Thursday, 13 December 2012

What Is Wrong with the UK Economy? A guest blog by Adam Posen

[This article. by Adam Posen, Director of the Peterson Institute for International Economics, and formerly a member of the Bank of England's Monetary Policy Committee, originally appeared here on the Peterson Institute website. He has very kindly agreed to allow me to reproduce it here as a contribution to the UK policy debate. Obviously the views below are his, not mine or NIESR's, although for what it's worth I am, as readers of this blog will know, in broad agreement.]

The British economy is lacking productive investment, but not for want of investment opportunities.  Banks and large corporations are sitting on cash, households are holding back on large purchases (including of housing), and the public sector is slashing its investment flow.  This shortfall reflects the deficiencies of the British domestic financial system, some of them longstanding from well before 2008, as much as lack of confidence in future prospects, and responsible macroeconomic policy can address both problems.  The current British coalition government’s economic policy program, however, instead is intended to address a lack of savings, not of investment, and is pursuing that mistaken priority in a self-defeating way.  The economic issue facing the UK therefore is not just one of Plan A versus B, or of the amount and pace of austerity versus growth – the issue is that the UK needs investment friendly structural reform and stimulus, not fiscal consolidation as a goal in and of itself.

If we were to listen to the Chancellor and Prime Minister, we would be told that the challenge facing the British people is to trim their spending to match their diminished means.   The claim is that they cannot get credit anymore the way they used to, either as households or as a government, to borrow against future earnings; in fact they have to pay down the debts from their past spending binge to prevent risk of having their remaining credit lines pulled.  Furthermore, any shortfall in paying that debt off would be seen as proof that the British ability and willingness to pay lenders has declined, according to Chancellor Osborne.  Unfortunately, the Bank of England Monetary Policy Committee [MPC] and the Office of Budget Responsibility [OBR] have of late supported this mistaken view by adjusting their forecasts for UK economic growth down, essentially assuming that recent that recent poor performance means future performance will be nearly as poor – that is, that the potential or underlying growth rate of the UK economy has diminished. 

This false assumption feeds back into further arguments for fiscal and household consolidation.  The UK public and private sectors are paying down debt less quickly than expected to, and that means by assumption that their future ability to pay down debt is declining, so they must cut back spending and borrowing even more today to remain solvent.  This framework also leads into defeatism for monetary policy, since the implication is that efforts to stimulate the economy through that means will only add to the debt burden or inflation, rather than sustainable growth.  And it distracts attention from failures of the British financial system, since no one would be expected to invest in an economy where future prospects and current creditworthiness are declared to be so shaky.

This interpretation of recent British economic experience – I refuse to call it an analysis – is profoundly wrong, profound both in how misguided it is, and in how much damage it has done by misdirecting UK macroeconomic policy.  The facts of recent experience, including of the recession, do not fit with this misinterpretation, but do fit with the view that investment failings are at work in the British economy:
  • The UK government debt has low interest rates now because growth is low and demand for safe assets is high. British interest rates decline in response to bad news on growth, and market measures of the riskiness of gilts increase when interest rates and growth drop.  The opposite should hold – rates and market risk should rise together – if indebtedness were markets’ concern.  They don’t and it isn’t.
  • Private UK businesses have kept adding workers in recent years (albeit some part-time or temporary) because they view future prospects as unchanged or better.  Employers only increase staff in a flexible decentralized labour market like Britain’s when they think wage costs are competitive.  The opposite should hold – declining growth and wages should lead to permanent cuts in employment – if UK potential growth was down for most businesses.  They didn’t and it isn’t.
  • The spreads between the interest rates that small businesses and first time mortgage borrowers must pay for loans versus established large borrowers, and the fees that those new borrowers are charged have gone up and stayed up.  If there were lack of demand for investment, the interest rates and fees that banks could charge for loans would be declining – they are rising instead.
  • Sterling has been stable in value since its 2008 depreciation, and foreign direct investment continues to pile in to such industries as auto manufacturing and fancy foods as well as business services.  If the lack of investment were due to doubts about government solvency or business competitiveness, capital would be flowing out of the UK and the pound would be declining.  The opposite is the case.
  • Cuts in government spending and increases in taxation have had large effects per pound on consumption and growth overall (far larger than the Government, the MPC, and the OBR projected).  That occurs when confidence is being beaten down rather than raised up by fiscal consolidation.  If lack of confidence in government finances were a major weight on British households and businesses, the direct drag from fiscal contraction would be offset (if not reversed) by a rise in investment.  Again, the opposite is the case, and no such confidence effects have been seen.
In sum, the economic understanding underlying the Government’s economic priority on deficit reduction without regard for investment – public or private – has proven wrong along every line.  Many of Britain’s current economic problems are the result of economic conditions these excessive austerity policies themselves have caused. 
So should the British government just go on a spending binge instead?  No, clearly not.  Even though there is legitimately little fear about UK government finances at present, with the large deficits largely driven by slow growth pushing down tax revenues and up benefits spending, there is nothing to be gained by making those fears more realistic.  Again, debt and deficit levels are important, but fiscal policy needs to be set with respect to the right underlying assessment of the economic difficulty – focusing simply the levels of public spending and taxes misses the point. 

What the British government should do instead is to follow my program for reforms and stimulus to support productive investment, which has just been published in Prospect.


  1. Mr. Posen makes a number of strong arguments, closing the door on many of the failed UK government policies...and then reopens it just a crack with the last paragraph. Why provide Conservatives with that kind of opening to frame the debate as a debt and deficit problem when that's clearly not an issue for a sovereign government with its own free-floating currency. The government and BOE will always be able to shuffle balances around between Gilts and Reserves through computer keystrokes. They don't face a solvency constraint so stop pretending they do. And deficits only matter when the economy is chugging along at full employment because now the government spending begins competing with the private sector for a scarce pool of employees and resources. The UK is nowhere near that point.

    What Mr. Posen needs to be saying is that tomorrow's consumption can only be funded by tomorrow's production. If we fail to invest now, we won't have the productive investments in place to provide the means to enjoy future consumption. Hoarding/Saving pound sterling denominated financial claims is actually counterproductive because it ensures we don't make the necessary investments towards tomorrow's technology and productive capacity. All this savings is actually pushing us backwards.

    The Conservative argument has the causality all backwards. Investment creates savings, not the other way around. We invest, which creates jobs, and those new worker's gather savings as they wait for the final products of those investments to come online.

    The UK debt is no different than a savings account at a retail bank. You move money from your checking account (reserves) to your savings account (Gilts).

    So if you want a change in policy, stop playing in to the Conservative hand by ever framing the debate like there is a government debt or deficit problem.

  2. Doesn't this suggest rather that capitalism itself is grinding evermore to a slow but inevitable halt?
    Particularly here in the UK we have a dominant financial sector focused on international transfers and government subsidised channeling of funds [pensions, ISA's etc]facilitated by a network of crown dependencies and dodgy tax jurisdictions which neither seeks nor needs British industry, hence our wretched debt-load on households and smaller business which will impinge on domestic orientated growth for another decade or longer. Public investment is worthwhile if it's direct and not fed through private industry whereupon it can be relied upon to wind up in shareholders accounts, executive pay hikes and zero rated hideaways. Future private investment is bound to accentuate the longer term problems too, by increasing the capital based nature of such investment leaving a residual army of un/under-employed to fester ultimately forcing down profit margins even further eventually choking off investment. If the state doesn't direct it [investment] and it is no more than an expedient to alleviate GDP figures and debt/GDP ratios without fundamentally altering the inevitable long term trend toward immiseration and redundancy for larger and larger sections of the community-leading who knows where?

  3. Is there also an impact of the popular media / politicians telling everyone for the last several years how bad everything was going to get? Most friends I know who lost jobs in the downturn lost them because profitable companies wanted to shed jobs before the downturn hit them too hard, rather than because they were in difficulty now.

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  5. The UK economy collapsed in 2008, and was in serious trouble before that, as is the rest of the global economy.

    The current UK coalition is trying to rebalance our economy, but with total debt levels of the UK over 500% of GDP, which makes us the second most indebted nation out side of the USA, and no global demand for goods, another crash is inevitable, but at least the UK may not be the hardest hit, just like the 1930's Great Depression, the UK has already taken a lot of pain, as the UK did in the 1920's before the Great Depression started.

  6. I agree with you completely,I just want to say that Taxing business profits is a low down sneaky way to tax the poor. The business will simply raise the cost of their products or else they will go out of business.
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  8. Interesting Post. Posen states at the end of an article on him in the NYT that there are 3 options of the table for the UK.Austerity, Stimulus and Do Nothing. Austerity seems not to be working even on the most superfiial of analyses (and may even be the very thing which is deepening the crisis rather than aiding recovery), Do Nothing is clearly a bad idea, and so we are left with Stimulus...its what kind of stimulus and how to apply it intelligently that should be the focus of the governments economic policies in the UK. Would you agree with this in general?

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    2. Broadly agree. Adam's specific proposals are here:

      while mine (there is substantial overlap, obviously, since Adam and I are in broad agreement on these issues) are, for example, here:

  9. Well, is it as simple as public spending versus cuts? We can check this by looking at the data for the UK economy for the past 65 years and look at the relationship between public spending and GDP in the UK. We have had plenty of booms and busts so increased spending should precede recoveries and decreased spending precede downturns. I have plotted the data at:

    Does public spending stimulate the economy?

    What I found surprised me. Increasing public sector spending seems to
    be bad whenever it exceeds private sector growth. Take a look at the
    graphs in the link above. It happens every time over the past 70 years. If you want to improve the economy, in the UK at least, your simplest action is to cut public spending, or so it appears. Any comments?

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