Britain Risks a Lost Decade Unless it Changes Course

It is the mark of science and perhaps rational thought to operate with a falsifiable understanding of how the world works. So it is fair to ask economists a fundamental question: what could happen that would cause you to revise your views of how the economy operates and acknowledge that the model you had been using was flawed? As a vigorous advocate of fiscal expansion as an appropriate response to a major economic slump in an economy with zero or near-zero interest rates, I have for the past several years suggested that if the British economy – with its major attempts at fiscal consolidation – were to enjoy a rapid recovery, it would force me to substantially revise my views about fiscal policy and the macroeconomy.

Unfortunately for the British economy, nothing in the past several years compels me revise my views. British economic growth post-crisis has lagged substantially behind the US and the gap is growing. British gross domestic product has not yet returned to its pre-crisis level and is more than 10 per cent below what would have been forecast from the pre-crisis trend. The cumulative output loss from this British downturn in its first five years exceeds even that experienced during the 1930s. Forecasts continue to be revised downwards, with a decade or more of Japan-style stagnation emerging as a real risk.

Whenever policy is failing to achieve its objectives, as in Britain today, there is a debate as to whether the right response is doubling down – perseverance and intensification of the existing path – or recognition of error or changed circumstances and a change in course. In Britain today such a debate rages on the aggressive fiscal consolidation that the government has made its economic centrepiece. Until and unless there is a substantial reversal on near-term fiscal consolidation, Britain’s short and long-run economic performance is likely to deteriorate.

An effective policy approach to Britain’s economic problems must start with the recognition that the principal factor holding back the British economy over both the short and medium term is the lack of demand. It is true that Britain also faces important structural issues ranging from difficulties in promoting innovation to deficiencies in the system of worker training. Still, it is apparent from the relatively low level of vacancies, the reluctance of workers to leave jobs and the pervasiveness across industries of increased unemployment that it is lack of demand that is holding the economy back. Testimony from companies on their investment plans also supports this view.

During the depression, John Maynard Keynes compared Britain’s economic woes to a “magneto” problem, referring to the fact that a car might have many infirmities but if its electrical system did not work the car would not go. If that was fixed, the car would run, even with other problems. So it is today. Moreover, to a greatly under-appreciated extent in the policy debate, short-run increases in demand and output would have medium to long-term benefits as the economy reaps the rewards of what economists call hysteresis effects. A stronger economy means more capital investment and fewer cuts to corporate research and development. It means fewer people lose their connection to good jobs and become addicted to living without work. It means that more young people get first jobs and it means more businesses choose leaders oriented to expansion rather than cost-cutting. The most important structural programme for raising Britain’s potential output in the future is raising its output today.

The objection to this view comes in many forms but it is in essence that reversing course on fiscal expansion now would undermine credibility, backfire with respect to growth by risking a spike in capital costs and risk catastrophe down the road as debts became unsustainable. This line of argument is profoundly flawed. First, the behaviour of financial markets suggests that economic weakness rather than profligacy is the main source of concern about future credit problems. Why else would the tendency be for the costs of buying credit insurance on the UK to rise when overall interest rates fall? In a similar vein, a tendency has emerged in both the UK and US for interest rates to rise and fall with stock prices, implying that it is evolving optimism and pessimism about the future, not changing views about fiscal policy driving markets. Second, the reality is that the primary determinant of fiscal health in both the US and UK over the medium term will be the rate of growth. An extra percentage point of growth maintained for five years would reduce Britain’s debt-to-GDP ratio by close to 10 percentage points whereas austerity policies that slowed growth could even backfire in the narrow sense of raising debt-to-GDP ratios and turning debt unsustainability into a self-fulfilling prophecy.

Britain must change the pace of fiscal consolidation to stand a chance of avoiding a lost decade. Rather than starving public investment, now is the time to add to confidence by making plans for structural reforms to contain the growth of public consumption spending over time. It is also time to take overdue measures to promote exports and, after years of appropriately low investment, to restart housing investment. But when demand is needed for growth and the private sector is hanging back, the first priority must be for the public sector to stop exacerbating the contraction.

The writer was director of the national economic council under Barack Obama and is Charles W. Eliot professor at Harvard University