Sunday, 26 September 2010

Lessons for Britain’s economy from the stimulus packages in Europe

By Michael Burke

The pattern emerging from the European economies on growth and public finances holds important lessons for Britain as the coalition begins its policy of cuts to public spending. Most European economies adopted some combination of tax and spending stimulus measures in 2009 in an attempt to restore economic activity. By contrast, the Dublin government took the diametrically opposite approach, and in a series of Budget and ‘emergency’ measures embarked on a ferocious reduction in public spending. The verdict on the impact of those differing policies is now in, and holds clear implications for Britain over the next period.

The Impact of Measures To Support Growth

The economic response to any stimulus measures is apparent after a time lag of some months. There is a further time lag as this change in economic activity is reflected in government finances. This is because many taxes (self-assessed income taxes and taxes on profits in particular) are paid some time after the income or profits were made, sometimes long afterwards.

The size and composition of the measures to boost growth varied across Europe. The European Central Bank (ECB) has an analysis of those measures, which were mostly adopted in 2009. (France and Germany also took further measures at the beginning of 2010, which are not part of the ECB’s analysis). Following the ECB, the table below sets out the level of fiscal stimulus measures in some European economies as a proportion of GDP. Alongside we show the impact both on taxation receipts and the overall level of the public sector deficit in the latest data for those countries.

Table 1

10 09 26 European stimulus table
The most striking feature is that in all cases, without exception, taxation revenues are increasing and the deficit is falling in those countries which adopted measures to boost growth. By contrast, in the one country which did nothing to boost activity, Berlusconi’s Italy, taxes continue to wilt and the deficit is higher in the first half of this year than in the same period in 2009.

It should also be noted that the size of the stimulus measures has some relationship with the pay-off in terms of the subsequent growth of taxes. But there is not a direct correlation. This is because the composition of the measures is also significant. In Keynesian terms, it is because differing types of stimuli have different multipliers attached; they have a widely differing ‘bang-for-buck’, with investment the highest multiplier of all. In Marxist terms, an increase in productivity relies on the investment of capital - combined with the energy and intelligence of labour. But investment formed only a fraction of the overall stimulus measures in the EU as a whole. The chart below, reproduced from the ECB shows that just 28% of the entire stimulus measures were public investment. The remaining two-thirds were measures to support household consumption and businesses.

Chart 1

10 09 26 European stimulus chart 1

But the different impact of these can be noted from the from the fact that the latest forecasts from Eurostat are that EU household consumption will rise by 2.3% this year, while investment (gross fixed capital formation) will fall again, by 2.6%

That is to say, the measures to boost private consumption have had a modest positive effect, whereas the measures to support business activity have not produced any positive result.

Lessons From Madrid

If we take the case of Spanish state, which had the largest package of measures, there has been a vigorous economic response. This seems to have completely by-passed the English-speaking commentators and analysts, who have focused on the meagre recovery in aggregate GDP, up just 0.3% in the first half of his year .

But there has been little analysis of the data, which shows a surge in import demand that masks the much stronger rise in the domestic economy and arithmetically subtracts from it. The final consumption expenditures of households, government and the non-profit sector rose by 1.9% in the first half of this year. Only investment continues to decline, down 2.4% in the first half of the year, hampered by the continuing meltdown in construction. But even here, investment in equipment has risen sharply. In the year since the stimulus measures were announced, investment in equipment has risen by 8.7%. As a result of this rising activity, the public sector deficit has halved in the first 7 months of this year. Rising taxes are overwhelmingly responsible, €18.5bn higher of a total €21.3bn improvement .

Of course the combination of EU, IMF, ratings’ agencies and financial markets have all conspired to strong-arm the Spanish government into adopting massive spending cuts, which were implemented after these data and will impact fully only with their own time lag. A rear-guard action in the form of clinging to cherished investment projects and a modest rise in the minimum wage will not be enough to prevent this capitulation from wrecking both the recovery and the improvement in government finances.

Crucially, over 50% of Spain’s measures took the form of direct investment by the government via public works’ programmes. Of the remainder, the bulk was in tax cuts aimed at the poor, along with the 1.5% increase in the minimum wage. It is this composition of the ‘stimulus’ measures, relying mainly on government investment and boosting the incomes of the poor, that accounted for the Spain’s relative success story. By contrast, initially, the entirety of Germany’s measures were tax cuts, with much more modest results.

Lessons From Dublin

The policy of the Dublin government was precisely the opposite to that of Madrid. Beginning at the end of 2008, a series of Budgets and emergency measures provided a fiscal contraction equivalent to 6.6% of GDP. More spending cuts were made this year more again are threatened for 2011.

The effects have been the reverse of those advertised. Recent editorials in both the Financial Times and the Guardian have highlighted the growing disillusion with the Dublin government’s severe reductions in public spending, arguing that they have not led to any narrowing of the Budget deficit. Only The Economist could find (modest) reasons for optimism, by the simple expedient of accepting the Dublin government’s own forecasts for the deficit rather than analysing the current situation .

The latest economic data show the Irish economy contracting once more in the 2nd quarter of this year. In contrast to Spain, the domestic sector has contracted at a faster rate than GDP, as import demand has plummeted. Crucially, this domestic downturn has led to a continuing contraction in taxation revenues despite a series of tax increases. Overall, investment is 54% below its peak level and is equivalent to the entirety of the slump in GDP.

Equally bad, there is outright deflation in the economy, with prices falling since the end of 2008. These price falls include wages as well as goods, and therefore lower the taxation revenues on all activity. This has the disastrous effect of reducing the government’s income stream to finance the existing level of debt. In real terms, deflation increases the debt burden.

Normally, ‘Depressions’ are spoken of when output falls by 20% or more. In nominal terms Irish GNP, excluding the external sector, has now fallen for 9 consecutive even though the Euro Area recession ended a year ago. And it has fallen by 24% from its peak. This is an Irish Depression.

Of course, Irish tax revenues have plummeted as a result, and now the public sector deficit is projected by the EU to be 14.7% of GDP next year. This is more than double the initial size of the deficit in response to the slowdown and is now the highest in the Euro Area. This is a policy-induced crisis of the economy and of government finances.

The cuts promised by the collation government in Britain are of the same order as their fellow Thatcherites in the Dublin government.

Tuesday, 7 September 2010

Structural weakness of UK GDP

By Mick Burke

The British economy grew 1.2% in the 2nd quarter of this year, following a rise of 0.3% in the previous quarter. It was the strongest quarterly growth rate recorded since the beginning of 2001, prompting the Daily Express to talk of a ‘mini-boom’ continuing into next year.

A more sober consensus is that this may be the strongest growth rate for some time and many commentators, some of whom are very far from the political left, continue to point to the danger that the government’s fiscal policy is increasing the risks to the recovery. Thus for example, according to David Kern, economist at the British Chamber of Commerce: ‘The huge scale of the retrenchment that the government wants to implement, and the decision to cut the fiscal deficit at an accelerated pace, will inevitably increase dangers of double-dip recession. In spite of the relatively strong recent UK performance in the second quarter, the recovery is still fragile and risks of a relapse are high.’

State of the Economy

The cyclical upturn in the economy follows the sharpest British recession in the post-World War II period, a contraction of 6.4% taking place over 18 months (six quarters). The economy has been expanding now for nine months and yet GDP remains 4.5% below its peak.

There is nothing ‘V-shaped’ about the recovery. In monetary terms the real decline in the economy, measured in constant 2006 prices, was £88bn, while the subsequent expansion has been just £20bn - £16bn of that in the latest quarter.

Even this rebound is not a token of renewed underlying strength, but above all a restocking of inventories. The quarterly change in business inventories accounts for 1.0% of the 1.2% growth in the quarter. Even if the restocking has further to run, which seems probable, it is not a sustainable basis for economic recovery without a rebound in consumption and investment.

The slump in fixed investment was a key contributor to the recession and remains its main area of weakness. The charts below highlight this Figure 1 shows the changes in the components of GDP over the six quarters from the beginning of the recession to its deepest point.

Figure 1

10 09 06 Mick Burke Chart 1

GDP contracted by £88bn. This was driven almost equally by a fall in personal consumption and in fixed investment (gross fixed capital formation) which were down £42.9bn and £40bn respectively. Declining inventories also subtracted from growth. Statistically, net exports rose but this was only because the decline in imports exceeded the fall in exports. The only substantive positive contribution to growth came from rising government consumption spending which was up £9.5bn. It should be noted that the latter important government prop to growth has led to a reduction in the budget deficit, not an increase. As SEB has previously shown, government income have risen in response to increased government spending.

Chart 2 below shows the same components of GDP from the beginning of the recession in 2008 to the second quarter of 2010. The main feature is that the decline in investment has continued, falling again in the 2nd quarter of this year even while other components such as personal consumption have recovered and dragged aggregate GDP higher.

Figure 2

10 09 06 Mick Burke Chart 2

As a result, the decline investment now accounts for nearly two-thirds of the entire decline in GDP to date, £40bn within a total decline of £62.7bn. In consequence, net exports make a reduced contribution to growth, as exports have barely recovered and remain 9.4% below their peak while imports have risen faster. Among the many fantastical forecasts made by the Office of Budget Responsibility was that a 6.1% rise in world trade this year would lead to a growth in British exports of 4.3%. Yet the rebound in world trade already exceeds that forecast, up 7% according to the IMF. Yet British exports are up just 2.7% in the 1st half of this year, despite a fillip from Sterling’s depreciation.

Since investment is the key determinant of long-term growth the persistence of this private sector investment strike will transform a cyclical weakness into deepening structural one.

Private firms cannot be certain of achieving a profit when demand is subdued. Their response is to cut investment programmes and to attempt to reduce costs. They also look to government to reduce their external costs via lower tax rates and other means (reduced pension contributions, lower entitlements to sickness and maternity pay, abandoning equality provisions, etc.) and above all, lower wages.

The chart below shows the main income categories of GDP; compensation of employees, the gross operating surplus of firms (GOS - akin to profits) and taxes (all in nominal terms). As the chart shows, the GOS fell in the recession, down by 8.3%. It has since recovered but remains well below its peak, whereas taxes have risen and the compensation of employees, initially flat, has recently risen. (This rise is not a significant increase in wage levels but reflects the increases in pay and bonuses in the financial sector).

Figure 3

10 09 06 Mick Burke Chart 3

Political Response

From the perspective of many individual capitalists, all this is a disaster. Profits have declined, but taxes and compensation have risen. Aside from reducing investment and hoarding cash, the response demanded is that the government reduce taxes and take measures to reduce wages. The hue and cry about the deficit masks this central thrust of economic policy. Corporate taxes are being lowered towards 24% (even as VAT rises, hitting the poor) and all types of welfare benefits are reduced in an effort to drive incomes lower.

This is the thrust of government policy. It has the effect not just of increasing short-term risks to the economy but ensuring long-term damage via the continuation of the investment strike. It enshrines a lower level of wages and benefits to the poor in return only for the prospect of increased profits.

But recently, David Milliband argued, echoed by Tony Blair in the BBC interview with Andrew Marr on his biography, that this government economic policy should be accepted!

David Milliband even claimed:"The closest parallel [to Labour’s current situation] I can think of is the Tories’ rethink under R.A. Butler after they lost the 1945 General Election". "Rab" Butler was the prime mover behind the post-War Conservative acceptance of the 1945 Labour government’s reforms, the introduction of the welfare state, the NHS and nationalisation of major bankrupt industries. In this speech, David Milliband signals he is willing to accept the ferocious assault now being organised against workers and the poor. It would condemn the whole economy to prolonged slow growth, with the poorest suffering the most.