowing may not be as bad as slow growth BBC News, James Landale (6/3/13)
David Cameron: We will hold firm on economy BBC News (7/3/13)
David Cameron: We will hold firm on economy BBC News (7/3/13)
Clegg Backs Cable Over Controversial Economy Comments LBC Radio, Nick Clegg (7/3/13)
It’s plain what George Osborne needs to do – so just get on and do it The Telegraph, Jeremy Warner (6/3/13)
Vince Cable’s plan B: a “matter of judgement” BBC News, Stephanie Flanders (7/3/13)
George Osborne needs to turn on the spending taps The Guardian, Phillip Inman (12/3/13)
Questions
- Why has monetary policy proved ineffective in achieving a rapid recovery from recession?
- Distinguish between discretionary fiscal policy and automatic fiscal stabilisers.
- Why has the existence of automatic fiscal stabilisers meant that the public-sector deficit has been difficult to bring down?
- In what ways has the balance of risks in using discretionary fiscal policy changed over the past three years?
- In what ways is the depression of the late 2000s/early 2010s (a) similar to and (b) different from the Great Depression of the early 1930s?
- In what ways is the structure of public-sector debt in the UK different from that in many countries in the eurozone? Why does this give the government more scope for expansionary fiscal policy?
- Why does the Office of Budget Responsibility’s estimates of the tax and government expenditure multipliers suggest that “if fiscal policy is to work in a Keynesian manner, it needs to be targeted carefully, concentrating on capital projects”?
- Why did Keynes argue that monetary policy is ineffective at the zero bound (to use Dr Cable’s terminology)? Are we currently at the zero bound? If so what can be done?
- Has fiscal tightening more than offset loose monetary policy?
According to the first estimate by the Office for National Statistics, the UK economy shrank by 0.3% in the final three months of 2012. This means that over the whole year growth was flat.
The biggest contributor to the fall in GDP in Q4 was the production industries, which include manufacturing. Output of the production sector fell by 1.8% in Q4. Construction sector output, by contrast, was estimated to have increased by 0.3%. Service sector output was flat. The chart below shows quarterly and annual growth in the UK from 2007 to 2012. (Click here for a PowerPoint.)
Latest estimates by the IMF are that the UK economy will grow by 1.0% in 2013 – well below the long-term growth in potential output (see also the last blog, High hopes in the Alps). But some forecasters are predicting that real GDP will continue to fall for at least one more quarter, which means that the economy would then be in a ‘triple-dip recession’.
Not surprisingly politicians have interpreted the statistics very differently, as have economists. The government, while recognising that the UK faces a ‘very difficult economic situation’, argues that now is not the time to change course and that by continuing with policies to reduce the deficit the economy will be placed on a firmer footing for sustained long-term growth
The opposition claims that the latest figures prove that the government’s policies are not working and that continuing attempts to bear down on the deficit are depressing aggregate demand and thereby keeping the economy depressed.
The following webcasts, podcasts and articles expand on these arguments. Try to be dispassionate in using economic analysis and evidence to assess the arguments.
Webcasts and podcasts
Video Summary: Gross Domestic Product Preliminary Estimate, Q4 2012 Media Briefing (Click here for the following Q&A) ONS (25/1/13)
Triple dip on the menu? Channel 4 News, Siobhan Kennedy and Faisal Islam (25/1/13)
Getting and spending – the key to recovery Channel 4 News, Cathy Newman (25/1/13)
UK economy shrinks by 0.3% in the last three months of 2012 BBC News, Hugh Pym (25/1/13)
Danny Alexander on GDP figures and economic plans BBC Daily Politics (25/1/13)
Osborne defends government’s deficit reduction plan BBC News (25/1/13)
Ed Balls: UK economy urgently needs a ‘Plan B’ BBC News (25/1/13)
UK heads for triple dip as GDP contracts 0.3pc The Telegraph, Philip Aldrick (25/1/13)
Economist: Government may need to rethink its fiscal policy The Telegraph, Jim O’Neill (25/1/13)
Has austerity really been tried in Britain? BBC Today Programme, Jonathan Portes and Andrew Lilico (29/1/13)
Articles
UK GDP: Economy shrank at end of 2012 BBC News (25/1/13)
UK GDP shrinks by 0.3% in fourth quarter: what the economists say The Guardian (25/1/13)
New Bank of England head Mark Carney hints at big shift in policy The Guardian (26/1/13)
The Bank of England, the chancellor, and the target BBC News. Stephanie Flanders (29/1/13)
The Entire World Of Economics Is Secretly Thankful To The UK Right Now Business Insider, Joe Weisenthal (26/1/13)
Data
Gross Domestic Product: Preliminary Estimate, Q4 2012 ONS (25/1/13)
Video Summary: Gross Domestic Product Preliminary Estimate, Q4 2012 ONS (25/1/13)
Preliminary Estimate of GDP – Time Series Dataset 2012 Q4 ONS (25/1/13)
Business and Consumer Surveys DG ECFIN
Questions
- What are the reasons for the decline in GDP in 2012 Q4??
- Examine how likely it is that the UK will experience a triple-dip recession.
- What measures could be adopted to increase consumer and business confidence?
- If there is substantial spare capacity, is expansionary fiscal policy the best means of achieving economic growth?
- What additional monetary policy measures could be adopted to stimulate economic growth?
- Find out what has happened to the UK’s public-sector deficit and debt over the past three years. Explain what has happened.
What lies ahead for economic growth in 2013 and beyond? And what policies should governments adopt to aid recovery? These are questions examined in four very different articles from The Guardian.
The first is by Nouriel Roubini, Professor of Economics at New York University’s Stern School of Business. He was one of the few economists to predict the collapse of the housing market in the USA in 2007 and the credit crunch and global recession that followed. He argues that continuing attempts by banks, governments and individuals to reduce debt and leverage will mean that the advanced economies will struggle to achieve an average rate of economic growth of 1%. He also identifies a number of other risks to the global economy.
In contrast to Roubini, who predicts that ‘stagnation and outright recession – exacerbated by front-loaded fiscal austerity, a strong euro and an ongoing credit crunch – remain Europe’s norm’, Christine Lagarde, head of the IMF and former French Finance Minister, predicts that the eurozone will return to growth. ‘It’s clearly the case’, she says, ‘that investors are returning to the eurozone, and resuming confidence in that market.’ Her views are echoed by world leaders meeting at the World Economic Forum in Davos, Switzerland, who are generally optimistic about prospects for economic recovery in the eurozone.
The third article, by Aditya Chakrabortty, economics leader writer for The Guardian, looks at the policies advocated at the end of World War II by the Polish economist, Michael Kalecki and argues that such policies are relevant today. Rather than responding to high deficits and debt by adopting tough fiscal austerity measures, governments should adopt expansionary fiscal policy, targeted at expanding infrastructure and increasing capacity in the economy. That would have an expansionary effect on both aggregate demand and aggregate supply. Sticking with austerity will result in continuing recession and the ‘the transfer of wealth and power into ever fewer hands.’
But while in the UK and the eurozone austerity policies are taking hold, the new government in Japan is adopting a sharply expansionary mix of fiscal and monetary policies – much as Kalecki would have advocated. The Bank of Japan will engage in large-scale quantitative easing, which will become an open-ended commitment in 2014, and is raising its inflation target from 1% to 2%. Meanwhile the Japanese government has decided to raise government spending on infrastructure and other government projects.
So – a range of analyses and policies for you to think about!
Risks lie ahead for the global economy The Guardian, Nouriel Roubini (21/1/13)
Eurozone showing signs of recovery, says IMF chief The Guardian, Graeme Wearden (14/1/13)
Austerity? Call it class war – and heed this 1944 warning from a Polish economist The Guardian, Aditya Chakrabortty (14/1/13)
Bank of Japan bows to pressure with ‘epoch-making’ financial stimulus The Guardian, Phillip Inman (22/1/13)
Questions
- What are the dangers facing the global economy in 2013?
- Make out a case for sticking with fiscal austerity measures.
- Make out a case for adopting expansionary fiscal policies alongside even more expansionary monetary policies.
- Is is possible for banks to increase their capital-asset and liquidity ratios, while at the same time increasing lending to business and individuals? Explain.
- What are the implications of attempts to reduce public-sector deficits and debt on the distribution of income? Would it be possible to devise austerity policies that did not have the effect you have identified?
- What will be the effect of the Japanese policies on the exchange rate of the yen with other currencies? Will this be beneficial for the Japanese economy?
Japan’s general election on 16 December was won by the centre-right Liberal Democratic Party (LDP), led by Shinzo Abe. It gained a two-thirds majority in the lower house. It returns to power after losing to the Democratic Party in 2009. Previously it had been in office for most of the time since 1955.
The LDP has promised to revive the flagging Japanese economy, which has been suffering from years of little or no growth and returned to recession last quarter. Economic confidence has been damaged by a dispute with China about the sovereignty over some small islands in the East China Sea. The economy, whose exports make up some 13% of GDP, has suffered from the global slowdown and a high yen. The yen has appreciated against the dollar by around 40% since 2007.
The economy has also suffered from the shutdown of all its nuclear reactors following the earthquake and tsunami last year. Nuclear power accounted for over 30% of the country’s electricity generation.
Mr Abe promises to revive the economy through fiscal and monetary policies. He plans a fiscal stimulus package in early 2013, with increased government expenditure on infrastructure and other public-works. He also wants the Bank of Japan to increase its inflation target from 1% to 3% and to achieve this through various forms of monetary easing.
The initial reactions of markets to the election result were favourable. The stock market rose and the yen fell.
However, as the following articles discuss, there are dangers associated with Mr Abe’s policies. The expansionary fiscal policy will lead to a rise in the country’s general-government debt, which, at some 240% of GDP, is by far the largest in the developed world. This could lead to a loss of confidence in Japanese debt and a fall in the price of bonds on the secondary markets and a rise in government borrowing costs. Also, a depreciation of the yen, while welcomed by exporters, would increase the price of imports, including food and raw materials.
Changing of guard in Japan as PM concedes vote CNN, Yoko Wakatsuki, Brian Walker, and Hilary Whiteman (17/12/12)
LDP Win Clears Pipes for Japan Fiscal Spigot Bloomberg Businessweek, Toru Fujioka (17/12/12)
Economic implications of Japan’s election Huffington Post (16/12/12)
Japan economy contracts again Taipei Times (11/12/12)
Japan elections: Shares rise and yen weakens on Abe win BBC News (17/12/12)
Shinzo Abe’s challenges in reviving Japan’s economy BBC News, Puneet Pal Singh (17/12/12)
Can Shinzo Abe Save Japan? Slate, Matthew Yglesias (30/11/12)
Deflation only natural when politicians refuse to fix oversupplied Japan Japan Times, Teruhiko Mano (17/12/12)
New Year messages from Japan BBC News, Stephanie Flanders (18/12/12)
Japan – Muddling On Or Growing Stronger? Seeking Alpha, Anthony Harrington (12/12/12)
Japanese government unveils £138bn stimulus package The Guardian (11/1/13)
Questions
- Using macroeconomic data from sources such as sites 6, 7 and 9 in the Economics Network’s Economic Data freely available online, describe Japan’s macroeconomic situation over the past 10 years.
- Why has the Japanese yen appreciated so much in recent years?
- What forms could monetary easing take in Japan?
- Why might it prove difficult to stimulate the Japanese economy through fiscal and monetary policies?
- What undesirable side-effects might result from expansionary fiscal and monetary policies?
- What structural weaknesses are there in the Japanese economy that have hindered economic growth? What policies might the new Japanese government pursue in tackling these structural weaknesses?
The UK economy is suffering from a lack of aggregate demand. Low spending in real terms is preventing the economy from growing. A simple solution would seem to be to stimulate aggregate demand through fiscal policy, backed up by even looser monetary policy. But this is easier said than done and could result in undesirable consequences in the medium term.
This second question has led many economists to argue that we need to see a rebalancing of the economy. What is needed is an increase in investment and exports, rather than an increase in just consumer expenditure funded by private borrowing and government current expenditure funded by public borrowing.