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Risks in the UK government's fiscal strategy--time for a Plan B? Opinion is divided over how the UK government should go about reducing the budget deficit and overall debt. Is it time to slow down the fiscal retrenchment, or to increase public-sector infrastructure investments to boost the economy?

It is universally agreed that the UK needs to reduce its budget deficit and lower government debt to GDP ratio. Both are unsustainable and, unless corrected, will damage the economy in the long run. The debate is not about the need for fiscal adjustment, but about the timing, speed and method of adjustment. And this debate is not just between politicians of different hues; economists and analysts are also divided.

Fiscal retrenchment

When it came to power early in 2010, the UK's coalition government inherited one of the largest structural budget deficits in the industrialised world and immediately committed itself to two rules that serve as the centrepiece of its fiscal strategy: public sector net debt to be declining as a percentage of GDP and, over a rolling period of five years, a balanced structural current budget position to be put in place. To date, neither have been achieved.

There are several reasons for this. First, the government has been deleveraging at the same time as the personal sector and the banking sector. Never before in the UK has there been a protracted period of simultaneous deleveraging in this way. This, of course, is a legacy of the crisis and the debt accumulation in the years leading up to it.

Second, a false comparison was drawn with Canada and Sweden which, in the 1990s, adopted successful fiscal retrenchments that had a negative impact on growth for only a short period. The problem with this comparison is that those two countries applied the policy at a time when other countries were not, and when the world economy was growing strongly. That is not the case now.

Third, with the combination of a sovereign debt, and a euro and banking crisis, the European economy has been weaker than originally envisaged, which in turn has weakened the UK economy and made it more difficult to achieve the fiscal targets. Lastly, externally generated inflation has been much higher than forecast at the time, which has had a massive impact on consumers' real incomes and expenditure.

The main issue is whether, as the circumstances have changed, the UK government should slow down its fiscal retrenchment.

Recent trends and their long-term impact

Will the recent recession have a lasting and negative impact on both the level and future rate of growth of maximum potential output in the economy? By definition, the actual level of output will always be equal to, or usually somewhere below, the full capacity of the economy. The major determinant of the growth of the economy's productive potential is the trend growth in labour productivity.

A serious possibility is that the prolonged recession could have negatively affected the level of productive capacity, and even its future rate of growth. In the former case, the loss of output is permanent and never regained. In the latter case, the trend growth of the economy in the future will also be slower than in the past.

The output/employment conundrum

The conundrum that is making it difficult to interpret recent trends is that, compared with past recessions, employment has continued to rise. While public-sector employment has fallen by 400,000, private-sector employment has risen by more than 600,000 since mid-2010. At 29.5 million, total employment is within 100,000 of the pre-crisis

peak. By definition, this means that productivity has fallen. The key issue is whether this is temporary or permanent.

There are four possible explanations for this. First, it may simply reflect the hoarding of labour by firms in order to avoid the costs of recruitment when output picks up, and in order to retain key skills.

Furthermore, in some areas of the economy the real cost of hoarding has decreased due to lower real wages. If this is the case, productivity will rise sharply when a sustained upturn occurs.

A second possibility is that the composition of employment has changed as more workers have moved to part-time and self-employed status. In other words, while the numbers employed have held up, on average people are working less. A third possibility is that the output data published by the Office of National Statistics is wrong.

The final possibility, and by far the most serious, is that the level (and possibly future growth) of productivity has been permanently lowered as a result of the recession. There are several explanations for this: a smaller capital stock as a result of weak investment; structural change in the economy from high productivity sectors (such as financial services) to lower productivity sectors; a loss of skills that will be difficult to regain; banks being either less willing or able to finance new, dynamic and innovative companies, most especially in the SME sector; and banks generally being permanently less able to expand lending at the same rate as they did in the past.

There are serious implications if there has been a fall in productive potential and its future rate of growth:

* Excess capacity will be lower at each level of output than in the past, which in turn has implications for future inflation.

* The standard of living will be lower and grow at a slower rate compared with earlier trends.

* The structural budget deficit (i.e. abstracting from the economic cycle) will be higher than originally thought.

Partly because of this, fiscal austerity would be deeper and last longer than in the government's current plan. In other words, if the coalition government sticks to its present fiscal strategy, more cuts would be needed as the long-term sustainable level of deficits and debt would be lower.

Plan B?

Because of all this, there have been increasing calls for the government to moderate its fiscal plans, at least with respect to timing, as all governments should respond to changed circumstances. It might be necessary to look again at some of the assumptions and conditions at the time the policy was established in early 2010. The most common elements suggested for a new strategy are: slower fiscal retrenchment; a credible plan for a prolonged period of fiscal retrenchment; an increase in public-sector infrastructure investment; and a cut in social security entitlements and fiscal transfers. Taking the last two together, this would imply a restructuring of spending from current to capital. There would be several political problems: it could be seen as a "failure" and credibility could be lost; it would be seen as a capitulation to the ideas proposed by the Labour opposition; and the Liberal Democrats would certainly strongly resist cuts in entitlements.

This is all about the structure and timing of fiscal retrenchment so as to minimise the impact on the economy. There would still be a pre-commitment to addressing the debt and deficit problems. The new pre-commitment strategy would, of course, need to be credible, precise and monitored (a new role for the Office of Budget Responsibility?).

There are several reasons why such an alternative strategy has been recommended (by none other than the IMF for one). A central factor is that the current strategy is simply not working as originally envisaged, with the costs to the economy being greater than initially thought. This is partly, as noted earlier, because circumstances have changed. Furthermore, there is a danger of an austerity trap emerging (i.e. if fiscal contraction weakens the economy it becomes yet more difficult to achieve the fiscal targets because tax receipts are lower and social security payments are higher; we begin to chase our tail); cuts in government spending to lower the deficit; the GDP ratio has the effect of lowering GDP, which in turn (at least partly) offsets the decline in the ratio. Some analysts also question the wisdom of public-sector deleveraging when other sectors are doing so at the same time.

There is a further consideration: real interest rates are now negative and lower than at virtually any time in the recent past. If the real cost of borrowing is negative the government could borrow in order to finance real capital projects, yielding positive real rates of return for generations. This could be the opportunity of a lifetime to cash in on exceptionally low real rates of interest to finance long-term infrastructure capital investment.

Policy is always about balancing risks

Economic policy is always about balancing risks in an uncertain environment, and there is an especially high degree of uncertainty at the moment, which is likely to persist. That said, the main risk in maintaining the status quo with regard to fiscal policy is that the recession returns with an enhanced risk of long-term damage to the productive capacity of the economy. If an alternative strategy is adopted, however, the risk is that the government loses its credibility with regard to serious fiscal retrenchment, interest rates might rise (though some question whether this really matters), and the debt to GDP ratio would rise further and stay higher for longer.

There seem to be "problems for every solution". My own judgement is that, on balance, the risks of not adjusting fiscal strategy are probably greater than the risks of making limited changes to the overall thrust of fiscal policy. But, in a situation of great uncertainty, it is a genuinely difficult call to make.

This means that the UK economy, government policy management and business face formidable challenges in the years ahead as the economy is forced to adjust to more sustainable structures, not the least of which will be the balance between the public and private sectors. However, many parts of the economy, such as the labour market, have become more flexible and more adapted to meeting the challenge. So there are silver linings ...

By Professor David T Llewellyn of Loughborough University

Professor David T Llewellyn is professor of money and banking at Loughborough University School of Business and Economics and the Vienna University of Economics & Business. He is also vice chair of the Board of the Banking Stakeholder Group at the European Banking Authority.

Professor Llewellyn can be contacted at
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Title Annotation:Technical Notes
Author:Llewellyn, David T.
Publication:Financial Management (UK)
Geographic Code:4EUUK
Date:Apr 1, 2013
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