Current UK and EU stagnation are in part the consequence of deficit obsession

 

The rule of thumb journalists use to define a recession, two quarters of negative GDP growth, is unhelpful in many ways. If the economy grows by 0.1%, the headline is ‘UK avoids recession’, but if it grows by -0.1% in two consecutive quarters, the headline is ‘UK enters recession’. Yet the difference between those two, 0.2% of GDP, is well within the measurement errors typical associated with GDP growth. From an economic point of view there is no material difference between 0.1% growth and -0.1% growth, so calling the later a recession but the former not is rediculous.

Another problem with this way of defining a recession is that it makes no reference to trend growth. If the economy typically grows by 3%, then zero growth is a big difference (3% less than normal). However if trend growth is more like 1%, then zero growth is not such a big deal (just 1% less than normal). This can lead to serious misreporting when talking about a recovery from a recession. For example some have claimed that because GDP started growing in 1982 after the 1980/1 recession the famous letter from 364 economists was wrong. As I noted here, growth in 1982 was around the trend rate. The recovery, in the sense of getting back to trend, only really started in 1983.

One final problem with the ‘official’ definition of recession is that it refers to GDP, rather than GDP per head. The latter is far more relevant in almost every way.

UK Quarterly growth	Real GDP	Real GDP per head
2022Q1	0.5	0.2
2022Q2	0.1	-0.2
2022Q3	-0.1	-0.2
2022Q4	0.1	0.0
2023Q1	0.3	0.2
2023Q2	0.2	0.1
2023Q3	0.0	-0.1

As the table above shows (source), if we used GDP per head in the official definition of recession, then we had a recession in 2022, and we could be heading for a second recession in the second half of this year. Again this shows the nonsense of being so literal about defining a recession.

A much better way of describing 2022 and (so far) in 2023 is that the economy has flatlined. It is tempting to ascribe this period of very weak growth as a consequence of rising interest rates to combat high inflation. Growth in the major EU economies has also been weak over the last two years. However one important counterexample should make us question this simple explanation. As the graph below shows, growth in the US has been much stronger.

Martin Sandbu shows a similar graph comparing US GDP to EU GDP. While UK GDP per capita remains at similar levels to just before the pandemic, US GDP per capita is almost 6% higher. The UK recorded a slight fall in GDP per capita in 2023Q3, but US GDP per capita increased by over 1%!

As Martin notes, this is not because US GDP per capita growth is always higher than in Europe. Equally, as I showed here, UK growth in GDP per capita was at least as strong as the US before the financial crisis and austerity. Something has been happening in the US since the pandemic that has not been happening in the UK and EU.

As with any puzzle there are many possible answers, and not enough evidence to know for sure which is correct. One answer is that the energy price shock hit Europe much harder than the US, because gas markets are more local than the oil market and gas supplies were restricted by Russia’s invasion of Ukraine. If that was the case, then in 2023 we should be seeing some rebound in Europe relative to the US as gas prices came down, but as yet there is no sign of this. So this is only a partial explanation.

The argument I have made before, and Martin also makes, is that US fiscal policy has been much more expansionary since the worst of the pandemic than in Europe. The details are discussed at length in that previous post and in Martin’s article so I will not repeat them here, except to say that they involve a combination of the timing of fiscal stimulus and directing that stimulus to those who will spend more of it. Instead I want to broaden this out to make a much more general point.

One feature of Biden’s tenure as President is that policy has not put the budget deficit or debt at the centre of fiscal decisions. This is in contrast to Europe, where in both the EU and UK constraints on debt or deficits imposed by politicians always seem to bite, and also in contrast to previous Democratic administrations which have ‘worried about the deficit’ to varying degrees. In my view the strength of the US economy coming out of the pandemic owes a great deal to this difference, and this holds important lessons for European policymakers who remain obsessed with and constrained by deficit or debt targets.

What do I mean by deficit obsession? After all, I have consistently argued that setting fiscal policy over the medium term to follow the golden rule (matching day to day spending to taxes) during normal times is a good objective. Deficit obsession, by contrast, implicitly views public debt as always a bad thing, erects totally arbitrary targets to reduce that debt, and allows this to dictate policy at almost all times, which invariably means underinvestment in public services and infrastructure.

Deficit and debt obsession matters most after a severe economic downturn, caused for example by a financial crisis or a pandemic. After the Global Financial Crisis the key mistake was not the absence of fiscal support during the period when output was falling, but during the period after that when we would normally expect a recovery from that recession. This was because in the US and UK, Democrats and Labour were in power. However even in Europe there was some fiscal support during the worst of the recession. During the worst of the pandemic all governments offered considerable fiscal support. It is after the immediate crisis that mistakes were made. It is as if policymakers were prepared to suspend their deficit obsession while output was falling, but once output stopped falling that suspension ended. In a way, they were also being misled by the 'official definition' of a recession.

We know from the 1930s depression that the level of output after a crisis does not always bounce back to its pre-crisis trend. Thanks to Keynes we also know why. If consumers and firms think that perhaps such a bounce back will not occur, it will not, because consumption and investment will remain depressed. In the 1930s unemployment stayed high, yet wages and prices stopped falling. It needed a fiscal stimulus, in the form of the New Deal or a war, to reduce unemployment. Unemployment did fall after the Global Financial Crisis, but output did not return to its pre-crisis trend.

We are seeing the same pattern after the pandemic. We had a V-shaped recession, but output in Europe has not returned to its pre-pandemic trend, because in the EU and in the UK policymakers have returned to imposing deficit or debt targets that leave no room for encouraging a full recovery. The one exception is the US, and it is there that output has returned to something like its pre-pandemic trend.

In the EU and UK policy makers typically view the increase in debt during the crisis as an unfortunate outcome, rather than a beneficial means of softening the impact of the crisis. As a result, as soon as the crisis is over they try to reduce the new higher level of debt through fiscal consolidation rather than stimulating the recovery. We know that is unlikely to work on its own terms (fiscal consolidations when the output gap is negative tend to increase debt to GDP) , and it also risks permanently damaging average incomes.

I have been making this argument consistently over the decade I have been writing this blog, but for most of this time all the major economies have been afflicted by deficit obsession so I have been unable to point to a current example of how things could be done much better. Thanks to President Biden and Democrat policymakers, now I can, and the results speak for themselves.

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