Wednesday, 4 November 2009

Osbornomics- the triumph of hope over reality

Don't worry there will be some Obama later. However, the piece I've written is more a reflection on where we are than a celebration of the victory itself. There was plenty of that last year and the early part of this year. Interestingly, looking back at the blog at that time I didn't write anything about his victory at all. I think that I'd just had enough, focusing instead on finishing the book. I still had a conclusion to write....

Anyway, the more prosaic business of the economy: people's jobs, homes and businesses.

Giles Wilkes at CentreReform has run some separate scenarios on the Conservative approach to solving the fiscal deficit and extracting the economy from recession. The Osborne strategy is to lift the burden from fiscal supports and let exports and capital investment take the strain.

It could work. It's just highly unlikely. In Slash and Grow. Spending cuts and economic recovery. Wilkes points out:
"Several organisations, from the CBI to the Bank of England, predict that the UK can only grow sustainably through net exports and business investment. Consumption, both by households and the government, needs to fall. But if these two elements (which tend to comprise 80-85% of the economy) are to remain stagnant, the other two will be left with a huge burden to carry. The highest 5 year contribution that capital investment and net exports have ever made was in the mid 1990s, when they added an average of 1.1 percentage points to annual growth.

An even more extraordinary performance will be needed if a future Conservative administration is to achieve budget sustainability by 2015. This is because, even with spending flat in real terms for five years, the gap will need to be closed by higher revenues, which require economic growth."
And remember, such a strategy would require there to be sufficient growth in world demand to take up the slack of the loss in domestic fiscal support. Other countries would also have to be pursuing strategies that were not similar to ours (everyone can't devalue all at once.) And the business sector would have to gear itself towards export markets very rapidly- this is in an economy that has a largely non-tradeable sector (Ocado can't deliver in Brussels.)

Moreover, capital investment- the second Tory anticipated economic recovery driver- is highly volatile. There is no way of predicting where it will head. It is one reason for a degree of caution in the imposition of tougher capital reserve requirements for banks- that may drain the markets of liquidity just as the recovery is gaining some pace. I must emphasise this is absolutely a short-term consideration. And you really have to wonder just how capital investment can expand at the 9% rate needed in Wilkes' Osborne scenario to get the deficit back to sustainability. The Government is not having to force Lloyds TSB and RBS to lend because they are desperate to anyway.....

This also assumes that there is a huge appetite for corporates to leverage themselves up again. There will be caution both with households and corporates if we look at, say, what happened in Japan in the 1990s and 2000s which bears some similarities to our current situation, i.e. it is a credit recession rather than an inflationary adjustment.

So what is likely to happen when fiscal supports are withdrawn?

Well, time to dust down my trusty old friend, Richard Koo, once again. Japan tried a premature fiscal consolidation in both 1997 and 2001 as I discussed a few weeks back. What was the result? Well, fiscal deficits actually increased and they precipitated a credit crunch and multiple banking failures as well.

What this means in practice is for George Osborne's highly optimistic, high risk scenario to work he needs an enormous amount of luck.

For what it's worth, my prediction? Should the Tories win and begin cutting expenditure immediately, Osborne will be forced to reverse his policy within a year or face a new economic/ fiscal crisis.

1 comment:

  1. Anthony

    Thanks for the mention, and for the record I agree: there might be a very quick turnaround once the Conservatives are in power and they 'own' the problem. In fact, I would actually repeat the verdict I made in 'a balancing act' - they may TALK down fiscal support, but they would actually engage in it, is my guess: it is just that because their economic oppositionism is all about tactics and nothing about strategy, they refuse to talk in opposition as if they were in government.

    The big unknown is the household sector. It may ride to their rescue again.