A point I have repeatedly made about George Osborne’s plans for a new wave of austerity, confirmed in his Autumn Statement today, is that they risk making the same mistake as 2010. Short term interest rates will be only just above their lower bound in 2015, at best. Large cuts in government spending from 2015 on will reduce aggregate demand. So if something goes wrong (and the list of possibilities is long), monetary policy will not be able to come to the rescue.
The OBR conservatively calculate that austerity reduced growth by 1% in financial year 2010/11, and by 1% in 2011/12. As a result, the recovery in those years faltered. Are we going to be saying the same thing in 2016 or 2017?
It is a pretty obvious point, even if it appears beyond most of mediamacro. So it was good to see the OBR hinting at much the same in their forecast that accompanies the autumn statement. First, in discussing why their forecast of medium term growth is subdued, with the output gap closing very slowly, they say this (para 1.19):
“the Government’s fiscal plans imply three successive years of cash reductions in government consumption of goods and services from 2016 onwards, the first since 1948. The corresponding real cuts directly reduce GDP. The economy should be able to adjust to such changes over time, but it is unlikely to be a simple process when monetary policy is already very loose and external demand subdued.”
The words may be a little obtuse (‘unlikely to be a simple process’), but the meaning is clear. Monetary policy will not be able to offset all of the demand implications of a second wave of austerity even in the base forecast.
But the real concern involves risks, just as it did in 2010. In para 1.25 they first note that government consumption of goods and services falls to its lowest share of GDP since 1938. Then they relate that their forecast implies a sharp rise in the real share of GDP accounted for by business investment and a rising household debt to income ratio following higher house prices. They also assume that the UK will partially arrest the decline in export market share that was a feature of the pre-crisis decade. In the following paragraph they say:
“While these assumptions are mutually consistent – private spending would be expected to rise as a share of GDP when the share of household income and corporate profits derived from government pay and procurement falls – they do illustrate the challenge facing the UK economy in adjusting to the further fiscal tightening that the Government is assuming.”
Politicians are fond of talking about the challenges facing the economy, but this is one that the government itself proposes to create. It is a challenge the UK economy could do without.