I think the Government now has its opportunity to give its 110 per cent attention, effort and energy to getting the economy moving and using time available in Parliament to do just that.
Those were the words of George Osborne after the Bank of England reduced its growth forecast for the UK to 0%. The Chancellor is now under increased pressure to change his economic strategy, particularly from his shadow counterpart Ed Balls, who is never slow to argue that cuts have been implemented too far and too fast.
But the notion of a 'growth vs austerity' debate (where 'growth' means more government spending and 'austerity' means spending cuts) is a complete fallacy. Why? Three reasons. The first one is that growth will not come from more government spending. The second is that cuts to public spending so far have been very limited. The third reason is that real reductions in government spending, a smaller state, a rebalancing of the economy and structural reforms are needed to generate growth in the long run. Let me expand on each of these points in turn.
Growth Vs Austerity
Those advocating for growth in this debate (e.g. Paul Krugman, Richard Murphy, etc.) rely on the economic theory of the 'multiplier', which measures the amount by which the economy expands when the government increases its purchases of goods by 1 unit (say £1 billion). In theory the increased consumption from the government would increase demand, which would in turn provide increased employment to meet that demand. So for example, if the government spends money on infrastructure people need to be employed to complete the project. This worker will then go out and spend this money on other goods in the economy, and so businesses face higher demand and then they will be encouraged to hire more staff, etc. The 'multiplier' effect gets its name from the idea that when the government inputs money into the economy it is circulated and hence its effect is multiplied. In today's low interest rate environment this argument becomes stronger. Conventional wisdom predicts that the low interest rates will make the stimulus more potent as the government is able to borrow and use resources at low cost. The theory goes that the more money the government spends then the greater the boost to the economy. And because this can be done at a lower cost there is really no reason to delay a stimulus package.
But now back to reality. What if in reality there is little or no multiplier effect? Or what if there was a negative multiplier? What if conventional wisdom is wrong?
Many empirical studies show that fiscal multipliers are normally no larger than 1, and usually below 1 for the UK. The OBR assumes a fiscal multiplier for 1 for capital expenditure (so the increase in spending of £100 billion should increase GDP by £100 billion). This compares to slightly more conservative estimates of 0.8 by Robert Barro, an economics professor at Harvard University, and an IMF multiplier estimation of 0.5 for the UK. But other studies are not even as optimistic as this. Empirical research by Ilzetzki, et al. (2010) shows that a fiscal stimulus while debt-to-GDP is in the region of 60% could have a significant negative impact. Their work argues that open economies with floating currencies will show little response to a rise in government consumption. All of these characteristics apply to the UK: the OBR is forecasting debt to peak at 76.3% of GDP in 2014-15 (compared with an IMF forecast of 95.9% in 2015-16), up from 67.3% now; exports account for 11% of GDP while imports are in the region of £309.056 billion per year; and sterling has been a floating currency since the UK departed from the gold standard in September 1931. What's more, studies that consider future taxes may rise to pay for today's spending find much smaller multipliers - even considering a low interest rate environment. Drautzburg and Uhlig (2011) find that the short run multiplier is around 0.52, while the long run multiplier is -0.42.
A more practical issue is that in today's environment of high household debt multipliers are likely to be small as consumers deleverage and save extra income. The general point here is that any stimulus is likely to only be effective in the short run. But now it may not help at all and could even be counter-productive. It would, however, with certainty, add to the UK's national debt at a time when we cannot afford it.
People may want to re-write the laws of gravity but it doesn't mean they will be able to do so. So when Krugman, et al. rely on economic theory to argue that the government should 'stimulate' the economy they may want to remember the reality - it is just a waste of time, money, and effort. Throwing good money after bad will not solve the problem. It will make it worse.
Public Spending Cuts (Or lack of them)
As entertaining as it is to watch George Osborne and Ed Balls debate about the extent of austerity a simple reality has been completely overlooked - the size of the government is far too big. In the UK it accounts for just under half of all economic activity. And unfortunately it is showing now signs of shrinking. Not only is the government borrowing more than expected, but it is spending around £100 billion more than it takes in taxes (sounds like a stimulus to me). By the end of this parliament, public spending will still be above pre-2008 levels (according to data from the Tullett Prebon UK Economic & Fiscal Database):
As I've argued many times before, they key problem with austerity is that it has been composed of mainly tax increases as opposed to spending cuts. According to the Institute for Fiscal Studies, by the end of 2012 only 12% of the planned cuts to public spending and 6% of the cuts in current public service spending will have been implemented - in complete contrast to 73% of the planned tax increases. Thus, the reduction in the deficit of 25% has come mostly from tax hikes (the structural deficit is only down 13%, however).
There are several empirical studies which show that deficit-reduction strategies composed of mostly spending cuts (rather than tax increases) are much more successful in lowering debt levels. Making a strong commitment to cutting public spending allows the government to lower taxes, thereby encouraging private sector expansion. Moreover, fierce deficit-reduction policies have the benefit of revising down agents’ expectations of future tax burdens, which encourages consumption, which can help to boost the demand side of the economy too.
If the UK is to have a sustainable recovery it requires addressing the factors underpinning the imbalances in the economy - notably a rapid accumulation of debt and an over-reliance on a dominant state. However, the problem with a bloated public sector is that when the government reduces expenditure it also cuts the main source of income in the economy. But it also distorts the private sector, making it more difficult to enjoy a private sector led recovery. According to a study by Faggio and Overman (2012), increases in public sector employment changes the composition of private sector employment away from manufacturing towards services.
Another simple reality is evident here. In order for the UK to become a more competitive and dynamic economy it requires a large private sector recovery and a smaller state. Politicians across the spectrum all agree that improving the UK manufacturing sector will be a key driver in bringing growth back to the economy. They should perhaps pay attention to this study.
Supply Side Reforms
In fairness to the coalition, there are a few factors impeding growth beyond their control. The eurozone crisis is the most obvious example. However, there are areas where the government can take action to help the economy, and there should really be no excuse for not following through with these policies.
Of course, regulation is needed in the modern economy. Rules are needed to give agents confidence in market transactions and to promote competition. But at the same time too much regulation can hinder the ability of businesses to expand and create jobs.
At present, UK businesses spend around £80 billion complying the with administrative requirements of legislation. This is £80 billion which is not being invested in developing a new product. While some of this legislation may be necessary, some is not. For example, Justin King, Chief Executive of Sainsbury's cites unnecessary rules preventing retailers and manufactures using A-class roads, restrictions on delivery times, and a lack of parking as measures which negatively impact the British high street. In total, UK businesses have around 21,000 regulations to comply with. Government estimates already predict that simplifying legislation could save companies around £1.4 billion on obtaining advice from consultants alone. Furthermore, the British Chambers of Commerce have pointed to the flow of employment law (mostly from the EU) as a burden on business, arguing it stifles competition and makes it more difficult for companies to create jobs. Although 800,000 new private sector jobs have been created since 2010, this figure would probably have been much higher had the government not imposed new and unnecessary regulations on businesses.
The UK government should also be looking at addressing the number of procedures and length of time required to start a business. According to the 2012 World Bank Doing Business report the UK ranks 19th for this, down from 17th in 2011. This is well behind other advanced economies such as the US (13) and Australia (2).
But it is not only business legislation that should be improved. A more controversial item is the deregulation of the labour market. Those on the left of the political spectrum would argue reform could take away "worker's rights". However, the UK ranks 36 for hiring and firing practices - on par with countries such as Kazakhstan and behind countries like Kenya. Studies have shown that higher employment regulation results in lower labour force participation and higher levels of unemployment. For example, Botero, et al. (2004) study the evidence of labour market regulation from 85 countries and find:
...that the political power of the left is associated with more stringent labour regulations and more generous social security systems, and that socialist, French, and Scandinavian legal origin countries have sharply higher levels of labour regulation than do common law countries. However, the effects of legal origins are larger, and explain more of the variation in regulations, than those of politics. Heavier regulation of labour is associated with lower labour force participation and higher unemployment, especially of the young. These results are most naturally consistent with legal theories, according to which countries have pervasive regulatory styles inherited from the transplantation of legal systems.
A second, perhaps even more controversial item is the power of trade unions. It is a well-known fact in economics that the greater the trade union power the higher the structural rate of unemployment, and hence the lower the rate of economic growth. A study by Morgan and Mourougane (2011) find that:
...changes in regional mismatch, trade union density and the ratio between consumer and producer prices are positively associated with structural unemployment.
The UK currently ranks 25th for co-opoeration in labour market regulations, something which could be improved if there was greater restrictions on union power.
The point is that much more focus should be made on examining ways to reduce the so-called 'red-tape' burden on businesses. Guidelines need to be simplified and new (mostly unnecessary) legislation that simply duplicates previous regulation should be scrapped. Freeing businesses from burdensome regulation and simplifying the complex regulatory system can improve the capacity they have to innovate, diversify, grow, and create jobs. Striking the right balance between a level of regulation that promotes competition, protects workers, and ensures market stability without hindering businesses ability to operate should therefore be a key priority for the government.
Adapt the School System
A big problem in today's society is the level of youth unemployment, and measures really need to be taken to get young people into work - otherwise the UK really will face a lost generation. In fairness to the government they are trying to develop incentives for companies to hire staff and get young people into work through their wage subsidy initiative. However, this is not a long term solution because companies have no incentive to hire younger workers, other than to get their subsidy from the government. And because the marginal product of labour is diminishing, the actual number of new jobs created could be quite small. Business experts have been saying for some time now that there needs to be greater emphasis on boosting manufacturing skills in the school system, thereby making younger people more employable and not just cheaper to employ.
The past few years have seen traditional manufacturing jobs being lost to the emerging markets. Of course, the UK can never be expected to compete with countries such as China in the mass production of low value-added goods. But the rise of emerging markets should not be seen as a threat but rather an opportunity. The UK's manufacturing does have the ability to specialise in areas such as transport, machinery, and chemicals, and the government should really be making efforts to promote British exports to these emerging markets.
Adapting the secondary education system to reflect this new market dynamic will help to encourage younger people to pursue careers in manufacturing and construction, and the UK can look forward to enjoying a comparative advantage in these areas.
Simplify the Tax System
Tax reform is another area which can be politically difficult to change, but it is change that is needed to encourage economic growth. The UK now ranks 24th in terms of how easy it is to pay taxes - compared to 12th in 2008 and 16th in 2011. According to the 2011-12 World Economic Forum's Global Competitiveness report the UK ranks 94 out of 142 for the "extent and effect of taxation" - compared to last year's 95 out of 135.
The government has taken steps to improve the tax system by setting up the Office for Tax Simplification. The Director, John Whiting has stated:
Simpler tax laws would mean an easing of the administrative burden on business, individual taxpayers – especially the unrepresented – and tax collectors. They would make the tax system more transparent and more comprehensible, and therefore more likely to command public and business confidence. They would also mean fewer loopholes and distortions, leading to fewer unintended consequences and fewer opportunities for tax avoidance. Simpler, more effective tax laws are in the interests of all concerned – taxpayers, their advisers and the authorities.
Again, this is another area where there is an obvious need for improvement. The UK once had a tax system that was seen as an asset to the country. Reforming the 17,000 page tax code is now essential to make the tax regime more economically efficient and more competitive.
I am not for one minute saying that by following through with these suggestions the UK will suddenly enjoy a rapid increase in economic growth and a return to full employment. But both the both the World Bank and the OECD have stressed the importance of structural reforms for advanced economies, and there should really be no objection to making it as easy as possible for businesses to grow and expand, particularly in today's economic climate.
By decreasing the size of the state, returning to a policy of sound money, and implementing important supply side reforms the government can make room for the private sector recovery the UK desperately needs. All that is required is a bit of political will.
UPDATE (3rd February 2013): Andrew Neil reports that in 2001 the UK tax code was 5,952 pages. In 2007 it was 9,866 pages. Today it is 17,795 pages.