Austerity or growth stimulus. Comparison between USA and UK.  

By Shan Saeed

 I agree with Mr Krugman –Nobel Laureate from Princeton University that USA need more econ0mic growth. It is highly imperative that to create more jobs in the US, the UK and the rest of the EU. In the end, bottom line is to raise living standards. Like Mr Krugman I am no fan of austerity.

I also see Mr Krugman agrees that the Euro was a badly designed currency. He and I agree that there have been major imbalances between various states in Euroland, with no easy way of correcting the large balance of payments and banking imbalances that have built up thr0ugh the foolish design of the system. He has pointed out that Florida, after a housing bubble, received 4% of its GDP in the form of enhanced federal transfers. This is aid on a scale unknown within the Eurozone, where the richer areas are reluctant to subsidise the poorer areas. I have always argued you need a banking, budgetary and payments union to make a success of a single currency. Alternatively they need to get on and break it up quickly and cleanly.

 Where I find Mr Krugman less convincing is in his belief that a country deeply in debt can simply borrow more or print more to create sufficient extra public sector demand to get back to rapid growth. He believes that most of the UK deficit is cyclical – that it will vanish once UK will have fuller employment. He further believes UK can get to full employment by printing and spending more in  the public sector, without triggering an inflation which could  damage the private sector . Such an inflation could more  than  offset  or swamp the beneficial effect of more public spending on demand. Any analysis of past UK recoveries would lead people to doubt this idea.

 Mr Krugman does not agree with those in the UK who say that President Obama has got it right by administering a big public sector spending boost which has led to faster growth. He is very criticial of the US for cutting too far too fast. He points out that since the middle of 2011 US real government spending per head has been falling. Despite or because of this the US economy has grown reasonably for the last three quarters. Meanwhile the UK, where real public spending has been rising, has experienced two quarters of decline in output. Not all of the differences in spending levels are the result of cyclical effects.

If I critically analyze at the UK’s recovery from the 1981 and the 1991-2 recessions, I will see that in each case the government cut the growth rate of public spending and the economy started to grow more quickly. On each occasion commentators and the Opposition united to say that public spending was being cut savagely and too far.  In each case the move to decent growth came from a good increase in private sector consumption and investment.

 In 1981 output fell 2.5% whilst public spending was constant. In 1983 compared to 1982 real public spending rose by just 0.5% whilst investment and consumption expanded to give an overall growth rate of 2%.. In 1991 output fell 2.5% whilst public spending rose by 3.25% in real terms. In 1992 real public spending came down  by 0.25%, and rose by the same amount in 1993. By 1993 the economy was growing at 1.25%, and by 3% in 1994.

 On both occasions of recovery the government felt it had to set out a path for cutting the level of public borrowing, to prevent high interest rates doing more damage to the larger private sector.   Growth came from a change in the stock cycle, from a pick up in private sector investment, and from increased consumption. Any or all of these could have been hit by a loss of market confidence in the public finances, leading to crisis interest rates.

 This time there are some differences. The first is that the loss of output in the recession was far larger than in 1981 or 1991-2. The second is the level of public spending and borrowing is so much higher relative to the size of the economy, than in the earlier periods. The public sector borrowing requirement was 2.75% of GDP in 1982-3, and 5.75% in 1992-3. The third is the banks are under much stricter regulatory requirements to cut loans and reduce credit to the private sector than in previous periods. The fourth is official interest rates are much lower. Then as now, sensible commentators and Ministers allow some  extra borrowing to accommodate  the impact of lower activity.

 Mr Krugman would doubtless argue that the magnitude of the output loss coupled with the savage deleveraging of banks in the private sector is a good reason to demand even more extraordinary measures to increase spending and borrowing in the public sector further. I would argue that UK  need instead to look at the intensity of the private sector squeeze, and do more to alleviate that. The combination of large tax rises and continuing high inflation for many basics have squeezed the UK private sector badly, and left it so far unable to trigger the bounce back that has characterized previous recoveries. They need work on tax levels and banks, as I have argued here, with continuing pressure to improve productivity in the public sector.

Disclaimer: This is just a research piece and not an investment advice. All financial transactions carry a RISK.