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The UK needs to worry about ‘depression deniers’ not ‘deficit deniers’

8:05 am - May 31st 2013

by Duncan Weldon    

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I’ve written before that I find the current political debate ahead of the spending review somewhat confusing. The Government, and many of their supporters in the media, now appear to think that the way to gain “economic credibility” is to commit to a fiscal plan that has failed to achieve growth, deal with the deficit or even retain the UK’s AAA rating.

The argument can be summarised as: “our plan has failed to achieve any of its goals and opposition parties will only be seen as credible if they agree to stick with it.”

I’ve argued before that the real debate ahead of the coming CSR should not be whether political parties sign up to it but instead what the UK’s fiscal framework should look like.

A more appropriate framework for the UK would focus on reducing debt/GDP over a much longer timetable.

The more I think about it though, the more I think an even bigger point is being missed in the current debate around the politics of the CSR.

On most forecasts the economy is still likely to be depressed in 2015/16 and indeed 2016/17.

The crucial number to examine here is the output gap – and in particular the OBR’s own assessment of it.

Simply put, the output gap is a measure of how much spare capacity there is in the economy. If the output gap is negative then the economy is operating below capacity and there is a strong case for expanding demand to make good the difference While if the output gap is positive then the economy is operating above trend and may be overheating with consequences for inflation.

Back at in June 2010 the OBR forecast that by 2015 the output gap would be -0.9% of GDP, i.e. the economy would be operating a below potential but not by a huge amount.

The current OBR forecast is for an output gap to be -3.4% in 2015 and still at -2.9% in 2016. In other words, come April 2016 (the time when any new government can actually make spending decisions in a meaningful manner) the economy is still expected to have an output gap of almost three per cent . The OBR’s own forecasts imply that there is room for a fiscal expansion of almost three per cent of GDP in 2016/17.

Recent work from NIESR, funded by the TUC, found that in ‘crisis times’ (when output is depressed – i.e. a -2.9% output gap implies ‘crisis times’) then a capital spending intensive stimulus of 2% of GDP will boost growth, lower unemployment and lead to a lower debt/GDP ratio in the medium term.

Much of the current politics around the CSR feels “very 2010”.

The assumption in much of the political (if not the economic) coverage of the CSR seems that by 2015 macroeconomics will not really matter. The economy will broadly have recovered and the task of the Treasury will the essentially distributional job of managing cuts in public spending and tax rises to close the deficit, rather than actively managing demand and boosting growth. This is looking like an increasing optimistic view.

The economy in 2015 and 2016 is likely to remain, by any reasonable standard, depressed. The case for a new fiscal framework, which gives governments the room to borrow to boost growth in the short term, will remain strong.

To put this all really simply, we shouldn’t be so concerned about the ‘deficit deniers’, it’s the ‘depression deniers’ we need to worry about.

A longer version of this post is at Touchstone blog.

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About the author
Duncan is a regular contributor. He has worked as an economist at the Bank of England, in fund management and at the Labour Party. He is a Senior Policy Officer at the TUC’s Economic and Social Affairs Department.
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Reader comments

Some bizarre, confused, and otherwise incorrect comments in this piece.

(1) “failed to achieve growth”

As opposed to where in Europe? Growth is ellusive the world over in developed countries, and it is in fact those that have economically free economies that have faired the best.

(2) “failed to deal with the deficit”

This is just wrong. Although not nearly fast enough, the deficit has gone from 156bn to 121bn. Labours plans are to increase it.

(3) “or even retain the UK’s AAA rating”

Like every other developed country. Again, we have to consider all countries. The simple fact is that the world is in a slump and its not just because of this government. Please don’t pretend that it would be made any better under Labour, because there is strong evidence to suggest it would be made worse.

Unfortunately the Niesr stats you cite failed to consider increased borrowing costs. However, more fundamentally, and it is a point you allude to yourself. There is good evidence to suggest that problems start when Debt/GDP ratio becomes too high. This is what needs to be addressed. High government debt, especially in the case of the UK where a lot is foreign owned, suppresses growth. What credible alternative does Labour have???

I think Labour supporters are hoping and praying the economy is not recovered at all by 2015. Otherwise they will be crucified in the next election and everything they have been talking about will have been pointless.

Compare recent news about Britain’s economy:

From the Telegraph on Friday: “Bank of England figures showed on Friday that net business lending dropped nearly £3bn after a £545m contraction in March, and was 4pc down on the year, dealing a blow to hopes that investment might spur growth.”

From the BBC on Wednesday: “UK retail sales fell at their fastest annual pace for 16 months in May, according to a survey by the CBI.” [BBC website]


“(1) […] As opposed to where in Europe?”

That’s a particularly bad example, given the widespread adoption of austerity policies in Europe. If you look at the extent of economic recovery for developed countries relative to their pre-crisis position, growth and austerity are inversely correlated.

“(2) […] This is just wrong.”

No it isn’t. You have to be clear about the causal factors of the deficit spike. Pre crisis, the deficit had ranged between ~£30-40 billion for 5 years (arguably a mistake in a period of growth, but in no way unmanageable), and only jumped as a direct result of the crisis. This is what you should *expect* to happen in the face of a financial crisis of this magnitude, with revenues falling from loss of GDP, and increases in welfare spending due to the associated job losses. Returning the economy to (meaningful) growth, and getting people back to work should see such an exceptional deficit be slashed far below the levels we currently see. A 20% reduction from a peak, one year deficit level is not a success, it is an abject failure.

“There is good evidence to suggest that problems start when Debt/GDP ratio becomes too high…”

You appear to be citing Reinhart-Rogoff here, a paper that has been shown to be wrong on a number of levels. There is no threshold for debt seriously impacting growth, only a very small negative correlation, and the causality appears to work in the other direction; that is, low growth leads to high debt, not the other way around. As for who holds the debt, it’s far more important to consider the currency in which the debt is denominated (i.e. ours), and worth noting that the UK also owns large quantities of the debt of other countries (e.g. ~$160 billion of US Treasuries).

Martin Wolf writing in the FT on 23 May: “Harvard’s Carmen Reinhart and Kenneth Rogoff have shown the way:

‘A higher borrowing trajectory is warranted, given weak demand and low interest rates, where governments can identify high-return infrastructure projects. Borrowing to finance productive infrastructure raises long-run potential growth, ultimately pulling debt ratios lower.’” [Why George Osbrne should not be so complacent]

On its recent visit, the IMF also proposed more spending on infrastructure investment projects, which Osborne had slashed in 2010.

5. thoughtful

Bob B – I thought that the bulk of bank lending was on mortgages – and this increased. Most lending to business is done through bond markets and commercial paper, so does the finding you report actually make the point you are seeming to make?

And is there real evidence of infrastructure spending helping economies? From what I recall, the massive spending programmes of FDR in the 30s did not do much to drag the US out of depression. And nor did the massive investment of Spain in infrastructure in the 1990s sem to give the economy sufficient strength to survive the crash of their mutual banks.


“is there real evidence of infrastructure spending helping economies?”

Yes. For example:

Here the infrastructure multiplier is reported as 1.6.

More recent papers have argued this is an underestimate under present conditions, for example:

A key issue is the difference between economies operating at capacity, and economies operating well under capacity (as is the case now); when an economy is under capacity, infrastructure spending puts that unused capacity to use, rather than competing with the private sector. That’s why infrastructure spending now (and ideally, over the last few years, where we missed an opportunity) makes so much sense.

thoughtful: “Most lending to business is done through bond markets and commercial paper, so does the finding you report actually make the point you are seeming to make?”

I was quoting from the Telegraph report that “net business lending dropped nearly £3bn after a £545m contraction in March, and was 4pc down on the year”. By any benchmark, those are significant numbers although the investment picture will become clearer when the ONS reports on Business Investment during 2013Q1.

Big corporates, which are reportedly mostly flush with cash balances, may deal in bond markets but SMEs are very likely to depend on bank lending because of what was once dubbed “the Macmillan gap” – namely, the costs and difficulties of borrowing up to c. £250,000. That was why the Attlee government in the 1940s set up ICFC, which eventually mutated to 3i. That was why the Conservative government in the 1980s devised the Loan Guarantee Scheme to help small businesses raise capital. Try this on SME current access to bank loans:

“In their defence, the Big Four banks – RBS, Lloyds Banking Group, Barclays and HSBC – say much of the decline in lending is down to a loss of borrowing appetite among SMEs.”

If so, that is indeed a worrying indication of business confidence among SMEs. Recap: just over half of employment in the business sector in Britain is in SMEs employing up to 249 employees. What happens in the SME sector is crucial for new job creation.

Try this on: Sources of finance for startups and SMEs:

“External sources: Loan capital – This can take several forms, but the most common are a bank loan or bank overdraft.”

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