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Cameron Is Consigning the U.K. to Stagnation

Author: Martin Wolf, Distinguished Visiting Fellow for International Economics
May 18, 2012
Financial Times


Can it make sense for policy makers to stick with their policies, regardless of adverse changes in circumstances and outcomes? David Cameron thinks not. In a speech earlier this week, Britain's prime minister advises the eurozone to change its monetary policies and fiscal institutions. But what does he think about the policies his government is following at home? On that he is not for turning. The policies decided when the coalition came into office two years ago are, he insists, also correct now.

The world, eurozone and UK economies are in a far worse state than expected. Yet Mr Cameron insists that "we are moving in the right direction". Who is this "we"? UK gross domestic product is stuck at 4 per cent below its pre-crisis peak in what is the longest such slump since the 19th century, with no end in sight. Even if one believes that part of the pre-crisis output was an illusion, why should one accept that the UK economy has lost the capacity to grow altogether? How can Mr Cameron believe the economy is moving in the right direction when it is not moving?

The reason Mr Cameron believes this is because he is fixated not with the dire economic performance, but with the public sector's balance sheet – and not even the whole balance sheet, but with its liabilities. "We cannot blow the budget on more spending and more debt," he says.

Yet if not now, when? As Jonathan Portes, director of the National Institute of Economic and Social Research, argues in a recent blog post: "With long-term government borrowing as cheap as in living memory, with unemployed workers and plenty of spare capacity, and with the UK suffering from both creaking infrastructure and a chronic lack of housing supply, now is the time for government to borrow and invest. This is not just basic macro-economics, it is common sense."

With real interest rates close to zero – yes, zero – it is impossible to believe that the government cannot find investments to make itself, or investments it can make with the private sector, or private investments whose tail risks it can insure that do not earn more than the real cost of funds. If that were not true, the UK would be finished. Not only the economy, but the government itself is virtually certain to be better off if it undertook such investments and if it were to do its accounting in a rational way. No sane institution analyses its decisions on the basis of cash flows, annual borrowings and its debt stock. Yet government is the longest-lived agent in the economy. This does not even deserve the label primitive. It is simply ridiculous.

The results, however, are not at all ridiculous. They are extremely costly to both the economy and society. Yet, instead of taking advantage of the opportunity of a lifetime to repair and upgrade the capital stock, as Mr Portes notes: "Public sector net investment – spending on building roads, schools and hospitals – has been cut by about half over the past three years, and will be cut even further over the next two."

He recommends a £30bn investment programme (about 2 per cent of GDP). I would go for far more. Note that the impact on the government's debt stock would be trivial even if it brought no longer-term gains. Indeed, it would be modest at many times this level.

It is a scandal that in an exceptionally severe downturn, the Treasury, in its majestic unwisdom, slashed its investment so deeply. Penny wise, pound-foolish does not come close to it. As Brad de Long of Berkeley and Larry Summers of Harvard argue in a paper that I have commented on in the Wolf Exchange blog, with a positive impact on output and modest "hysteresis" effects (permanent costs from high unemployment and low activity), extra spending can pay for itself.

Why is the government determined to stick to its plans even though the weak economy has led to far higher borrowing than originally expected? The answer is that it is terrified of what Warren Buffett calls "Mr Market". It believes that if it raised investment and supported demand, the market for its bonds would not just fall – as one must hope it would, once recovery came – but collapse. Yet a country with huge private sector financial surpluses, a floating exchange rate and an independent central bank is most unlikely to experience the runs it fears, as I have recently argued in the Wolf Exchange. The eurozone is simply a different case. It is more likely that the bond markets would collapse if the economy did not recover and so huge deficits continued indefinitely.

In its fear of the spectre of a bond price collapse, the government is consigning the UK to stagnation. It is refusing to take advantage of the borrowing opportunities of a lifetime. It is unwilling to contemplate even a clearly time-limited fiscal boost out of fear that the gilt markets would promptly panic. It is determined to persist with its course, regardless of the unexpectedly adverse changes in the external environment. The result is likely to be a permanent reduction in the output of the UK, not to mention permanent damage to a whole generation of the unemployed. I have words for such behaviour. Not on this list is the word "sensible".

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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