Thinking About the Double Dip Recession in the UK

The news is well-known now: There the UK is in the first double dip recession since 1975 thanks to among other things the government’s contractionary fiscal policies. This recovery is in fact worse than that of the Great Depression [Macroscope] Here are three other observations that might not be so obvious: (1) Growth has been lackluster ever since the election of the coalition government in May 2010; (2) growth under the program of austerity has compared poorly against the (admittedly insufficiently stimulative) fiscal policy framework in the US, and; (3) UK GDP growth has been lackluster even with the depreciated pound, which is interesting given that exchange rates can act as a shock absorber.

UK growth has been lackluster since 2010Q2

I found it notable that UK growth has been so weak ever since the implementation of the austerity program. In some ways, it’s “textbook”. Figure 1 shows growth in log differences since 2009.

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Figure 1: UK annualized q/q GDP growth (chained 2008), calculated as log differences. Dashed line at 2010Q2. Source: UK ONS.

UK growth compares poorly to US growth

I was slightly surprised that the UK growth had lagged so much against US growth, given that obstructionism in the US political system had prevented implementation of additional pro-growth policies. But the current policy framework in the UK seems even more anti-growth than that in the US. Of course, (unlike Professor Ed Lazear), I recognize the fact that growth in the wake of financial crises is on average slower than those not accompanied by such crises. With a larger proportion of UK GDP involved in financial activities, one might expect extra headwinds.

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Figure 2: Log UK GDP (chained 2008) and log US GDP (chained 2005), normalized to 2010Q2=0. Dashed line at 2010Q2. Source: UK ONS April 2012 release, and US BEA, April release and author’s calculations.

Nonetheless, it’s clear the contractionary fiscal policy has not attained the objectives sought. According the IMF’s Article IV report from 2011, FY2009/10 structural budget balance, was -5.3%. The FY10/11 budget balance, under the new government, was -4.5%. The programmed (cyclically adjusted) balances in FY11/12, FY12/13, FY13/14 were -3.2%, -2.0%, and -0.6%, respectively (and into surplus in subsequent years!) according to the March 2011 budget. Most reasonable models would predict contraction and that’s what we get.

Austerity in a (relatively) small, open economy is still not expansionary

The UK economy is about one sixth the size of the US evaluated at current exchange rates. If there was a country where the expansionary fiscal contraction scenario could play out, it would be there.

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Figure 3: Log UK GDP (chained 2008) (blue, left scale) and log real trade weighted pound (red, right scale). Dashed line at 2010Q2. Source: UK ONS April 2012 release, and BIS, and author’s calculations.

And yet, with a pound some 20% depreciated (log terms) below levels at the beginning of 2007, the UK economy has struggled to exceed zero growth. I predicted back in November the UK would go into official recession, and here we are. It is no wonder that the troubled economies of the euro zone, lacking the exchange rate shock absorber, and operating at the zero interest rate bound, should be slipping deeper into recession. In other words, expansionary fiscal contractions might be little more than a curiousum, much more a fevered fantasy of the Republican members of the Joint Economic Committee and Paul Ryan than anything else. (See also Simon Wren-Lewis on why expansionary fiscal contraction is unlikely to work in the UK context.)

The implications for the US

Now let’s consider a fiscal framework that entails spending reductions relative to baseline, at close to the zero interest bound, and without much room for dollar depreciation. That scenario would be closely mimicked by programs such as the Ryan budget plan (unless one believed in some implausibly high elasticities as in the Heritage Foundation’s “analysis” of last year’s incarnation [1] [2] [3]).

I think the fact that fiscal drag is greater now is not surprising given that the share of fiscal consolidation coming from spending cuts is rising. This is shown in Figure 4, from the IMF’s Article IV report (p. 35).

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Figure 4: from IMF, United Kingdom: 2011 Article IV Consultation — Staff Report (August 2011).

So, we too can make the current US recovery worse than that of the Great Depression; just implement a front loaded fiscal contraction, heavy on spending cuts. Furthermore, in order to maximize the contractionary impact, harass the monetary authorities to tighten policy by inciting fears of high inflation (à la Rep. Paul Ryan), when year-on-year inflation as measured by the personal consumption expenditure deflator is 2.1%.

(More on the UK, from Interfluidity, which stresses the Neoclassical synthesis vs. New Keynesian vs. Post-Keynesian interpretations. I believe the data are not puzzling from an open economy perspective but that might reflect my training; deficient aggregate demand and relatively high inflation can occur when there is a large imported share in GDP.)

This post originally appeared at Econbrowser and is posted with permission.