[This article. by Adam Posen, Director of the Peterson Institute for International Economics, and formerly a member of the Bank of England's Monetary Policy Committee, originally appeared here on the Peterson Institute website. He has very kindly agreed to allow me to reproduce it here as a contribution to the UK policy debate. Obviously the views below are his, not mine or NIESR's, although for what it's worth I am, as readers of this blog will know, in broad agreement.]
The British economy is lacking productive investment, but not for want of investment opportunities. Banks and large corporations are sitting on cash, households are holding back on large purchases (including of housing), and the public sector is slashing its investment flow. This shortfall reflects the deficiencies of the British domestic financial system, some of them longstanding from well before 2008, as much as lack of confidence in future prospects, and responsible macroeconomic policy can address both problems. The current British coalition government’s economic policy program, however, instead is intended to address a lack of savings, not of investment, and is pursuing that mistaken priority in a self-defeating way. The economic issue facing the UK therefore is not just one of Plan A versus B, or of the amount and pace of austerity versus growth – the issue is that the UK needs investment friendly structural reform and stimulus, not fiscal consolidation as a goal in and of itself.
If we were to listen to the Chancellor and Prime Minister, we would be told that the challenge facing the British people is to trim their spending to match their diminished means. The claim is that they cannot get credit anymore the way they used to, either as households or as a government, to borrow against future earnings; in fact they have to pay down the debts from their past spending binge to prevent risk of having their remaining credit lines pulled. Furthermore, any shortfall in paying that debt off would be seen as proof that the British ability and willingness to pay lenders has declined, according to Chancellor Osborne. Unfortunately, the Bank of England Monetary Policy Committee [MPC] and the Office of Budget Responsibility [OBR] have of late supported this mistaken view by adjusting their forecasts for UK economic growth down, essentially assuming that recent that recent poor performance means future performance will be nearly as poor – that is, that the potential or underlying growth rate of the UK economy has diminished.
This false assumption feeds back into further arguments for fiscal and household consolidation. The UK public and private sectors are paying down debt less quickly than expected to, and that means by assumption that their future ability to pay down debt is declining, so they must cut back spending and borrowing even more today to remain solvent. This framework also leads into defeatism for monetary policy, since the implication is that efforts to stimulate the economy through that means will only add to the debt burden or inflation, rather than sustainable growth. And it distracts attention from failures of the British financial system, since no one would be expected to invest in an economy where future prospects and current creditworthiness are declared to be so shaky.
This interpretation of recent British economic experience – I refuse to call it an analysis – is profoundly wrong, profound both in how misguided it is, and in how much damage it has done by misdirecting UK macroeconomic policy. The facts of recent experience, including of the recession, do not fit with this misinterpretation, but do fit with the view that investment failings are at work in the British economy:
- The UK government debt has low interest rates now because growth is low and demand for safe assets is high. British interest rates decline in response to bad news on growth, and market measures of the riskiness of gilts increase when interest rates and growth drop. The opposite should hold – rates and market risk should rise together – if indebtedness were markets’ concern. They don’t and it isn’t.
- Private UK businesses have kept adding workers in recent years (albeit some part-time or temporary) because they view future prospects as unchanged or better. Employers only increase staff in a flexible decentralized labour market like Britain’s when they think wage costs are competitive. The opposite should hold – declining growth and wages should lead to permanent cuts in employment – if UK potential growth was down for most businesses. They didn’t and it isn’t.
- The spreads between the interest rates that small businesses and first time mortgage borrowers must pay for loans versus established large borrowers, and the fees that those new borrowers are charged have gone up and stayed up. If there were lack of demand for investment, the interest rates and fees that banks could charge for loans would be declining – they are rising instead.
- Sterling has been stable in value since its 2008 depreciation, and foreign direct investment continues to pile in to such industries as auto manufacturing and fancy foods as well as business services. If the lack of investment were due to doubts about government solvency or business competitiveness, capital would be flowing out of the UK and the pound would be declining. The opposite is the case.
- Cuts in government spending and increases in taxation have had large effects per pound on consumption and growth overall (far larger than the Government, the MPC, and the OBR projected). That occurs when confidence is being beaten down rather than raised up by fiscal consolidation. If lack of confidence in government finances were a major weight on British households and businesses, the direct drag from fiscal contraction would be offset (if not reversed) by a rise in investment. Again, the opposite is the case, and no such confidence effects have been seen.
In sum, the economic understanding underlying the Government’s economic priority on deficit reduction without regard for investment – public or private – has proven wrong along every line. Many of Britain’s current economic problems are the result of economic conditions these excessive austerity policies themselves have caused.
So should the British government just go on a spending binge instead? No, clearly not. Even though there is legitimately little fear about UK government finances at present, with the large deficits largely driven by slow growth pushing down tax revenues and up benefits spending, there is nothing to be gained by making those fears more realistic. Again, debt and deficit levels are important, but fiscal policy needs to be set with respect to the right underlying assessment of the economic difficulty – focusing simply the levels of public spending and taxes misses the point.
What the British government should do instead is to follow my program for reforms and stimulus to support productive investment, which has just been published in Prospect.