UK: Is Osbourne Cutting Too Hard or Not Hard Enough?

Is George Osborne cutting too fast or not fast enough? The Office for National Statistics’ second estimate of GDP in the first quarter, as expected, left the rise in GDP unchanged at 0.5%, following the 0.5% fall in the fourth quarter of last year.

I will not go over old ground on the reliability of these figures, though there are further oddities in the numbers that will no doubt be revised away over time. At face value they tell a story of an economy that has been stagnant over six months. Ed Balls, the shadow chancellor, says the economy has been flatlining since Osborne stood up to deliver his spending review in the autumn, which detailed the cuts.

What the GDP figures also showed, however, was that government spending rose by 1% in the latest quarter, after an increase of 0.4% in the final quarter of 2010. Public spending grew as the economy shrank and contributed two-fifths of GDP growth in the first quarter. Spending in cash terms in April was 5% up on a year earlier.

There is a case that January’s Vat hike contributed to the exceptional first quarter consumer spending weakness, though it is sensible to suspend judgment given that retail sales rose during the quarter. There is no case yet for the argument that spending cuts are killing the economy.

What about an apparent change of heart by the Organisation for Economic Co-operation and Development (OECD)? Its twice-yearly Economic Outlook, endorsed the government’s plans, saying “the current fiscal consolidation strikes the right balance and should continue in line with the medium-term plan to eliminate the deficit”, But its chief economist, Pier Carlo Padoan, appeared to suggest the government should go slow on cuts if growth is weak.

After talking to the OECD, and subsequently listening to Angel Gurria, its secretary-general, what he meant, I think, is that if growth is weaker, so-called automatic stabilisers should be allowed to operate. Weak growth means weaker tax revenues and higher spending on unemployment benefits. If, in spite of these, the chancellor tried to stick to firm deficit targets, he could make things worse. So Osborne should stick to his plans, but not to try to offset any impact on the deficit from weaker than expected growth.

Indeed the OECD appeared to offer some support for the view that Britain’s cuts are not that exceptional. It compared reductions in the projected budget balance (the deficit) in member states between 2009 and 2012. Easily the biggest were the crisis-hit eurozone economies, Greece, Ireland and Portugal, plus Spain, with deficit cuts ranging from 4% of gross domestic product in Ireland to more than 12% for Greece.

Britain’s projected deficit cut is significant, around 3% of GDP. That, however, is not much more than Italy and France, neither of them natural big cutters.

Another OECD comparison, which we reported last week, showed Germany’s public spending to GDP ratio – again to 2012 – falling by 2.5 percentage points, compared with 2.2 for Britain.

This highlights criticism of the cuts by some commentators, that they have been sold as much tougher than they are. Certainly, the coalition has been unsubtle in its warnings about the tough times ahead.

There are two problems with these comparisons, however. One is that the public spending to GDP ratio is not a good measure of the fiscal pain being inflicted. This is because it is influenced by the performance of GDP as well as spending.

So Greece’s public spending to GDP ratio falls only 0.1 points between 2010 and 2012, despite very deep spending cuts, because of GDP weakness. It works the other way too. During Gordon Brown’s tenure at the Treasury the public spending to GDP ratio barely rose until recession hit, even though spending was being increased rapidly.

The other problem is that Britain’s cuts go well beyond 2012, and only really begin this year, 2011-12. The IMF compared planned fiscal tightenings in eight economies over the period 2010-15 – Britain, America, Germany, Japan, France, Italy, Canada and Spain – and found Britain’s tax hikes and spending cuts, nearly 8% of GDP, easily exceeded America, France and Spain (4% to 5%), Canada (3%), Germany (2.5%), and Japan and Italy (less than 2%).

The spending cuts, far from being a scratch, are significant. Revised calculations from the Institute for Fiscal Studies, based on recent (and higher) inflation projections from the Office for Budget Responsibility show over the four years from 2010-11 to 2014-15, real departmental spending will fall 11.7%. Take out the protected areas of health and overseas aid and departmental cuts are even larger.

Overall government spending (total managed expenditure) will fall 4% in real terms over that four-year period. That does not sound much but includes a sharply rising debt interest bill. It is also unusual. In only eight years since 1948 has spending on this measure fallen, and never more than two years in a row. This four-year squeeze will break historical precedent.

Will it kill the recovery? I say not but this is an uncomfortable time for the government. The OECD is the latest to revise down growth forecasts for Britain, forcing the Treasury to trot out the line that recovery was always going to be choppy. Maybe, but not long ago it predicted growth of more than 3% for this year.

Barely more than a month into the start of his four-year programme of spending cuts Osborne cannot change course now. There is a case, as the OECD says, for allowing automatic stabilisers to operate if growth is weaker than hoped, rather than sticking rigidly to deficit targets.

If high inflation persists, as the Bank of England’s Andrew Sentance predicts, there may also be a case for revisiting the cash totals for public spending, to prevent the real squeeze from being even tougher.

There is no case, however, for going back on the thrust of the government’s deficit reduction plans. The chancellor is known for occasionally having spent time on yachts. Any sailor knows that if you drift too much you get into trouble.

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This post originally appeared at David Smith’s EconomicsUK and is reproduced here with permission.