Plan B - The Defamation of George Osborne

New Spin Doctor: Corporal Jones

Don't panic, don't panic! The Institute of Fiscal Studies has endorsed George Osborne's strategy to cut the deficit. The endorsement comes in the shape of the IFS's 'Green Budget' in collaboration with Barclays Wealth and Barclays Capital, an assessment of the government's underlying assumptions about the economy before the Chancellor presents his real budget on 23rd March. They insist that George should press on with his fiscal strategy. Stop the marches! Endure the cuts! Were we wrong to complain?

Well, no. The report is reminiscent of a crew of a sinking ship, reassuring the passengers, while causally edging closer to the last lifeboat. Why? Because Osborne's whole strategy to sort out the public finances rests upon strong economic growth, but as the 0.5% reduction in GDP during the last quarter showed, that recovery should not be taken for granted. We can't rely on it not snowing again, can we?

The IFS looked at five key 'demand drivers' to test the robustness of the recovery. The first indicator was the 'impact of fiscal tightening'. This measures the reduction in GDP in relation to government cuts and tax rises. In normal circumstances, for an economy the size of the UK,  it would be assumed that a £1 reduction in government spending would result in a reduction in demand between 50p and £1, a 'multiplier of somewhere between 0.5 and 1. Meanwhile, it is assumed, a 1% tax reduction would reduce GDP by 0.25%-0.5%.

According to the IMF these assumptions only apply where the central bank can ease the process by reducing interest rates. In circumstances, like ours, where that is not an option - the overall reduction on GDP can be much larger. More worrying is when fiscal tightening occurs alongside other trading partners going through the same process, the 'multiplier' in GDP reduction can be double the government cuts or tax increases. The IFS concludes that the likely 'multiplier will be 1.5, much higher than the government has forecast. It means they think the cuts will bite much deeper than has been anticipated.

The IFS have a similarly pessimistic outlook for 'household income growth'. Having grown 1% in 2010, the government has assumed a similar growth rate in 2011. However, the IFS confirm that rising inflation means that household purchasing power is dropping in real terms and will not reach a healthy growth rate until 2015.  They also predict that their will not be a substantial increase in employment to drive demand. Confidence is low:

"psychologically speaking, most households are feeling vulnerable: many feel that they have yet to join in the supposed economic recovery that they have read about in the papers."  

As a consequence they foresee the VAT increase having a stronger effect on spending than would usually be the case. Ironically, the level of consumer spending as a proportion of income is well above historical levels already, but it is predicted to fall substantially before rising to even higher levels. It seems that we can't wait to restart of shopping spree. In the long run our insatiable desire for the latest patio furniture might just drag us out of the mire, what a happy thought. In the short term we can assume that the recovery will not emerge from consumer spending.

What about an industrial recovery? The government made a lot out of the 9% increase in business investment in the third quarter of 2010. However, the IFS suggest this was a response to the 'unprecedented' collapse of 19% in 2009 and warn against seeing the growth as an indicator of future growth. In fact, they conclude that the lack of confidence undermining consumer expenditure is reflected in the prospects for British industry:

"Recent surveys of business confidence suggest firms are concerned about the uncertainty over both consumption at home and export performance, in light of weakness in some of the UK's major export markets."

Quite simply firms will not invest if the prospects for domestic sales and exports are poor. The IFS also notes that in previous recessions, business investment has not driven recovery but has lagged behind other 'drivers'. Finally, they point out that following the previous four recessions business investment has declined. That doesn't bode well for long-term competitiveness, as we shall see.

The one note of optimism is that the UK may regain lost market share. This 'rebalancing', it is suggested, will result naturally from the devaluation of the pound against other currencies, making British exports relatively cheaper. However, the cloud on that horizon is the possibility that UK exports will not recover. It appears that despite a very competitive pound (16% below its 2007 average), exports have not recovered at the expected rate. The concern is that this is not a blip but part of a structural decline as Britain loses market share to other countries. The overall reduction in business investment following the last four recessions may be coming back to bite the UK.

The final ''driver' is the labour market. Again the outlook appears bleak. The recession has been characterised by firms' reluctance to reduce their workforce. However, this high employment has inevitably resulted in a sharp decline in productivity, 8% lower than pre-recession levels. The IFS speculate that with growth not returning as quickly as expected, firms may embark on a US style reduction in workforce in order to regain a higher productivity level. In this worst case scenario, unemployment could rise as high as 12% with the relative decline in household demand. 

The more likely outcome is that firms 'hold steady'. However, with inflation above the level of wage increases this will also squeeze demand. The IFS also point out the number of people employed includes an increasing number of people who work part-time but would prefer to work full-time. This under- employer may be disguising some of the real pain that unemployment figures don't fully reflect. The excess capacity ensures that there will be little pressure for wage growth for the foreseeable future.

The final point I wish to highlight is, by the standards of other governments, Osborne has taken a particularly sharp axe to the public sector. As Stephanie Flanders said in her blog,

"the report gives the lie to the suggestion that the government's cuts are similar to the consolidation plans of other countries. Out of 29 industrialised countries, only Greece is planning a sharper decline in structural borrowing between 2010 and 2015. And only Ireland and Iceland are planning a larger reduction over this period in public spending as a share of GDP."

The government's justification was that the debt was so large that the country may not be able to refinance it, like Ireland and Greece. There is no doubt that our debt is very large. Only the USA and Ireland, those free market miracles, have higher debt as a % of GDP. However, 'crisis, what crisis?' Britain ranks 4th overall, in the ability of the government to raise finance and service the debt. The report states that investor demand for UK debt has remained strong. However, it should be recognised that some of that confidence from the markets is in response to the Tory strategy. Whether we like it or not, that is important, but, the UK currently sits 32nd out of 60 industrialised countries in the Barclays Capital Fiscal Vulnerability Index, and with the governments ability to raise finance, there seems little doubt that the case for the cuts has been overstated. 

The IFS's 'endorsement' comes in the shape of them confirming the government's assumptions. However, as I have attempted to illustrate, the IFS believes there are some serious 'downside' risks to the government strategy. They believe that there is a significant threat from high inflation and without 'roaring' growth it will be virtually impossible to control because it won't raise interest rates without damaging the economy.  

No u-turns?

Their conclusion? The BBC reported that at the press conference launching the report, Carl Emmerson, the IFS director, made it clear that the IFS believes that the Chancellor needs a Plan B. Both Barclays and the IFS, believe that this would boost market confidence. Only Mr Osborne disagrees. Even the US have delayed making cuts for another year. US Treasury Secretary, Tim Geithner, warned that premature cuts could damage the recovery. 

It is rare that you can get a consensus, but what commentators from all sides agree, is Osborne's position has more to do with protecting his own credibility rather than doing what is right for the UK economy.