Lending Is the Key to Putting the Fiscal Strategy On Track

My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

It is the party conference season, when the government’s economic strategy comes under attack, and ministers run some eyecatching announcements up the political flagpole.

We have already had a foretaste of this from the Liberal Democrats. Most of it boiled down to ‘if you are Lord Sugar do not expect a free bus pass and expect to pay more tax on your mansion’, though not until after the elction.

For this week’s Labour conference, in Manchester, the coalition has at least been spared the indignity of an economy that has shrunk on their watch. Two months ago that was the case: the Office for National Statistics said then that gross domestic product in the second quarter was 0.3% lower than two years earlier, when the government took office.

Now, thanks to revised figures last week, it is 0.2% larger, and one of the five quarterly falls in GDP of the past three years – in the second quarter of last year – is now recorded as a rise. The initial 0.7% GDP drop in this year’s second quarter is now put at 0.4%. There will be many more such revisions to come.

This will not, for now, save the coalition from taunts about the double-dip recession. Nor will it prevent a political narrative that runs like this: the government’s fiscal strategy has not only flattened the economy but is failing on its own terms by not reducing the budget deficit according to plan.

There is a lot to say about this. The fiscal tightening is only one aspect of disappointing growth, the others being the high-inflation squeeze on real incomes (which the latest figures suggest has eased considerably), the absence of credit growth and the eurozone crisis. In the past year the eurozone’s woes have weighed down heavily on Britain’s economy.

A bit of a myth has grown up about the public finances, which we shall no doubt hear more of this week. The benchmark for the government’s austerity plan was laid down by the June 2010 forecast from the Office for Budget Responsibility (OBR), the official fiscal watchdog.

Its forecast then was for public borrowing, estimated at £155 billion in the 2009-10 fiscal year, the last year of the Labour government, to drop to £147 billion in 2010-11 and £116 billion in 2011-12.

Latest figures show borrowing running pretty close to those projections, with 2009-10 put at £159 billion, 2010-11 £142 billion and 2011-12 £119 billion. If you wanted to stretch it you might say that a reduction from £159 billion to £119 billion is slightly bigger than from £155 billion to £116 billion, but the central point is that as far as the tightening for the first two years is concerned it is a case of so far, so good.

It gets more difficult from now on. The OBR’s June 2010 forecast was for a drop in borrowing to £89 billion this year, leaving aside any accounting shenanigans from the transfer of the Royal Mail pension fund to the public sector.

So far in 2012-13, borrowing is running a fifth about last year’s level. That should change as we move into the second half of the fiscal year – there were similar worries about a big overshoot 12 months ago – but it would take a minor miracle to get back to where the OBR said in 2010 we would be, let alone achieve the deficit reductions to £60 billion, £37 billion and £20 billion for the following three years.

Future deficit reduction has become harder because of growth in current government spending, notably benefits, which in the April-August period were 6.5% up on a year earlier. This was mainly because of the decision to uprate most benefits by 5% in April and it is why talk is now turning to freezing such benefits.

Some tax receipts, particularly corporation tax, are also very weak, down nearly 10% on a year earlier. A rise in company profits in the second quarter should turn this around somewhat, but the loss of the revenue cash cow of the business and financial sector is genuine.

The big reason for the slowing of progress on deficit reduction is, of course, the disappointment on growth. When the coalition took over in May 2010, it adopted a tight fiscal/loose monetary strategy that had worked so well in the 1990s.

With hindsight (though it did not seem so at the time) Britain bounded out of the recession of the early 1990s, with growth rates soon hitting 3% or more. The loose monetary policy of the time; lower interest rates and a sizeable sterling devaluation, more than compensated for a fiscal tightening that saw hundreds of thousands of public sector jobs cut. A budget deficit of 8% of GDP turned to surplus in five years.

Why did it work then but is so much tougher now? The 1990s model required monetary policy to do the heavy lifting in kickstarting and maintaining the recovery. This time, monetary policy has struggled to keep the economy’s head above water.

Three and a half years of Bank rate at an unprecedented low of 0.5%, £375 billion of quantitative easing and a 25% drop in the level of sterling, most of which has stuck, have failed to do what a more modest monetary relaxation did two decades ago. Either the forces pushing the economy down are even more powerful than we thought, or monetary policy has lots its potency.

We may know soon enough. The Bank of England-Treasury £80 billion funding for lending scheme (FLS) is the latest attempt to reboot monetary policy. Last week the Bank announced the first 13 banks and building societies to have signed up, between them accounted for nearly three-quarters of the stock of lending to households and firms.

Under the scheme, lenders will be provided with cheap liquidity in the form of Treasury bills for up to four years, in return for commitments to maintain or increase lending between now and the end of 2013.

Paul Fisher, the Bank’s executive director for markets, is not suggesting that the scheme will transform a weak economy overnight. But, he said in a speech last week: “I am confident that the FLS will help the supply of credit. Before its introduction, it was more likely than not that the stock of credit would contract further over the next 18 months. Perhaps it still may. But any return to positive credit growth would be a better outcome than we could have previously hoped for.”

It needs to happen Monetary policy has to work to boost the economy, and to keep the fiscal strategy on track.

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

One Response to "Lending Is the Key to Putting the Fiscal Strategy On Track"

  1. William T   October 2, 2012 at 4:43 pm

    pushing on a string is not known to have a strong effect.