Wednesday, September 7, 2011

Pursuing the Wrong Objective

The UK economy has grown by a meagre 0.2% in the past nine months. This slow growth is even worse when you consider the level of spare capacity and lost output which existed after the recession of 2008/09. The main factors behind the return to a double dip recession are:
  • VAT increase and spending cuts - which have both reduced aggregated demand and reduced confidence in the economy. People now expect a second recession; nor is it just limited to manufacturing but also the service sector.
  • Global slowdown, especially in EU.
  • After effect of balance sheet recession - reluctance of banks to lend, e.g. quantitative easing led to increase in bank reserves which largely have not been lent to other parts of the economy.
Vindication of Spending Cuts?

The Chancellor feels vindicated in pursuing spending cuts because of the turmoil in other EU bond markets. By contrast, the UK government is able to borrow at low long term interest rates 2.5%.

  1. Other European countries have pursued even bigger spending cuts (Ireland, Greece and now the likes of Italy). Interest rates are high in Euro countries because of liquidity fears which are greater when a country doesn't have an independent monetary and exchange rate policy. (see: why UK bond yields have stayed lower than EU)
  2. The low interest rates in the UK are partly due to the markets expectation of very low economic growth.
  3. The slowdown in UK economic growth will reduce cyclical tax revenues and keep welfare spending high. As other European countries are learning, you can pursue painful austerity measures, but these just prove self-defeating as the lost output harms the budget situation.
What the UK Needs
  • The government pursued the wrong objective. They saw short term deficit reduction as the highest economic priority.
  • Their target should be strong economic recovery and reducing unemployment. Against this back drop of strong economic recovery and growth, the economy could then absorb necessary changes to the long term structural deficit.
I can't see the government changing its mind. It rather reminds me of the early 1980s, when Mrs Thatcher famously said ' you turn if you want to, but this lady's not for turning.'

The situation had many parallels. - The idea that short term pain (unemployment, low growth) is good for you. But, it is isn't. A double dip recession will make everything worse including reducing long term budget deficit.



Basudeb Sen said...

In the 1930s, the US was reluctant to accept Keynesian theory of spending out of recession: now Obama preaches spending and taxing - since the multiplier of the former is offset by the negative multiplier of latter, he wants all the more high enough spending. America has run out of technological progress.
UK is not currently not heeding to Kenesian advice of spending out of of recession but trying to cut deficits! Keynes probably did not say anything about any limit on how much spending through deficits is advisable. The fear of unsustainable debt causes concern to the traditional prodent given the soverign defaults and rating downgrades. The people in need of fast recovery believs there is nothing like sovereign defaults- sky is the limit for deficit spending and borrowing - something very difficult to eastablish theoretically.

bg said...

The current low borrowing rates for the UK government indicate that the Market expects the UK to borrow now to finance national projects that will boost growth and employment levels on a short to medium term.

Thomas G. Clark said...

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It is nice to get informed and often unorthodox viewpoint on the economy. This is not a criticism, many of the orthodox thinkers in power today are stuck in the faulty paradigm of neoliberal small-statism that imploded during the credit crunch. thinking that it can be fixed with more of the same is absurd and the kind of behavior that Einstein described as Insanity: Doing the same thing over and over again and expecting different results.

Anyhow, I have added your site to the recommended links on my site and would be delighted of you cared to link back to it from somewhere on your site.

Kind regards