Getting to grips with the economic debate

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It’s five years since the financial crisis and we are still talking about the economy. Despite trying very hard at being a proper science, economics is essentially about using narratives to describe events and supporting them with dubious statistics. It is therefore ripe for political manipulation and partisanship.

Changes to the welfare state this week have crystallised the debate between the Coalition and Labour. You’ve heard the arguments already. The Coalition was formed in the national interest to ‘sort out’ the mess left behind by the last Labour administration. In rebuff, the Opposition declaim that the government is cutting ‘too far, too fast’ and that borrowing is essential for the recovery. But who’s right? Despite all the rhetoric and bluster, both sides make coherent cases that can be supported statistically.

Take Labour’s case first. David Cameron has repeatedly said that a country can’t borrow its way out of a debt crisis, appealing to the common-sense household budget where the AAA rating shares drawer space with AAA batteries. But many prominent commentators argue that large deficits explain why the United States emerged from recession in 2010 and has not looked back since.

An IMF report issued last October revealed that its estimates of the fiscal multiplier are much higher than previously thought. They now believe that every £1 reduction in the deficit reduces national income by between 90p and £1.70, because demand in the economy is still less than its potential supply and because worldwide austerity is suppressing global trade. The TUC estimate that deficit reduction has cost the UK £76bn over 5 years, reducing the growth rate by about 1 percentage point.

In the UK, however, the facts do not seem to support this theory. Britain’s fiscal policy, despite all the talk of austerity, has been broadly similar to that in the US if you compare deficits as a proportion of national income over the last 5 years. This is the crux of the issue: Labour imply we should be spending more because our economy was hit worse by the recession; the Coalition argue that the fiscal multipliers just aren’t there.

Their argument is that the country’s continued weak performance is in large part due to recession in the eurozone, with which we trade about 40% of our exports, and the legacy of the permanently impaired financial sector on which we have overly depended since deindustrialisation. We can’t borrow more, they say, because we can’t assume that investors will continue to buy government debt at high prices such that they bear low interest rates. If investors think that the public finances are out of control, they’ll sell government debt, raising interest rates across the economy; which will reduce investment by companies and spending by individuals as loans and mortgages become more expensive. In other words, they imply the fiscal multiplier is effectively negative and will weaken the economy.

The government therefore increasingly talks about ‘winning the global race’. They believe that a sustainable recovery can be delivered only after supply-side reforms are taken that address the fact we struggle to pay our way in the world. These are policies that make a country’s economy more competitive, including reducing taxes and benefits, reforming education and focusing on industries that deliver the most value to the world’s market. Thus we can only reduce the deficit if we become better at producing more stuff rather than just demanding it, and we increase our wages by improving our productivity not by increasing benefits.

Lord Heseltine, the old Tory grandee, was wheeled out to provide some suggestions for how we can become less a nation of shopkeepers and more a land of exporters with high-value service and manufacturing industries. It is commendable that the government will implement most of them but they will take time to be effective.

The source of confusion in the public debate, then, is two seemingly incompatible arguments: demand creates supply in the short-run but supply creates demand in the long-run. Notwithstanding all the braying and carping associated with the political class, they are not worlds apart in ideology. The Coalition accept that the pace of fiscal consolidation should be slowed and Labour embrace the need for supply-side reform.

The benefits debate is used as a faux battleground for the title of fairness, but it is also a microcosm of the wider discussion regarding the juxtaposition between short-term and long-term policy. Should we be transferring income to those most affected by the recession or should we be reforming the welfare state to help make the country more productive and richer? Owen Jones, the socialist polemic, suggests both can be achieved through introducing a living wage.

Jargon buster

AAA rating: A grade assessment by a credit ratings agency of the quality of a debtor and the likelihood of his servicing a debt. AAA is the highest rating and is a factor in determining the price of debt, including government debt.

deficit: The government’s annual borrowing requirement, which is the difference between tax revenue and spending commitments over a financial year.

fiscal policy: The economic policy of HM Treasury, involving taxation and spending.

fiscal multiplier: The ratio of the increase in national income to the increase in government spending. IMF estimate fiscal multipliers to have increased from 0.5 to between 0.9-1.7, indicating a significant role for fiscal policy in downturns. A negative fiscal multiplier implies that government spending harms the economy.

government debt: the total outstanding liabilities (bonds) of the government to investors. A deficit increases government debt.

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