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Analysis
Learning from the US

Learning from the US

Osborne should ease off on austerity
Over-reliance on aggressive QE risks precipitous drop in sterling

by Trevor Greetham, Advisory Board

Thu 2 May 2013

The UK's ambitious fiscal tightening plans gained plaudits from the International Monetary Fund and ratings agencies in 2010. But, less than three years later, Moody's has stripped the country of its triple-A credit rating, blaming persistent economic weakness.

Ironically, America was downgraded by Standard & Poor's for putting off spending cuts and yet the US economy is growing, banks are lending and house prices are rising.

Chancellor George Osborne should follow the US lead and ease back on austerity until consumer deleveraging has run its course. Business Secretary Vince Cable is right to suggest that the markets would allow such a strategy without a destabilising spike in gilt yields. The alternative of leaning ever more heavily on unconventional easing by an unleashed Bank of England risks a precipitous fall in the pound and a more extended period of stagflation.

Fiscal policy used to be something of a sideshow for investors. It was central bank-watching that paid off. An overly loose or tight stance by the government would be offset by a hike or cut in interest rates and it was changes in interest rates that drove the business cycle.

The global financial crisis changed all that. The US and Europe plunged into a balance sheet recession long familiar to the Japanese in which consumers don't borrow, banks don't lend and interest rate cuts fail to boost the economy as paying down debt is the primary objective of a traumatised private sector.

At times like this, fiscal policy matters hugely and front-loaded austerity can be self-defeating. With a weak global backdrop we are all in effect closed economies. The government, consumers and corporate sector cannot all pay down debt at the same time.

One group's spending is another group's income. This is Keynes's 'Paradox of Thrift'. If fiscal tightening hurts confidence, consumers and corporates retrench, tax revenues drop and government debt goes up, not down. Counter-intuitive as it sounds, if you are the government you can save yourself into debt. And yes, sometimes you can borrow your way out of it.

Lessons from the 1930s depression and IMF analysis of more recent financial crises point in a clear direction. Countries able to maintain loose fiscal and monetary policies stand the best chance of growing or inflating their way out of debt.

Federal Reserve chairman Ben Bernanke understands this well. In his book, 'Essays on the Great Depression', he argues policy should have been eased massively and kept loose until all fear of deflation was gone. As it was, it took forced government spending during the Second World War to end the slump.

Bernanke's Fed would rather err on the side of overdoing monetary stimulus with a possible overshoot in inflation – a price worth paying.

In stark contrast to Bank of England governor Mervyn King, Bernanke has repeatedly advised Congress to delay spending cuts until the economy is stronger. President Obama has done his best to follow the loose policy game plan in the face of increasingly tough opposition.

It was a deferral of government spending cuts that lost America its triple-A rating from S&P in August 2011. So far, the policy is working well. Interest rates remain exceptionally low, economic activity is well above pre-crisis levels and clear signs of revival in the housing market suggest the economy may be close to escaping its debt trap.

There's one important message for George Osborne. Sometimes the ratings agencies are best ignored. They played a pernicious role in the run-up to the financial crisis, assigning their highest ratings to flawed debt instruments linked to overheated housing markets.

The hit to bank capital when these investments turned sour is what created the credit crunch. With consumers scrambling to pay down debt, the same ratings agencies are advising governments to add to the pain by implementing aggressive austerity plans when their economies need as much support as the markets will allow.

Now that the UK’s top-notch credit rating has been lost due to economic weakness it makes sense for the Chancellor to ease the pace of fiscal consolidation.

A large infrastructure program financed at record low gilt yields would make good sense. The private sector lacks the confidence to invest on the necessary scale and overseas investors would charge too much. A policy volte-face would wrong-foot Osborne's opponents and the subsequent economic boost would make political sense for the Conservatives ahead of the 2015 election. The notion that markets would prevent such a policy is nonsense, as anyone observing the recent plunge in Japanese government yields can tell you. A complicit central bank can keep interest rates low.

The alternative of continuing with tight fiscal policy settings would lead to over-reliance on ever more aggressive quantitative easing.

And it would risk a precipitous drop in the pound. This would help the export sector but it would usher in a more extended period of stagflation with rising food and energy prices squeezing scarce disposable income and keeping the consumer mired in debt.

Even long-suffering Japan has lost patience with this kind of deflationary policy. Prime Minister Shinzo Abe's fiscal, monetary and structural assault on the old orthodoxy has its critics, notably in the ratings agencies, but if it pays off it will turn the economics world upside down.

We are living in a time of great experimentation that academics will study for generations to come. Britain must make the right decisions on an appropriate fiscal-monetary policy mix and it must make them soon. Otherwise, the UK risks being on the wrong side of history.

Trevor Greetham is Director of Asset Allocation, Fidelity Worldwide Investment and a member of the OMFIF Advisory Board.

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