British economic growth post-crisis has lagged substantially behind U.S. growth, and the gap is growing. British gross domestic product has not yet returned to its pre-crisis level and is more than 10 percent below what would have been predicted on the basis of the pre-crisis trend. Britain’s cumulative output loss from this downturn in its first five years exceeds even that experienced during the Great Depression. And forecasts continue to be revised downward, with a decade or more of Japan-style stagnation emerging as a real possibility.
Whenever policy is failing to achieve its objectives, there is a debate as to whether the right response is doubling down on the existing path, or recognition of error and/or changed circumstances and a change in course. Such a debate is raging in Britain about the aggressive fiscal consolidation that the government has made the centerpiece of its economic strategy. Until and unless there is a substantial reversal of course with respect to near-term fiscal consolidation, Britain’s performance in the short and long runs is likely to deteriorate.
An effective policy approach to Britain’s economic problems must start by recognizing that lack of demand is the principle factor holding back the economy in the short and medium terms. Certainly, Britain faces important structural issues, including difficulties in promoting innovation and deficiencies in the system of worker training. But the fact that lack of demand is what is holding the economy back from producing as much as it could is apparent from the relatively low level of vacancies, workers’ reluctance to leave jobs, the pervasiveness across industries and occupations of increased unemployment, and firms’ testimony regarding the formation of their investment plans.
Moreover, to an extent greatly underappreciated in the policy debate, short-run increases in demand and output would have medium- to long-term benefits as the economy reaps the benefits of “hysteresis effects.” A stronger economy means more capital investment and fewer cutbacks to corporate research and development. It means fewer people lose their connection to good jobs and get addicted to living without work, that more young people get first jobs that put them on ladders to success, and that more businesses choose leaders oriented to expansion rather than cutting costs. The most important structural program for raising Britain’s potential output is raising its actual output today.
Those who object to this view argue, in essence, that reversing course on fiscal expansion now would undermine credibility, would backfire with respect to growth by risking a spike in capital costs and would risk catastrophe down the road as debts became unsustainable.
This line of argument is profoundly flawed.
First, the behavior of financial markets suggests that economic weakness, not profligacy, is the main concern about credit problems down the road. Why else would the tendency be for the costs of buying credit insurance on the United Kingdom to rise while overall interest rates fall? In a similar vein, a strong tendency has emerged in Britain and the United States for interest rates to rise and fall with stock prices, implying that evolving optimism and pessimism about the future, not changing views about fiscal policy, drives market fluctuations.
Second, the primary determinant of fiscal health in the United States and Britain over the medium term will be the rate of economic growth. An extra percentage point of growth maintained for five years would reduce Britain’s debt-GDP ratio by close to 10 percentage points, whereas austerity policies that slowed growth could backfire in the narrow sense of raising debt-GDP ratios and turning the unsustainability of debt into a self-fulfilling prophecy.
A change in the pace of fiscal consolidation is necessary for Britain to have a chance to avoid a lost decade of economic performance. It is, however, not sufficient. Rather than starving public investment, now is the time to add to confidence by making plans for structural reforms to contain the growth of public consumption spending over time, to take (overdue) measures to promote exports, and, after years of appropriately low investment, to restart housing investment. But when demand is needed for growth and the private sector is hanging back, the first priority must be for the public sector to stop exacerbating the contraction.