24th November 2008
The Pre-Bust Report: a prelude
‘Too little, too late’ is an easy charge to make against any Government as this world economic crisis continues to drag us headlong into a deepening recession. The Conservative critique, incredibly, seems to be that the Government is doing too much and almost appears to be suggesting that ‘nature be allowed to take its course’. This is familiar territory for those of us old enough to remember the Geoffrey Howe budgets of the early 1980s when the Conservative Government actually did cut spending in the middle of a recession to ‘purge’ the economy of waste and inefficiency. Conservative rhetoric this time is also coming dangerously close to those ‘quack’ doctors in the Middle Ages who advocated the practice of ‘cupping’ - removing pints after pint of blood to purge the body - and nine times out of ten killed their patient in the process. For the rest of us, a return to mass unemployment is not a very attractive prospect.
Outside of the Conservative party and the dwindling Chicago or Austrian school of economists most of us would argue that fiscal stimulus is a very necessary response to stave off the kind of deflationary spiral that currently envelops us. But is the Government about to do the right kind of thing but in the wrong way and for the wrong reason. What do I mean by that? Well, there are a number of reasons for supporting fiscal stimulus (extra spending or tax cuts):
1. Directly compensate pound for pound for the shortfall in demand in the economy
2. Shield the vulnerable from the worst effects of the downturn
3. Provide a psychological boost in confidence to get consumers and businesses spending again
4. Take advantage of spare capacity in the economy to bring forward socially useful investment e.g. on housing or renewable energy
The last three reasons all make absolute sense. The problem is that if the Government plumps for a reduction in Vat of 2,5% as its principal policy lever it is obviously opting for policy approach number one which is the Keynesian caricature of ’spending one’s way out of recession. There are a number of problems with this approach. First up, scale: to plug the gap caused by the shortfall predicted next year by the bank of England the Government would need an immediate package of extra spending and tax cuts worth about £30 billion - the VAT cut represents just about a third of that. Secondly, effectiveness: will cutting the price of something that costs £4.99 today to £4.87 unleash a wave of mass consumerism. Unlikely, and it will do nothing for the business-to-business market which will be unaffected by the change. There is a case for a tax cut but the purpose must be to change people’s long-term expectation about the economy - not so much to create a feel-good factor but at least to take away their fear. Only that will begin to change the prospects for the housing market. Cutting VAT by this minuscule amount - to make a modern medical analogy - is a bit like putting a patient on a drip when he really needs CPR. There is a need for tax cuts but a better approach would be to raise the tax allowance by £2,000 which would have an immediate and more visible effect on people’s take home pay and take millions out of tax altogether. It would also cost more or less the same as the VAT proposal. Cutting VAT more substantially - to 5% as we have suggested in labour-intensive sectors like construction and tourism - could also have a noticeably beneficial effect.
The other problem with the Government’s proposed tax cuts is how they’re funded which in the short-run at least looks likely to be added borrowing. There is a big risk that this will drive up long-run interest rates - because of the need to offer higher yields on Government bonds. This will make the Government’s stated policy of getting the banks to start lending again by offering more attractive terms to its customers much more difficult to achieve. The fiscal stimulus package should, at least in part, be funded by higher tax rates on the very wealthy today not just tomorrow, as well as a windfall tax on energy companies and the scrapping of unnecessary commitments like Trident and ID cards.
On the socially useful spending front there are a number of important initiatives the Government could take including creating a Citizen’s pension of a £100 (boosting the Basic State Pension will be necessary anyway because of the massive collapse in pension funds) and also introducing free social care for the elderly as in Scotland. Capital investment programmes should include housing, renewable energy and public transport infrastructure - all overdue and beneficial to future generations who will be saddled with the debt.
The fear is that the Government will end up spending and borrowing a lot of money but which will have negligible or indeed even a negative effect.
An even more worrying thought is that the Government’s action on the fiscal front will obscure the need for urgent changes in monetary policy. The underlying roots of the current crisis are after all monetary in nature, as are the solutions. The Bank of England needs now to cut interest rates to 1%. The Government needs to issue a clear ultimatum to the banks that if they do not pass this cut on to their customers then the semi-nationalisation of some of some of the banks will become a full-scale nationalisation.
Even a cut in interest rates might not work on its own of course, which is why the Government has to embrace the prospect of ‘quantitative easing’ which is the nice technical word for ‘printing money’, economic heresy only a few months ago but now possible the one thing that can prevent deflation becoming a depression. In practical terms that would mean the Bank buying up corporate debt and boosting the money supply. At a time of falling prices, where there a literally too little money chasing too many goods, the normal rules of conventional economics are turned on their head. I am not sure the Government has grasped that. The wheels of contraction in the economy are spinning out of control. It remains to be seen if what the Chancellor will announce in a little under an hour can halt that process let alone shift it to reverse.
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