Friday, October 22, 2010

Britain Spending cut lessons for others--But will it work---By Shan Saeed

Spending cut will get the UK economy further into stagnation----By Shan Saeed

Whats the solution? We need to look at economic history to get the answers.

The prescription is thus the exact opposite of the Keynesian: It is for the government to keep absolute hands off the economy and to confine itself to stopping its own inflation and to cutting its own budget.

It has today been completely forgotten, even among economists, that the Misesian explanation and analysis of the depression gained great headway precisely during the Great Depression of the 1930s – the very depression that is always held up to advocates of the free market economy as the greatest single and catastrophic failure of laissez-faire capitalism. It was no such thing. 1929 was made inevitable by the vast bank credit expansion throughout the Western world during the 1920s: A policy deliberately adopted by the Western governments, and most importantly by the Federal Reserve System in the United States. It was made possible by the failure of the Western world to return to a genuine gold standard after World War I, and thus allowing more room for inflationary policies by government. Everyone now thinks of President Coolidge as a believer in laissez-faire and an unhampered market economy; he was not, and tragically, nowhere less so than in the field of money and credit. Unfortunately, the sins and errors of the Coolidge intervention were laid to the door of a non-existent free market economy.

If Coolidge made 1929 inevitable, it was President Hoover who prolonged and deepened the depression, transforming it from a typically sharp but swiftly-disappearing depression into a lingering and near-fatal malady, a malady "cured" only by the holocaust of World War II. Hoover, not Franklin Roosevelt, was the founder of the policy of the "New Deal": essentially the massive use of the State to do exactly what Misesian theory would most warn against – to prop up wage rates above their free-market levels, prop up prices, inflate credit, and lend money to shaky business positions. Roosevelt only advanced, to a greater degree, what Hoover had pioneered. The result for the first time in American history, was a nearly perpetual depression and nearly permanent mass unemployment. The Coolidge crisis had become the unprecedentedly prolonged Hoover-Roosevelt depression.

THE speeches have been made, the sums calculated, the columnists have opined. Britain's plan to cut its budget deficit has been through the 24-hour news cycle. I don't want to go though the minutiae but to think about what lessons [good and bad] the British plans might have for other countries.

The first concerns the ability of politicians to decide. Having made his proposals, the prime minister and finance minister can be sure they will pass Parliament. This is not the same as being implemented in full, but it is a good start. The American system, with its division of power, seems wholly incapable of dealing with the issue. In times of war, the President, as commander-in-chief, has the ability to govern. But any finance proposals must be passed through Congress, with all the difficulties this involves, including the bribing of individual congressmen with pork barrel projects. The ideological divide, well illustrated by my colleague's post, means there is no incentive for Republicans to favour increased taxes or for Democrats to cut spending.

The second lesson concerns the division between spending cuts and tax rises. Economic history suggests that it is better to concentrate on the former if you want the plan to succeed. But there is no getting away from the fact that this will affect the poor most; since they are the chief recipients of benefit payments. The current government argues that the total package hits the rich more but that is largely because of a tax rise introduced by the last government. Inevitably, this will have a bigger impact on consumption since the poor have a higher marginal propensity to consume. then there is the politicial/moral issue. The package creates the understandable impression that the poor are paying the price for the folly of the bankers. That is why the government is introducing a further bank levy today and why it cut back on child benefit for high earners. Spreading the pain is essential.

The third lesson concerns the importance of a medium-term plan. Raising the retirement age to 66 by 2020 (not 62, as the French propose) will not save money in this parliament but shows the government is tackling the long-term problem of the imbalance between the working and dependent populations. The clear path toward structural balance over five years will also reassure markets. Again, given the two-year cycle of US elections, it is hard to see how any medium-term plan can have credibility.

None of the above means that the UK plan will turn into a roaring success. Aside from the danger of tightening fiscal policy when the economy is already weak (retail sales have fallen for two consecutive months), there is the danger that planned cuts may not turn into actual cuts. Efficiency savings may turn out to be illusory; welfare payments may rise, not fall, if unemploment rises or if people drift from one benefit to another, as happened when the unemployed switched to incapacity benefit. So the final lesson is that announcing a plan is only a start; even more attention has to be paid to following it through. UK economy needs more spending and tax cut in the short to medium term to bring the confidence back. Will this spending cut boost the economy remains to be seen.

According to Josepg Stiglitz --Nobel Laureate Professor at Columbia University

A wave of fiscal austerity is rushing over Europe and America. The magnitude of budget deficits – like the magnitude of the downturn – has taken many by surprise. But despite protests by yesterday's proponents of deregulation, who would like the government to remain passive, most economists believe that government spending has made a difference, helping to avert another Great Depression.

Most economists also agree that it is a mistake to look at only one side of a balance sheet (whether for the public or private sector). One has to look not only at what a country or firm owes, but also at its assets. This should help answer those financial sector hawks who are raising alarms about government spending. After all, even deficit hawks acknowledge that we should be focusing not on today's deficit, but on the long-term national debt. Spending, especially on investments in education, technology, and infrastructure, can actually lead to lower long-term deficits. Banks' short-sightedness helped create the crisis; we cannot let government short-sightedness – prodded by the financial sector – prolong it.

Faster growth and returns on public investment yield higher tax revenues, and a 5 to 6% return is more than enough to offset temporary increases in the national debt. A social cost-benefit analysis (taking into account impacts other than on the budget) makes such expenditures, even when debt-financed, even more attractive.

Finally, most economists agree that, apart from these considerations, the appropriate size of a deficit depends in part on the state of the economy. A weaker economy calls for a larger deficit, and the appropriate size of the deficit in the face of a recession depends on the precise circumstances.

It is here that economists disagree. Forecasting is always difficult, but especially so in troubled times. What has happened is (fortunately) not an everyday occurrence; it would be foolish to look at past recoveries to predict this one.

So, what is the strategic intent of this spending cut? We need to look at macro-perspective..

There is a shortage of aggregate demand – the demand for goods and services that generates jobs. Cutbacks in government spending will mean lower output and higher unemployment, unless something else fills the gap. Monetary policy won't. Short-term interest rates can't go any lower, and quantitative easing is not likely to substantially reduce the long-term interest rates government pays – and is even less likely to lead to substantial increases either in consumption or investment. If only one country does it, it might hope to gain an advantage through the weakening of its currency; but if anything the US is more likely to succeed in weakening its currency against sterling through its aggressive quantitative easing, worsening Britain's trade position.

Of course if Britain succeeds in getting the world to believe that its economic policies are among the worst – an admittedly fierce contest at the moment – its currency may decline, but this is hardly the road to a recovery. Besides, in the malaise into which the global economy is sinking, the challenge will be to maintain exports; they can't be relied on as a substitute for domestic demand. The few instances where small countries managed to grow in the face of austerity were those where their trading partners were experiencing a boom.

Lower aggregate demand will mean lower tax revenues. But cutbacks in investments in education, technology and infrastructure will be even more costly in future. For they will spell lower growth – and lower revenues. Indeed, higher unemployment itself, especially if it is persistent, will result in a deterioration of skills, in effect the destruction of human capital, a phenomena which Europe experienced in the eighties and which is called hysteresis. Lower tax revenues now and in the future combined with lower growth imply a higher national debt, and an even higher debt-to-GDP ratio.

Matters may be even worse if consumers and investors realise this. Advocates of austerity believe that mystically, as the deficits come down, confidence in the economy will be restored and investment will boom. For 75 years there has been a contest between this theory and Keynesian theory, which argued that spending more now, especially on public investments (or tax cuts designed to encourage private investment) was more likely to restore growth, even though it increased the deficit.

The two prescriptions could not have been more different. Thanks to the IMF, multiple experiments have been conducted – for instance, in east Asia in 1997-98 and a little later in Argentina – and almost all come to the same conclusion: the Keynesian prescription works. Austerity converts downturns into recessions, recessions into depressions. The confidence fairy that the austerity advocates claim will appear never does, partly perhaps because the downturns mean that the deficit reductions are always smaller than was hoped.

Consumers and investors, knowing this and seeing the deteriorating competitive position, the depreciation of human capital and infrastructure, the country's worsening balance sheet, increasing social tensions, and recognising the inevitability of future tax increases to make up for losses as the economy stagnates, may even cut back on their consumption and investment, worsening the downward spiral.

No business with a potential for making investments yielding high returns would pass up the opportunity to make these investments if it could get access to capital at very low interest rates. But this is what austerity means for the UK.

Critics say government won't spend the money well. To be sure, there will be waste – though not on the scale that the private sector in the US and Europe wasted money in the years before 2008. But even if money is not spent perfectly, if experience of the past is a guide to the future, the returns on government investments in education, technology and infrastructure are far higher than the government's cost of capital. Besides, the choices facing the country are bleak. If the government doesn't spend this money there will be massive waste of resources as its capital and human resources are under-utilised.

Britain is embarking on a highly risky experiment. More likely than not, it will add one more data point to the well- established result that austerity in the midst of a downturn lowers GDP and increases unemployment, and excessive austerity can have long-lasting effects.

If Britain were wealthier, or if the prospects of success were greater, it might be a risk worth taking. But it is a gamble with almost no potential upside. Austerity is a gamble which Britain can ill afford.

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