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Britain’s modest fiscal consolidation pays off

Britain’s modest fiscal consolidation pays off

UK fiscal 2010-13 adjustment less than OECD average 

by David Marsh

Wed 8 Jan 2014

Britain’s economy has had a buoyant start to the year, fuelling speculation of tax cuts and higher pensions as David Cameron, the Prime Minister, kick-starts a long campaign to the general election in 16 months.

There are many complicated reasons for the UK’s better-than-expected recovery – at a time when large parts of the euro area (by far Britain’s biggest trading partner) are emerging only gingerly from recession.

The overall explanation is that Cameron and his Chancellor of the Exchequer George Osborne have followed the right strategy of bearing down moderately on the fiscal deficit and leaving room for accommodative monetary policy to bear fruit.

The downside to the better economic news is that Mark Carney, Governor of the Bank of England, will probably have to announce a rise in interest rates more quickly than he had earlier indicated – possibly by the end of the year.

According to the November 2013 Economic Outlook projections of the Organisation for Economic Cooperation and Development (OECD), UK GDP is likely to expand 2.4% in 2014 and 2.5% in 2015 against 1.4% in 2013. This is around 50% higher than the 0.9% and 1.6% growth for 2013 and 2014 respectively projected by the OECD only a year earlier.

That represents a larger upgrade than for any other large industrialised nation apart from Japan, where the OECD has raised its forecasts dramatically following the reflationary measures brought in by Shinzo Abe, the Japanese Prime Minister. The UK went into the New Year with a higher underlying growth rate than any of the Group of Seven industrial nations apart from the US (forecast to grow 2.9% this year against 1.7% in 2013).

Cameron and Osborne frequently rile observers by excessive self-confidence. Yet on the economy they have scotched the sceptics, including the Opposition Labour Party, who claimed that the Conservative-Liberal Democrat coalition government’s emphasis on budgetary austerity would propel the economy into another recession similar to the 2009 downturn.

In fact, the economy has been rescued by a number of developments. For a start, the statistics for past years have been revised, showing that the UK GDP decline in 2009 was 5.2%, rather than 4% as previously thought, and the recovery in 2011-12 was more sustained than hitherto believed.

Exports have been holding up reasonably well in spite of a relatively firm exchange rate for sterling. OECD figures show that Britain’s share of world exports (for both goods and services) has remained reasonably stable in recent years (although well down from the beginning of the century) at 3.5%, above the level for France (3.2%) and Italy (2.7%).

Employers’ propensity to hold on to workers in the weak economy of the past few years, which has sharply depressed British productivity, has had a positive influence maintaining consumer spending power and preventing a worse impact on the fiscal deficit.

Undoubtedly, the main factor behind the recovery is that the UK authorities have achieved an appropriate balance between fiscal and monetary policies. The much-criticised understanding in 2010-11 between Osborne and previous Bank of England chief Mervyn King, under which the Bank would maintain easy money in return for a relatively restrictive fiscal policy, has paid off.

The euro area, on the other hand, has faced the unrelenting challenge of highly restrictive policies in both the fiscal and monetary field, explaining why, in contrast to the UK, the OECD has revised downwards rather than upwards its projections for 2013 and 2014 euro area performance.

Controversy on the government’s budget policies has swirled since the publication of a letter to the Sunday Times in February 2010 in which a battery of leading economists – including Lord (Meghnad) Desai, Chairman of the OMFIF Advisory Board, several other leading figures from the London School of Economics, and Andrew Turnbull, a former Treasury chief – called for 'a credible medium-term fiscal consolidation plan to make a sustainable recovery more likely'. This sparked a furious counter-reaction from opposing economists charging that the government would spark a new recession.

In fact, the UK has pursued the middle ground in terms of fiscal adjustment. Far from imposing draconian austerity, the coalition government has brought in fiscal consolidation that has been slightly less severe than in the OECD as a whole.

According to OECD figures, the net fiscal tightening between 2010 and 2013, measured by changes in the structural budget position over that period as a proportion of GDP, has been 2.9 percentage points for the UK against 3.3 points for the entire OECD and 5.1 points for the US, which has suffered large automatic budgetary cuts and has been rewarded with a much better than average economic recovery.

Budgetary consolidation in the euro area has been much more severe than in the UK, with structural tightening of a net 22 points in Ireland over 2010-13, against 13.7 in Greece, 6.5 in Portugal, 4.9 in Spain, 3.6 in France, 3.3 in Germany, and 2.8 in Italy. As a result, Britain’s general government deficit for 2013, at 6.9% of GDP (compared with 6.5% for the US), was higher than the distressed countries in the euro area – indicating that the UK is making optimal use of budgetary flexibility.

On top of this, the one-size-fits-all monetary policy of the European Central Bank combined with continuing financial fragmentation in the euro bloc has led to highly restrictive monetary policies in mainland Europe. Credit to non-financial companies has fallen in most euro member states over the past year. Broad money supply was up only 1.5% over the previous year according to latest ECB figures for November published last week.

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