Petty squabbling

1 March 2010 | By Daniel Ben-Ami

The economy looks set to be one of the main battlegrounds in the run-up to the election, which will most likely be on May 6. Britain’s main political parties will no doubt have heated rows over which of them offers the best policies for recovery. Indeed the whole result of the election could swing on which party’s economic plans appear most credible.

To assess the extent to which each of the parties is up to the task it is necessary to first outline the economic challenges ahead. Some of these are widely discussed, most notably Britain’s burgeoning debt problem, while others have a low profile. In particular, the sluggish character of the economy receives scant attention, despite some discussion of innovation. Although heavy dependence on financial services is often used to explain Britain’s severe downturn, there is no corresponding debate about how to achieve economic diversification. There is a voluminous discussion on financial regulation but this is so extensive it will not be covered here.

Once the problems are outlined it will be possible to examine the extent to which the different parties offer a solution to those that are most important. It may be that one party is better than the others in this area or alternatively the differences between them may be minimal. (article continues below)

 

PROBLEMS

(a) A growing debt mountain
The problem which towers above all others in the public discussion is Britain’s fiscal position. Public debt is high in absolute terms and is deteriorating fast - although it has the advantage of a relatively long average maturity (see graph, below). Although Britain is unlikely to lose its AAA status from credit-rating agencies any time soon, its position, if not addressed, could worsen.

 

As public debt increases the amount being spent on interest repayments will rise. Public spending will increasingly focus on repaying this debt burden rather than meeting other needs. If Britain does lose its AAA rating the costs of borrowing will rise even further.

For these reasons the public debt burden needs to be tackled sooner or later. In principle there are two mechanisms through which this objective is likely to be achieved. Public spending can be cut as a way of relieving and reducing the debt burden. Alternatively it is possible to raise extra revenue by imposing higher taxation. Some combination of these two methods is also possible. In effect either method is likely to mean a cut in living standards for the mass of the population.

Although solutions to the debt burden are easy to raise in principle they are harder to implement in practice. There is a widespread concern that if a fiscal squeeze is implemented too early or too harshly the economy could tip back into recession. Both routes to cutting the deficit also raise potential problems. Neither higher taxes nor public spending cuts are likely to prove popular. It is relatively easy for economists to raise the need for austerity in abstract terms but more tricky for politicians to implement measures to achieve the objective.

Although the current discussion focuses on government debt it should not be forgotten that it is only part of high overall burden. Other substantial forms of debt include financial institutions, household and non-financial business. According to an estimate by the McKinsey Global Institute the total debt, at 382% of GDP, is higher than every other major economy except Japan even after adjusting for foreign lending by British banks. From 2000-08, Britain’s total domestic debt grew at a faster rate than that of any other major economy except Spain.

 

(b) Loose money
While fiscal policy is receiving a huge amount of attention there is relatively little discussion of monetary policy. It is not hard to see why. For a start inflationary pressures appear minimal for the time being - particularly if estimates of the amount of spare capacity in the economy are right. Although there was a spike in inflation in January it was largely a result of the reinstatement of VAT at 17.5% after being cut to 15% amid the crisis in November 2008.

In addition, monetary policy was taken out of the political domain with the operational independence of the Bank of England granted by the incoming Labour government in 1997. Since all the main parties agree with this measure it means that debate about monetary policy has become the province of technical experts rather than politicians.

However, if inflationary pressures pick up there could be more room for it to enter the fray. Sustained low interest rates and quantitative easing risk creating another credit bubble (see graph, below). Although this is not likely to be a pressing concern for the time being - although equity prices are arguably one of the main beneficiaries of easy credit - this does not preclude it emerging as one.

 

 

(c) An unbalanced economy
The unbalanced character of the British economy has received some attention but not nearly as much as fiscal policy. Many recognise that the heavy reliance on global finance meant Britain was particularly vulnerable to the economic slowdown. That probably explains why Britain was among those hit hardest and longest by recession, with six consecutive quarters of falling output leading to a cumulative 6% fall in GDP (see graph, below).

 

According to IFSL, a body which promotes the City of London, financial services accounted for 8.3% of Britain’s GDP in 2007 (the most recent official estimate) compared with 5.3% in 2001. In addition, another 3.9% of Britain’s GDP in 2007 was accounted for by professional services such as accounting services, legal services and management consultancy. Britain’s dependence on financial services is substantially greater than its peers (see graph, below).

 

While finance has surged manufacturing has slumped in relative terms. Its share of GDP fell from 20.3% to 12.4% over the past decade.

Such a heavy dependence on finance was all very well when the sector was booming. But when financial institutions globally were facing retrenchment the weaknesses of Britain’s position became apparent.

Although it is easy to recognise heavy dependence on finance it is more difficult to identify what can be done about it. That probably helps explain why there is a much more extensive discussion on modifying the system of financial regulation than diversifying the economy. The key challenge in this area is to work out how to bolster areas of the economy outside finance such as industry or non-financial services. In that respect it is also a problem of generating greater economic growth.

 

(d) Slow growth - lack of innovation
Given the scale of Britain’s growth problem it is a surprise it has received so little attention. According to an analysis by the Financial Times output grew by an average of only 1.7% a year over the past decade - the lowest rate since the second world war - despite the credit-fuelled boom. By comparison the average annual growth rate in the 1960s was 3.1% a year.

Considering the importance of economic growth it is shocking that so little is being done to bolster it. Strong growth could play a key role in solving Britain’s other economic problems. For example, if the economy grew rapidly it would be possible to pay off public debt without necessarily raising taxes or cutting public spending.

Some independent authorities have argued that the growth potential of the economy is Britain’s trend rate of growth. The pre-budget report assumes 2.75% as its central estimate while the Institute for Fiscal Studies says it is close to 1.75%. Although one percentage point may not sound a lot, when compounded over time it makes a huge difference.

The key challenge facing the authorities is to create a framework for encouraging innovation. Although there is some talk of the desirability of this objective it has received relatively little practical attention.

Before moving on to party policies it is important to note that outlining key problems is not the same as establishing the relationship between them. Some economic weaknesses are more fundamental than others.

In particular, it is clear why Britain’s burgeoning deficit is such a pressing concern for politicians. The more it grows the more likely it is to damage prospects. Therefore it makes sense to create a plan to address the problem.

However, economic growth is a much more fundamental long-term concern. An economy that can manage strong, consistent growth is in a better position to tackle any challenges it faces. In contrast, a slow-growing economy has less flexibility to overcome problems.

The capacity of an economy to generate growth also has a direct bearing on its ability to repay its debt. In a slow-growing economy there is little choice but to squeeze consumption through public spending cuts, tax increases or a combination of the two. However, a fast-growing economy is in a much better position to tackle the problem. Tax revenue can increase as the economy grows even if tax rates stay constant. It is also easier to generate funds to pay for public spending.

Ideally the growth should be outside the already bloated financial sector. The point is not to create another bubble but rather to generate the basis for genuine economic dynamism. Achieving this objective will mean restructuring the economy so it is better able to achieve strong long-term growth. For the authorities the challenge will be how to encourage such innovation and entrepreneurship.

 

PARTY POLICIES

The most striking feature of the election debate so far is the overwhelming focus on Britain’s surging public debt. Not only that but there is widespread agreement that austerity, mainly in the form of spending cuts, is the only solution. Where parties differ is on the likely timing of spending cuts and the openness with which they are willing to talk about them.

All of the main parties talk in different ways of the need for cuts. In a speech on February 20 Gordon Brown spoke of securing the recovery and of reducing the deficit by half while protecting front-line services. Vince Cable, the Liberal Democrat shadow chancellor, has talked of the need to bring stability to public finance through spending cuts and some tax rises. Measures he has advocated include a tough public-sector incomes policy, reforming public-sector pensions, some cuts in welfare spending and reductions in military spending. The Conservative party website also highlights tackling the deficit and protecting front-line public services. Its favoured measures include a public-sector pay freeze, capping public-sector pensions, reviewing the state pension age and cutting bureaucracy.

Several commentators have remarked on the similarity of the main parties’ policies in this area. Mervyn King, the governor of the Bank of England, has said that in relation to the need for a fiscal consolidation later this year: “There’s a broad consensus across all political parties.” Similarly Jonathan Loynes, an economist at Capital Economics, has said: “The gap between the two main political parties is probably not as wide as the rhetoric suggests.”

To an extent the differences are primarily to do with the timing and the extent of the cuts. The Conservatives favour more severe cuts while Gordon Brown has advocated going for growth in the short term.

The Conservatives and Liberal Democrats have also at times talked more openly about austerity than Labour. David Cameron, the Conservative leader, gave a talk on “the age of austerity” in April 2009 while Nick Clegg, the Liberal Democrat leader, said in an interview with the Radio 4 Today programme that Britain needed austerity. Labour, in contrast, prefers code words for austerity such as convincing people of the need for fairness (which seems to mean that everyone should be prepared to make sacrifices).

But even the Conservatives and Liberal Democrats use the rhetoric of austerity sparingly. They do not want to alienate voters or potential voters. Cameron has also partly backtracked on his earlier remarks by ruling out what he called “swingeing” cuts.

Even these differences are probably less about principle than might first appear. Since Labour is the governing party it has more of an interest in postponing any cuts until after the election. The Conservatives, on the other hand, would prefer cuts to be started under Labour as it could hit the popularity of the governing party. On the basis of what all the parties have said it is difficult to see any substantial differences between them.

It is also striking that non-partisan figures also share the political parties’ emphasis on fiscal policy. The “battle of the letters” between different factions of economists centred on the timing of any fiscal retrenchment. The governor of the Bank of England too has talked about the need to curb public spending.

Although fiscal policy has some importance the significance attached to it by politicians and economists is overdone. If economic growth can be boosted then it should be possible to tackle the fiscal deficit without a sharp squeeze on consumption. Rising output on the production side of the economy will take the burden. Yet there is relatively little discussion of increasing the growth rate in the electoral debate. It is widely accepted that growth will have to remain slow for many years to come.

Besides growth’s instrumental value in tackling the deficit it is also a boon in its own terms. It is the motor force for improvements in living standards and associated advances in science and technology.

All the main parties do make reference to growth although it receives relatively little attention compared with fiscal policy. For example, in a recent speech to a Labour party event Gordon Brown talked of the need to support new industries and future jobs. He also gave a speech on “going for growth” at the start of 2010 in which he referred to it as the “government’s number-one priority” for the year. His government has produced numerous documents on the subject including “Going for Growth: Our Future Prosperity” from the Department of Business, Innovation and Skills.

Other party leaders have made similar statements. George Osborne, the Conservative shadow chancellor, wrote in the Times (London) on the need to encourage green investment and provide a modern transport infrastructure. Vince Cable has also said that financing capital investment in infrastructure is one of his party’s main economic priorities.

Despite the apparent recognition of the need for growth from all the parties there are several reasons to treat such statements sceptically:

• It takes up a relatively small part of their discussion of economic policy. Far more is accounted for by such subjects as fiscal prudence and financial regulation.
• To the extent that any money is being promised it is relatively limited in scale. For example, Brown boasted of £70m being invested in three state-of-the-art manufacturing research centres and £45m in 270 projects by the government-backed Technology Strategy Board in his “going for growth” speech. Yet Britain’s GDP - its output in just one year - is over £1.5 trillion. The sums proposed by Brown in his speech, as well as other government projects, are small in comparison.
• Green priorities distort economic needs. Much of the discussion of growth focuses on such areas as low-carbon technology and green jobs. Although these may sound appealing they are often more problematic than is generally acknowledged. For instance, green jobs can often refer to low-productivity positions such as monitoring the energy efficiency of old houses. Even if such technology is viewed as desirable it is unlikely to do much if anything to raise the overall productivity levels of the economy. Similarly low-carbon technology, such as wind or solar power, is often promoted for its supposed environmental benefits rather than its economic rationality. To have a positive effect such technologies need to be implemented on a substantial scale. The microgeneration favoured by David Cameron and others is unlikely to have a beneficial impact.
• The favoured model of innovation over-emphasises business models. Although there is much talk of innovation a lot of it is not about technology, nor research and development. Instead there is a huge emphasis on financing through such models as pay as you go, monthly subscription, leasing and so on. Once again the impact of these models on raising output is likely to be limited. As Big Potatoes, the London Manifesto for Innovation, argues: “It’s true that innovation cannot be reduced to technology. But to downplay technology in favour of business models is a great mistake.”

 

GROWTH SCEPTICISM

The big unanswered question in relation to the election debate is why there is so little emphasis on economic growth. Given its enormous benefits, both immediate and over the long term, the low priority attached to growth seems peculiar.

No doubt what could be called bubblephobia plays a role. The credit boom and subsequent bust of the past decade has increased anxiety about economic growth. Any rapid growth is associated with a risk of financial instability.

Such a concern is one-sided. The problem with the past decade was not rapid growth in the early years but lack of a real dynamic on the production side of the economy. If the growth had been real, rather than heavily dependent on credit, the outcome would have been very different.

However, the cultural aversion to growth is much more deep-rooted. It predates the 2008-09 financial crisis even if recent events have exacerbated the concern.

Two key factors seem to be at work in explaining this aversion. First, the relative deindustralisation of the West. As developed nations have moved away from production they have increasingly felt estranged from the real economy. Second, a loss of confidence in the idea of progress. It has become widely accepted that significant change may not be possible, or even desirable. In this view pursuing growth is likely to cause more problems than it solves.

Any party that can break away from the anxiety about growth and propose a credible way of achieving greater prosperity would stand out from the others. If it could persuade the electorate that its goals were achievable it could also gain considerable popularity. The problem is that in these anxious times none of the parties seems to have the vision to break away from the narrow consensus that passes for politics.

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Daniel Ben-Ami is the editor of Fund Strategy. Ferraris For All, his book defending economic progress, will be published in July. His personal website can be found at www.danielbenami.com.