Policy debate in the current recession is often portrayed to be
an irreconcilable political battle, pitting those pushing austerity
against those advocating growth. Indeed,
substantive real differences do separate groups having different
views on what different policies can achieve.
But, equally, uncertainty on the state of the
economy clouds judgment on what appropriate policies should be,
especially so in times of economic crisis. This
article examines that uncertainty. By studying
one example — UK policy options at the beginning of 2010 — it
argues we need to understand better the implications of different
measurements on an economy.
“You’re for me or against me. Choose.”
No one wants to live in a stagnant economy. Even those who don’t
believe higher incomes make people happier can't bear to see their
honest, hardworking neighbours unable to make monthly rent or
mortgage payment, or having to choose uncomfortably between new
clothes and shoes for the kids or food for the table.
No one wants to see masses of
unemployed on the streets. Everyone is for
But, at the same time, even the most diehard pro-growth
proponents must acknowledge that government efforts
to further increase
growth cannot always be appropriate. If an
economy were already close to full employment or were in any other
way overheated, then it is right for fiscal and monetary stimulus
to withdraw. Raising tax revenues and lowering
government spending — putting the government’s finances to order
and restoring to health the nation’s balance sheets — all have a
place in sensible, responsible policy-making.
Standing for growth does not mean constant and unwavering
support for always high government spending and expansionary
monetary policy. By the same token, backing
policies to lower debt and deficits does not mean wanting economic
life to be wretched. Even when the final goal is
the same — to have a healthy, prosperous, inclusive economy —
depending on circumstances there is a time and place for different
approaches to government policy.
A debate on UK growth versus austerity is on one level a debate
about what policy transmission mechanisms are most effective for
bringing about long-run sustainable economic growth:
People disagree about what works.
But equally important the debate is one about the
current state of the economy. Only after the fact will it become
obvious what the right policy actions should have been.
Moreover, because of lags in their effectiveness,
policy actions need to anticipate: Will
expansionary effects kick in only after the bottom of the economic
cycle has already passed, and thus overheat an already healthy
Many observers have firm views, conditioned by sound economic
analysis, on the first of these issues, what appropriate growth and
austerity policies are. It strikes me, however,
that the second matters much more in extraordinary situations: in
those circumstances, knowledge of the current state of the economy
necessarily carries far greater uncertainty.
Generally, the range of economic statistics to
look at is broad and constantly changing.
External circumstances in a shifting world
economy will confound historical regularities.
Economics education in every institution makes
students understand mechanisms of how policies affect an economy,
but hardly anywhere is there training on how to assess rigorously
the state of an economy. That latter is merely
“monitoring”. Perhaps accurately judging the
state of the economy is impossible — but that doesn’t mean zero
understanding is where one should stay.
Policy recommendations in a shifting world economy
That this is important is usefully emphasised by looking over a
recent turn of events.
2010 twenty economists signed a letter to London’s
Sunday Times supporting a
plan to lower steadily the UK structural budget deficit, starting
as early as the 2010/11 fiscal year. (For
transparency, I should say here I was one of those 20.)
The letter suggested that failure to do so could,
among other things, raise interest rates and undermine UK recovery,
given how the economy had entered the recession with a large
structural budget deficit. Not unexpectedly, this
proposal was not uniformly accepted, and many distinguished
economists suggested instead that such a policy was potentially
risky and that the first
priority had to be to restore robust growth.
But to bring about growth was never a point of
dispute. So, it might be useful now to look back
and assess the balance of risks then extant.
On the one hand, for some observers, there has never been any
UK had a depressed economy then, and it still does now.”
(Indeed, that particular writer upon reading that
in August 2012 some of the original group of
minds expressed disappointment
“to see so many of the prodigal economists asserting that they were
responding to changed circumstances rather than admitting that they
simply got it wrong. For circumstances really
haven’t changed [...].” (Again, for transparency,
I was one of those reported to have changed my mind, and indeed I
was reported to have emphasized changed circumstances.)
Did circumstances really remain fixed, and were they really so
transparent? Complicating the picture: Statistics
on recessions become available only with a fixed delay — to be in
recession, an economy has to have had negative GDP growth over two
successive quarters. So, to be in a double dip
recession, well, it's not enough just to announce one's beliefs,
the data have to come out just so.
What did the world look like in early 2010?
Things look really bad: Major recession
In September 2008, Lehman Brothers had filed for bankruptcy.
In January 2009 the IMF had predicted world
growth would fall to 0.5% for the year ahead, only three months
later to revise the figure significantly downwards to -1.3%.
The World Bank had forecast in March that the
world economy would contract by an even larger
1.7% in 2009: This would be the
first decline in world GDP since the Second World War.
The International Labour Organization estimated
that 51mn jobs would be destroyed in 2009, raising world
unemployment to 7.1%. Growth in China had fallen
from 9% in 2008 to an annual rate of 6.1% in the first quarter of
2009, the lowest recorded figure since 1992.
Between July 2007 and November 2008 world stock
markets had lost US$26.4 trillion in value, more than half of world
annual GDP. In April 2009, Olivier Blanchard, the
IMF’s Chief Economist, had written “the
crisis appears to be entering yet a new phase, in
which a drop in confidence is leading to a drop in
demand, and a major recession.” The UK had been
officially in recession mid-2008, with the last two quarters of
2008 suffering declines in GDP.
The return to growth?
By the beginning of 2010, the UK recession was already 18 months
in train. In this modern era, advanced economies
(like the US) have only had short sharp downturns: the 11 US
recessions since 1945 averaged only 11 months in duration, with the
four recessions between 1980 and 2001 lasting 6, 16, and then 8
months twice, respectively. By 2007, the UK had
gone 15 years since the end of its last recession, one that lasted
just 15 months. Of course, with hindsight, we now
know it is well possible for slumps anywhere in the world to drag
on, but set against both the UK’s own experience and against a
broader history (that of advanced economies, like the US, towards
which the UK had progressively become more similar), it was not
unreasonable to think by early 2010 that the UK was about ready to
No one would have reckoned in early 2010 that the global economy
had regained robust health. But, equally, was it
apparent the international situation was dismal?
By the first quarter of 2009, Brazil was reported
to be no longer in recession, having grown 2% after the two
previous quarters of GDP declines. The OECD
forecast the Eurozone and the US would show positive growth in the
last six months of 2009.
Back on track: By mid 2009 Asia’s industrial producation had
recovered not just to pre-crisis levels but to its pre-2008 growth
Early 2010 was six months past when incomes in China and the
rest of emerging Asia had already recovered.
Industrial production was not just back to
pre-2008 heights, but to its extrapolated pre-2008 growth trend.
The second quarter of 2009 saw a string of
astounding figures from across Asia: all at annual rates, the South
Korean economy grew by 2.3%, its fastest expansion in over five
years; the Chinese economy grew 7.9%; the Malaysian economy
expanded by 4.8%; the Thai economy grew 2.3%; both Japan and Hong
Kong were showing rising incomes again, after four successive
quarters of GDP declines. Singapore announced its
emergence from recession, big-time, with annualized GDP growth of
21% that quarter.
Sure, China’s government had announced in November 2008 a
US$600bn (CNY4,000bn) fiscal stimulus package: that by itself was
impressive enough, but also most observers at the time believed
growth in export-oriented China and Asia occurred primarily from
Western demand. The East was growing again.
Surely the West must be demanding.
It was natural to think that, somewhere somehow,
the West must have recovered.
Stimulus is an aircraft carrier
That “somewhere, somehow” was not unreasonable to hypothesize in
the slew of policy actions undertaken in all the world’s major
economies between late 2007 and early 2010. In
September 2008 the US Federal Reserve, the Bank of England, the
European Central Bank, the Bank of Japan, the Bank of Canada, and
the Swiss National Bank, in concert, added US$180bn of liquidity to
international money money markets. By November
2008, in the space of just four months, the US Federal Reserve had
pumped US$592bn into the US$ monetary base, increasing that
monetary base by 70%. In October 2008, US
lawmakers approved a US$700bn rescue package to purchase bad debt
from US banks; the UK government unveiled a reform package.
amounting to £400bn (i.e., again US$700bn) to provide funds to UK
financial institutions; the Japanese government announced a
US$270bn fiscal stimulus package targeted at families and small
businesses. The following month saw China’s
fiscal stimulus of US$600bn (already-mentioned)
and the European Commission’s US$260bn recovery plan.
Further add into the mix Japan’s April 2009
stimulus package of US$98.5bn or 2% of that country’s GDP, and
we’re talking significant fiscal stimulus in all the world's major
It wasn’t all just fiscal expansion either.
From a value of 6.25% in early August 2007, the
US Federal Reserve discount rate was reduced to 5.75% later that
month, to 4.75% the month after, and then again to 4.5% the month
after that. In January 2008 the Fed cut interest
rates by 0.75 percentage points, the largest single reduction in
over a quarter of a century. In October 2008,
just one month after their concerted action on international money
market liquidity, six of the world’s most important central banks
coordinated a simultaneous interest rate reduction of 0.5
percentage points. By the end of October, the US
Federal Reserve had again slashed interest rates, this time down to
1%, the lowest level since 2004. The following
month, the European Central Bank cut interest rates by 0.75
percentage points, its largest ever single reduction; Sweden’s
Riksbank, by a record 1.75 percentage points; the Bank of Korea by
a record 1 percentage point; the Bank of Canada lowered its
benchmark rate to 1.5%, the lowest since 1958. In
December, the US Federal Reserve’s discount rate had gotten down to
between 0 and 0.25%; Japan’s, 0.1%; China cut interest rates for
the fifth time in four months. The following
month, January 2009, the Bank of England reduced its interest rate
to 1.5%, the lowest setting in over 300 years of the Bank’s
Monetary stimulus had by then become not just a matter of
reducing interest rates. After all, interest
rates were already effectively zero. In November
2008, the US Federal Reserve injected US$800bn into the economy,
buying US$600bn of mortgage-backed securities and applying the
remainder to unclog consumer credit channels. The
Bank of England similarly engaged in quantitative easing, buying
securities with newly-printed money (£75bn in March 2008, and then
£50bn in May and then again in August 2009) to reach a total outlay
of £175bn (US$294bn) by the end of 2009. The
European Central Bank, in June 2009, pumped US$628bn in one-year
loans into the Eurozone’s banking system.
In the current Eurozone crisis, one hears talk of the troika
(the European Central Bank, the European Union, and the IMF) taking
a bazooka to the sovereign debt problem. If so,
the collection of 2008-2009 policy actions might seem more akin to
sending in an entire aircraft carrier.
The second quarter of 2009 recorded the official end of
recessions not just in the East, as described earlier, but also in
the two largest Eurozone economies France and Germany, both seeing
positive growth again after four consecutive quarters of GDP
declines. Financial institutions reported
profits: notably Goldman Sachs, JP Morgan Chase
(profits up 36% from the previous year), Deutsche Bank (up 67% over
the same period in 2008), Barclays, RBS, Italy’s largest bank
UniCredito, and the Dutch financial services group ING.
By September 2009, the FTSE 100 had again
breached the 5,000-point threshold, recovering completely all
losses since October 2008.
Time to get ahead of the curve
Arrayed against this monetary and fiscal stimulus worldwide and
the evidence of the world economy already growing again (admittedly
most strongly in the East), one might conclude that policy-makers
ought now cast a cautious eye on government balance sheets.
But that decision, for the UK, would still remain a balanced
one. In September 2009 the OECD had forecast the
UK would be the only G7 economy to still be in recession by the end
of the year, with both the US and the Eurozone predicted to show
two quarters of consecutive growth. Three months
earlier, the OECD had suggested the pace of decline among its
members was slowing and that the world economy had nearly reached
the bottom of its worst post-War recession, but that the UK would
continue to show zero growth in 2010.
Effects of policies often only emerge with a lag.
And, generally, government policy-making errs too
often by not getting ahead of the curve. On top
of all that, the UK is a small open economy, and its debt and
output markets are strongly influenced by international
developments. Was 2010 the right time to start
restoring the UK government’s balance sheet?
The UK’s debt/GDP ratio was in line with the largest Eurozone
economies and therefore larger than Spain’s; its deficit/GDP ratio
was worse than all except Ireland’s.
By July 2009, UK government debt had risen to 57% of GDP, the
highest ratio since 1974. That month, the UK’s
public sector net borrowing showed its first July deficit in 13
years. Earlier in the year, Spain had become the
first AAA-rated sovereign nation to have its credit rating
downgraded since Japan in 2001. In December 2009,
Greece acknowledged sovereign debt exceeding €300bn (US$423bn), the
highest in modern history, resulting in a debt/GDP ratio of 113%,
nearly double the Eurozone limit. The chart shows
the UK in 2010 right among the pack of the largest European
economies (the size of each ball indicates total GDP) in its
debt/GDP ratio, i.e., larger than Spain’s, but with a worse
deficit/GDP position than all except Ireland.
In February 2010, it didn’t take a lot of imagination to see
how, all else equal, UK government borrowing could easily have
become just as expensive and as difficult as in the most stressed
Backing off from austerity
In retrospect, of course, we know the austerity policy did not
work in the UK. A reversal might well be
warranted, because circumstances had changed, not because things
were the same.
After the first couple months of 2010, the Eurozone economy went
into free fall much faster and much further than one might have
expected. This had two effects on the UK fiscal position:
on the one hand, UK debt turned out looking,
well, not so bad after all relative to comparable advanced
TransAtlantic economies. The fear that UK borrowing would become
overly costly had become much less relevant.
Germany has kept growing exports through a shift in their direction
On the other hand, the continued inability of both sides of the
Atlantic to resume economic growth meant a further dramatic drag on
UK economic performance. Unlike, say, Germany, the UK has
historically consistently exported mostly to the slowest-growing
advanced economies, and so this TransAtlantic slowdown has
considerably depressed the UK exports and thus the UK economy.
[Germany, by contrast, today exports more to Developing Asia than
it does to the US.]
So, the international environment has shifted in such a way that
the urgency for UK rapid debt reduction has lessened.
The other large factor is how market perception on the stance of
UK monetary policy too has shifted. For most observers now, the
Bank of England has made clear how it is willing to put even more
resources into monetary easing.
What can one conclude from this? First,
policy-making needs to be sensitive to circumstances, and today in
the UK, that means international circumstances especially.
Monitoring and assessing the state of the world
economy is needed. Second, expansionary policies
need to be more sharply designed. While austerity
might not, under the current circumstances, any longer command the
support it once did, pro-growth proponents need to explain things
better. Just throwing money at the problem plainly does not
work. Obviously, the world’s expansionary policies
over 2008-2009 succeeded out East, but they did nothing to revive
the UK economy. Why will they do so now? How will
this time be different?