European Communities (Amendment) Act 1993

Lord Skidelsky Excerpts

Wednesday 25th April 2012 Lords Chamber

[Lord Eatwell]

My Lords, on the day that the British economy has fallen back into recession, it might have been expected that the Treasury spokesman would take the advantage of this economics debate to explain himself to the House. Apparently, he prefers to stay away and avoid the embarrassment. I am sure we are all grateful to the noble Lord, Lord De Mauley, for valiantly throwing his body into the breach.

We have learnt over the past couple of years that quarterly GDP figures should be taken with several grains of salt, but the figures released this morning are consistent with all the revised numbers over the two years that the coalition Government have been in office. Basically, the economy has ground to a halt and growth is negligible, and because of this the rate at which government borrowing is being reduced has also slowed down. Indeed, the deficit in March this year was higher than in March a year ago. No one can doubt that these dismal results are the consequence of the coalition policy of austerity. As the Financial Times has pointed out:

“Official figures on Tuesday showed five more years of grinding austerity were in prospect”.

Tightening your belt to pay back a debt is becoming painfully familiar to many households in this country, so simple arguments about austerity being the price of excess borrowing resonate with daily experience. Yet the analogy is false; coalition austerity is impoverishing not only the borrower but the lender too, for from whom have the UK Government borrowed this money? None other than our pension funds, our insurance companies and our investment trusts, all of which are suffering from the recession created by coalition austerity policies.

The Budget documents before us reveal the true dimension of the failure of the coalition policy of general impoverishment. It is that general failure that I wish to concentrate on today, rather than pick over the decaying bones of the Budget itself. I remind the House of the state of the economy that the coalition inherited; it was growing at 2 per cent per year, an almost inconceivable figure today. The coalition’s actions on taking office reduced that to zero in just a few months, primarily, as has been so effectively argued time and time again by the noble Lord, Lord Skidelsky, by destroying business confidence. They followed this by imposing the coalition one-club policy: austerity as the cure for all economic ills. Also, as is made clear in the Budget report, 90 per cent of planned government cuts are still to come—squeezing the life out of the British economy.

The Government also inherited an economy in which the public sector was running a fiscal deficit unprecedented in peacetime. That deficit inheritance is well illustrated in Chart 2.5 of the convergence programme report. Noble Lords will note that at the beginning of 2008 the deficit was about 2.5 per cent of GDP and was falling, as it had been doing for the previous two years. Then, in mid-2008, the Government’s finances were engulfed by a veritable tsunami as the financial crisis resulted in rapidly falling tax revenues and rapidly rising expenditure, such that the deficit rose to over 11 per cent of GDP by 2010. The question before us today is simple: is austerity securing recovery? Is it securing an effective elimination of that deficit and building strong foundations for future growth?

The answer to these vital questions can be found in the OBR report that accompanied the Budget, and indeed is embodied in the convergence report. The OBR points out that the austerity programme does not simply result in loss of output over the next five years or so, but results in a permanent loss of output as the productive potential of the economy is reduced, undermined by the lack of investment in productive capacity and the erosion of skills among a lost generation of the unemployed. The OBR could not be clearer in stating that,

“our estimates of potential growth do imply a significant and persistent loss of potential output relative to the pre-crisis trend … Our … estimates for 2011 imply a potential output loss of around 8 per cent … This shortfall widens to around 11 per cent by 2016”.

The permanent loss of potential output also results in a permanent loss of potential revenue for the Government and hence worsens the deficit, prolonging the age of coalition austerity. As the OBR argues,

“the output gap determines the ‘structural’ or cyclically adjusted component of the deficit. A more negative output gap”—

that means greater productive potential—

“implies that more of the deficit will disappear automatically as the economy recovers, pushing up revenues and reducing spending”.

As chart 6.7 in the report shows, the output gap is being narrowed, productive potential is being reduced by the recession itself. So according to the OBR, the policy of austerity is itself reducing the beneficial impact that growth can later have on the elimination of the deficit. Put another way, if the growth rate of the economy were to be stimulated now, if the policy of austerity were to be abandoned, not only would growth be higher now, but the long-term output of the economy would be permanently higher, and the potential for cutting the deficit would be strengthened.

The essence of the OBR’s powerful case against the Government’s austerity policy is the starting point of a case for a policy of fiscal stimulation put forward by Professor Larry Summers of Harvard University, the former US Secretary of the Treasury. In an important paper, co-authored with Professor DeLong of the University of California, Berkeley, delivered at the Brookings Institution on the very day before the Chancellor presented his Budget, Professor Summers provided empirical estimates of the long-term impact of austerity, and of the alternative policy of fiscal stimulation. He demonstrated that under current depressed conditions, a fiscal expansion would pay for itself by enhancing the permanent potential output of the economy—the OBR’s point—and producing higher long-term revenues for the Government. As Summers put it,

“temporary expansionary fiscal policies may well reduce long-run debt-financing burdens”.

What if the Government were to take up the Summers policy, and undertake “temporary expansionary fiscal policies” that are self-financing in the long run? Where would the money come from to pay for such policies today?

Fortunately, the Chancellor himself has provided the answer. If the nation can afford to lend £10 billion to the IMF, then it can afford to lend to £10 billion to a national infrastructure bank directly to attack the decline in productive potential that the austerity policies have produced. Mr Osborne said the IMF loan would come from the UK's reserves, was not money that would otherwise have been available for public spending, and would not add to the national debt. Okay, let us perform the trick again, but this time at home.

However, it might then be argued that the rating agencies—to which the Chancellor regularly pledges allegiance—and the bond markets may not be convinced by the Summers argument, resulting in a loss of confidence in Britain with knock-on effects on interest rates. Summers presumes no increase in risk premia, resulting in no increase in interest rates. His point is that the expansion would be self-financing and therefore an increase in risk premium would be irrational. However, perhaps it is too much to expect rational behaviour from Mr Osborne's friends in the ratings agencies. After all these are the clowns who told us that securitised sub-prime mortgages were as safe as Uncle Sam. How might we protect Britain from their irrationality? May I offer two proposals that have been floated elsewhere?

First, it has been suggested in the United States that austerity policies—cuts in spending or increases in taxes—should be contingent on the economy reaching predefined goals in terms of growth and/or employment. Legislation would commit the Government to cutting the deficit when the growth target had been hit. The potential flaw in this proposal is obvious. Cuts in demand might stifle a recovery before it had properly begun. But at least this idea of contingent deficit reduction provides some escape from coalition austerity.

Secondly, the fact that the 2010 deficit was unprecedented should have prompted some thought. Coalition austerity might have been appropriate if we were facing normal cyclical swings in the economy, rather than the most severe economic shock since the Second World War. And it is the funding of World War II that is instructive. The war was a severe economic shock, and Britain borrowed heavily to pay for it. We finally paid off our borrowing to pay for the war in 2006, 61 years after the war ended. That is a sensible way of dealing with unique financial shocks, with important lessons for economic management. Even though the debt to GDP ratio in 1945 exceed 250 per cent, rather than the 70 per cent of today, this did not stop the Government creating the NHS, introducing major educational reform, expanding the welfare state and starting the difficult process of rebuilding the postwar economy.

Given that we are facing an extraordinary event, why not place the excess debt created by the circumstances of the global crisis into a sinking fund? The fund could be financed by selling the long-term bonds that the Chancellor has suggested be issued, and bond redemption could be tied to a dedicated revenue stream. The repayment of the debt could then be extended over, say, 20 years—it need not be 61—and the Government could pursue a sensible growth strategy managing the normal residual debt on an annual basis. Neither of those proposals is a perfect solution. There is no perfect solution. But at least they are alternatives to blindly following coalition austerity. Of course, these rational responses to a unique event may not convince the irrational ratings agencies, but we cannot allow Britain's future to be dominated by their irrationality.

The failure of the policy of austerity is becoming more evident day by day, not only here in Britain, but in Europe, too. Even Germany is coming to realise that impoverishing your own customers may not be a wise policy. Only the coalition fails to recognise reality. A source close to Mr Osborne is quoted by the Financial Times as arguing that, with respect to low growth in the eurozone:

“It’s not too much austerity: it’s too much debt and not enough competitiveness”.

That is how out of touch they are. They have not understood the OBR's case that austerity is weakening competitiveness and making debt reduction more difficult. However, abandoning the austerity policy will require a new framework, within which to construct a sensible fiscal and monetary platform. The OBR and Professor Summers have provided the necessary framework. Their demonstration that austerity is permanently destroying future production, and hence future government revenue, is the starting point for a sensible new policy debate both in Britain and in the eurozone. Policy must be changed now, before coalition austerity does yet more permanent damage to the UK economy.

[Lord Skidelsky]

I take it that the question for debate this evening is not whether Britain is on track to meet the Maastricht budget criteria, but why, nearly four years after the economic collapse of 2008, our country finds itself officially back in recession.

Since July 2010, the policy for recovery has been set by the coalition Government. The main plank of that policy has been an accelerated programme of deficit reduction. Since the coalition came to office, recovery has gone into reverse. In 2010, Britain’s economy grew by 2.1 per cent. In 2011 it grew by 0.8 per cent. With today’s figure showing a fall of 0.2 per cent in the last quarter, the OBR forecast of 0.8 per cent growth this year has been exposed as a fantasy. I feel sorry for the Treasury official who wrote in paragraph 6.1 of the convergence report, just published:

“We still expect the economy to avoid a technical recession with positive growth in the first quarter of 2012”.

The truth is that the economy is smaller now than it was in September 2010. According to the latest NIESR report, the present slump is the longest in British history. Naturally, the Osborne Treasury denies that its recovery policy was in any way responsible for the non-recovery. A correct policy, it claims, was derailed by external shocks such as the rise in import prices, the euro crisis, the structural impact of the financial crisis, and so on. Now the extra bank holiday for the Diamond Jubilee will apparently be a further impediment to growth this year, so the Queen joins the list of shocks. No, these are excuses, not explanations. The policy was wrong from the start and would therefore never have got us out of the hole into which we had fallen.

The eurozone crisis, for example, which has now spread from the Mediterranean to Holland and France, results from exactly the same austerity policy that is being implemented in this country. I never believed that the policy would work, either to promote recovery or to meet the Government’s own deficit targets. Speaking in this House on 1 November 2010, I said:

“I have never been able to understand how cutting the budget deficit in present circumstances is supposed to help employment and growth”.—[Official Report, 1/11/10; col. 1501.]

I still await enlightenment.

Chart 2.4 of the convergence report shows that the ballooning of the Budget deficit in 2009-10 was almost entirely caused, as the noble Lord, Lord Eatwell, has pointed out, by the collapse of national output. This ballooning was quite common, and there is a good comment on it dating from 1931, penned by none other than Keynes, who remarked that the rise in the deficit was,

“nature’s remedy for preventing business losses from being ... so great as to bring production altogether to a standstill”.

It has always seemed bizarre to me to believe that the best way to eliminate a deficit caused by the collapse of output is to pursue a policy that retards the recovery of output. The OBR itself estimated in 2010 that every 1 per cent of GDP decline in current government spending knocks 0.6 per cent off economic growth. It believes that without the Osborne cuts in government spending, GDP in 2016 would be 2 per cent higher than forecast—that is, nearly £50 billion higher. Translate that into extra jobs and houses, schools and hospitals that will not be built as a result of current policy.

That brings me to a second bizarre feature of the Treasury document, which is almost too arcane to discuss in polite society. Most people understand the notion of the deficit; it is the gap between what Governments spend and the revenues that they raise in taxes. The task that the Chancellor set himself in his first Budget was to liquidate not the deficit but the “structural” deficit—the deficit that would remain after the economy had recovered and actual output was again equal to potential output. Unlike the actual deficit, the structural deficit depends on estimates of such things as potential output, the output gap and the trend rate of growth—all intellectual constructs to which a high degree of uncertainty attaches, yet the Government have tied their programme to this particular shaky mast.

One might suppose that the actual deficit would shrink as the economy recovered. The structural deficit, though, has to be eliminated by policy; that is the argument. The latest OBR forecast shows it on track to fall from 7 per cent of GDP in 2010-11 to 0.7 per cent in 2016-17. En route to this mandate that the Government set themselves, something very mysterious happened. The structural deficit, which had been chugging along at about 2.5 per cent in the Brown years without causing any alarm or increasing the national debt, suddenly turned into a structural deficit of 8.9 per cent in 2009-10, with the threat of large permanent additions to the national debt. How did a deficit mainly caused by the cyclical downturn mutate into a structural deficit that threatened the Government’s long-term solvency? That was the mutation that caused alarm bells to ring and anathemas to be rained down on the Brown chancellorship for having left his successors such a horrendous mess to clean up.

The Treasury report suggests two interesting reasons for the mushrooming of the structural deficit. The first, in chart 6.2, is that the pre-recession economy had been growing above trend. The actual level of output, it claims, was 2 per cent above the potential level consistent with inflation in the long term. Since the inflation rate was almost always below the target of 2 per cent between 2000 and 2007 and the Treasury’s current assumption of the sustainable level of unemployment, at 5.25 per cent is exactly the same as the rate that prevailed in the Gordon Brown years, it is difficult for me to understand why the Treasury thinks that the pre-recession level of output was too high.

The second explanation, in paragraph 2.8 of the report, is something that the noble Lord, Lord Eatwell, referred to: that the crisis itself has left potential output 11 per cent below its pre-crisis trend. In other words, the economy will emerge from the slump permanently smaller than it was before the recession. Again, no explanation is given for this assertion. Of course, if your policy closes down capacity, it is quite likely that you will get that result. It is on this mixture of assertion, slippery definitions, and dodgy calculations that the logical foundation of the present policy is built. The Government and Treasury clearly believe in the power of incantation—if they say often enough that their policy is restoring confidence and credibility, that will make it true.

Some time last year the penny started to drop and the Chancellor produced his Plan for Growth, a belated admission that deficit reduction is not itself a growth policy and that the Government cannot just stand back and wait for the private sector to spontaneously ignite. There were a lot of measures designed to stimulate growth: lower corporation tax, bigger capital allowances, enterprise zones, green investment and so on, and now a £20 billion credit guarantee for bank loans. The measures are useful but too small, and will hardly offset the 25 per cent reduction of public capital spending this year alone. So much for the Treasury’s claim that the Government have been,

“using the savings over the Spending Review period to fund infrastructure investment critical”.

That claim is simply wrong.

It is clear that the main plank in the Government’s growth strategy is what the report calls “monetary activism”, defined as,

“additional monetary stimulus through quantitative easing”.

There was £200 billion of it in 2009-10, and the Chancellor has recently authorised another £125 billion. Studies have shown that this is useful; it has raised GDP growth by between 1.5 per cent and 2 per cent more than it would have been in its absence. And yet the effectiveness of additional quantitative easing is far more limited—there are fewer bonds left to buy and less scope to move bond yields—so this source of growth is, at best, highly uncertain.

We are sure to get out of this recession; we always do. If, however, we are to escape from semi-slump in a reasonable period of time, we have to break free from Angela Merkel’s strategy of bringing Europe to a standstill and take some initiatives of our own. The noble Lord, Lord Eatwell, has made some suggestions, and I add three of my own. First, in its April world economic outlook, the IMF advocated “balanced budget fiscal expansion”—that is, tax increases matched by increases in government spending, a fragment of forgotten wisdom from the Keynesian era. Secondly, we could follow the example of Ireland and set up a bad bank to buy illiquid assets from the banks at fair present value, aiming to minimise losses to the taxpayer from their later realisation. That would address one cause for the much noted breakdown in bank lending. At least Ireland is growing, which is more than we are. Thirdly, I have long been an advocate of setting up a national investment or infrastructure bank to afford institutional investors such as pension funds a higher yield than they can earn on gilts. I believe that we will be driven to one or other of these unorthodox measures in the end—so why not act now, without wasting more time on excuses?