Sustaining economic growth and public vs private investment

Millen bridge London

Construction of the Millennium Bridge, London

What are the drivers of economic growth? Many economists would agree that investment is vital, as it adds to both demand as a form of spending, and supply as an increased capacity to produce output and raise productivity. Investment can come from either the private sector or the public sector. Since the 1990s, governments have also tried to get the private sector to finance major construction projects, and then pay for the use of them once the project is completed. This shifts public borrowing off the government’s balance sheet, while potentially raising subsequent spending. It remains controversial.

With global economic growth currently looking a little sluggish, there is plenty of debate among economists and policy-makers over what should be done, if anything. Continue reading

Growth in net exports as the motor for UK recovery in an ideal world

The UK economy is currently stagnating and may even fall into a triple-dip recession if growth proves to be negative in the first quarter of 2013. I have already written about the importance of fiscal policy in supporting recovery in a balance sheet recession, when nominal interest rates can hardly fall any further. However in the longer term, a sustainable recovery can only occur if the UK economy re-balances away from over-reliance on borrowing for consumption and financial bubbles and towards exports and private sector investment.

Recent UK trade performance has been poor, with a persistent deficit on the current account of the balance of payments, despite a substantial devaluation of the pound in trade-weighted terms since 2008. Sterling has depreciated by around 25% since then, with no discernible improvement in the current account.

If net exports (ie exports minus imports) were to grow rapidly, this would be exactly the kind of stimulus to demand that the UK economy needs. If sustained this demand from abroad for the output of UK-based companies would improve the current account and at some point stimulate investment in new capacity and employment as firms reach capacity constraints. Unemployment would fall more rapidly as GDP grows, and with falling jobless numbers and rising national output would come reduced welfare payments and increased tax revenues. The budget deficit would therefore fall from its current level even without extra cuts in public spending and increases in tax rates which are current policy in the UK. With increasing national income, household deleveraging could occur more rapidly, restraining consumption as individuals continue to save and pay off accumulated debts, while not leading to continued stagnation or even recession. All of this re-balancing would happen in an ideal economic world.

Sadly, we are not living in such a world, at least not yet. About a half of UK exports go to the EU, and much of that to the eurozone. The eurozone is currently in recession, partly due to the mindless pursuit of austerity across the continent (see graph at link). Recession among our European neighbours drags down their demand for UK exports. With the equally mindless pursuit of austerity in the UK, and the UK private sector in substantial financial surplus, where is demand to come from? The answer is: nowhere, unless private or public spending increase substantially. Despite having interest rates at record lows, UK business investment is languishing. Business as a whole is sitting on enormous cash surpluses, so the funds for investment are there, without the need to borrow. But it is quite possible that the lack of demand for their output is keeping investment plans on hold. If there is not prospect of increased sales, what would be the point in expanding capacity? A looser fiscal stance until recovery is established could help, especially if it took the form of public investment in goods and services with a low import content. Some leakage of an increase in demand to spending on imports is probably inevitable, reducing the multiplier as spending goes abroad, but suitably targeted public spending could minimize this effect.

The largest component of aggregate demand for the national income is consumption expenditure. Since the beginning of the recession households have chosen to save more, albeit relative to negligible rates of saving on the eve of the crisis, and they are paying down debt. This is to be welcomed as it helps to re-balance the economy and make it less dependent on unsustainable debt-fueled private spending for consumption. But it does act as a drag on growth. Throw in higher inflation generated by a weaker pound and therefore dearer imports, including commodity prices and the effect is compounded.

So when taking account of a drag from private consumption and languishing private investment, net exports, and the squeeze induced by the government’s austerity programme, there are no sources of demand left to generate a decent rate of growth and recovery for the UK. Despite the fact that the government is still running a substantial deficit, if the private sector is trying to run financial surpluses (ie with income greater than expenditure) greater than that of the public sector, then aggregate demand will fall and the economy will be dragged into recession.

But what if growth is not determined by demand but by supply in the long run? Well, Keynes did say that ‘in the long run we are all dead’, implying that policy-makers should act now to improve economic performance, rather than waiting for the long run to occur and hoping for the best (sounds a bit like the Cameron-Osborne strategy!), but in my opinion supply is just as important as demand, and the two elements interact in the growth process.

Those on the right of the UK Tory party are clamouring for steep tax cuts funded by steep public expenditure cuts, and deregulation, to ‘kick-start’ growth. This is all about the economics of incentives and stimulating entrepreneurial efforts, but ignores the importance of demand. Given that UK productivity has been falling recently, meaning that despite a stagnant economy, employment has actually been rising in the private sector, while real wages are falling, it might be thought that growth is not constrained by demand-side but by supply-side factors. The UK remains a ‘flexible’ economy with a ‘flexible’ labour market, as rated by the World Economic Forum on the issue, so if there are supply-side constraints, it is more likely that these are due to stagnant investment in capacity, which includes worker training, as well as relatively low levels of R&D and poor infrastructure. Since companies are unlikely to invest in new capacity and employment if they have low sales prospects, demand is important to stimulating investment. On the supply-side, if firms’ profits are taxed too heavily, or if wages take too large a share of earnings, they may once more come to the conclusion that it is not worth investing: these are supply-side constraints on growth. Neither of these sorts of constraints seem to be important at the moment. Wages are stagnant while firms are sitting on large cash surpluses, while the rate of corporation tax is not high by international standards. Demand seems a more likely constraint at the moment.

As long as firms have the capacity to increase production in response to a rise in demand, the expansion of net exports remains the most desirable route to recovery. But as discussed above, this is not presently forthcoming, especially while a turnaround on the continent looks remote in the short term. So the next-best source of growth must be domestically-led, in the form of a looser fiscal policy and incentives for UK-based firms to invest their cash surpluses in new capacity and employment. A boom in house-building would help as well! We are not powerless in the face of adversity.

The Keynesian solution and the problem of politics

More than four years on from the financial crisis and more than five from the start of the credit crunch, we still are not out of the woods by some margin. The turn to austerity in the UK from 2010 has at the very least proceeded too rapidly, and the economy shrank again in the final quarter of 2012, although the statistics are of course subject to revision. Austerity fever has gripped the governments of many countries across the world. Some, such as Spain and Greece, probably had no choice, but the UK, with its own currency and central bank did have a choice. A chorus of respectable opinion, comprising economic commentators to the chief economist at the IMF, have suggested that if the UK economy continues to stagnate, then it is time for a change of policy. But the government refuses, blaming the mess they inherited from the previous Labour government and insisting that the answer to dealing with your debts cannot be more debt ie increasing the deficit. But these arguments, though appealing, are simplistic and ignore the dynamic links between public debt and private debt in a national economy.

There seems to be a certain kind of obvious logic to saying that ‘the answer to dealing with your debts cannot be more debt’, but some basic economics moves us beyond the conflation between private debt and public debt that this argument creates. The large budget deficit and rising public sector debt in the UK and other economies was largely caused by the recession and the consequent collapse in private sector spending as households started to save more of their income and reduce their exposure to debt. When private sector spending collapses and there is not the prospect of a healthy global economy beyond national borders to generate growth from net exports, the only spender of last resort remaining is the government. When interest rates are already so low that they basically cannot be cut further, then monetary policy is exhausted and fiscal policy plays a vital role in mitigating a balance sheet recession of the kind that we are still going through. Attempts to cut government spending when private sector balance sheets remain weak and firms and households are still saving and paying off accumulated debts will only cause the economy to stagnate or stay in recession, as we are seeing in the UK.

So it would seem to be that part of the answer to economic stagnation in the UK is a temporary fiscal stimulus in the form of increased public investment on infrastructure repair and construction. The stimulus should help the private sector repair its balance sheets and pay off debt at an increased pace and thereby bring closer a real recovery in economic activity. No-one knows how long this process would take, but the sooner an economic recovery begins in the UK and across the developed world, the less suffering in terms of unemployment, underemployment and poverty there needs to be.

So why no major U-turn on the part of the UK government, to continue the austerity policy example? One possibility is that they really believe that they are impotent to improve matters, and that austerity is the only possible course of action. Another is that they are still worried about what Paul Krugman calls the ‘invisible bond vigilantes’, the risk that increasing deficits will only drive up interest rates and the policy will be entirely self-defeating as the private sector is put into an even worse situation. But if the current low long-term interest rates are more the result of economic weakness, rather than due to credibility won through austerity, then there would certainly be room for an effective fiscal stimulus which would work as described above. It is more likely that the government has mistakenly looked at the situation in Southern Europe and become convinced that if we don’t restore economic credibility by reducing the deficit then we will end up in the same situation. It is mistaken because we are not part of the euro, and have our own currency and exchange rate which can bear any necessary adjustments.

It is pretty clear that any public abandonment of fiscal austerity until the economy is recovering strongly would represent a major U-turn and lead to a massive loss of face by the government. So political reputations and non-existent credibility are put ahead of national well-being, growth and employment. But the Labour opposition have not proposed abandoning the policy, only a slower pace of adjustment. It seems that the chancellor has already begun this, as he is failing to meet his targets for reducing the deficit. So austerity is to be extended into the next parliament until 2017-18! He is also blaming international factors such as the eurozone crisis for the UK’s poor economic performance, which is a convenient story but one which is wrong. Exports to the eurozone are simply not a large enough part of our GDP to make them the key factor in the continuing stagnation. While deleveraging continues, private sector spending will remain weak and fiscal policy should support aggregate demand until this process is completed, and private sector borrowing, investment and consumption can rise at a rate strong enough to allow austerity to take place without causing economic and social damage. Once the private sector recovery is underway the deficit will fall even without extra spending cuts or tax rises.

The government’s strategy is exactly the opposite of what should be done. And to the extent that the eurozone crisis is not helping, this is partly due to significant austerity policies on the continent, which the UK government supported.

Labour is in a difficult position as they have a low level of economic credibility due to their being in government when the financial crisis began. And it would be easy for the opposition to argue that nothing has changed on their part if they argue for abandoning austerity policies. It is therefore likely that the austerity will continue, and UK economic performance will continue to be poor for a number of years, and unnecessarily so.

Some notes on China’s economy

As the world’s third largest economy, the dynamics of China’s development have a strong impact on the rest of the world. As one example of a country that relies on export-led growth (although this has been contested), and needs to change the balance of its development, it provides an interesting case-study. If indeed China’s enormous current account surplus has had a malign effect global financial processes, despite representing in another sense tremendous progress, how is it to be reduced in a sustainable way, and also with the minimum of social and political upheaval? How is China to reorient its growth towards domestic demand and consumption?
China is distinctive among large economies in that it is relatively open and exports constitute a relatively large proportion of GDP. The current slowdown in world economic growth, in credit-driven consumption in the US and other major economies, seems to be impacting China strongly. It’s tightening of monetary policy to prevent inflation in recent years may also have had an effect. It is also notable that China’s trade surplus has in fact grown despite the slowdown in export growth. This is partly due to the fact that 50% of imports are are used to produce goods for export. In addition, the construction sector has experienced a marked slowdown, and it is a heavy user of imported materials. Lastly, the fall in commodity prices has also reduced the value of imports.

China’s eastern seaboard acts as an industrial dynamo for the economy, with its export processing zones acting as magnets for foreign and domestic investment. As mentioned above, companies import materials and components for use in production and export the goods once assembled. The global slowdown has hit manufacturing industry particularly hard. The credit crunch has made it harder for firms to obtain credit for payment in advance for their inputs. Since one firm’s inputs are another firm’s outputs, the whole supply chain is affected.

The slump in international trade has left 20 million migrant Chinese workers unemployed in towns and cities. Many of them will be forced to return home to their families in the countryside, since welfare protection is minimal. This is likely to reduce rural incomes too, as the remittances sent home by urban workers will be falling.

It is clear that China needs to boost domestic demand to combat the recession, and it is taking steps to do so with a fiscal stimulus package, the size of which has been disputed. Maybe structural reforms are needed too, for the longer term reorientation of the economy towards domestic consumption. This would likely accelerate the emergence and growth of a consumer society in China, which seems inevitable. In addition, not only must growth be sustainable economically, but also environmentally.

The Economist argues that the structural reforms must include raising government expenditure on health, education and social welfare and to shift their economies away from capital-intensive manufacturing towards labour-intensive services. This should have the effect of reducing household saving and increasing consumption expenditure. They have argued that some liberalisation of finance would boost the growth of credit and from there consumer spending as a proportion of GDP. But China should be careful with how it sequences and times reforms, as it has been in the past. It is still a poor country in terms of income per head and has a long way to go to catch up with the West materially. A too rapid freeing of finance could lead to unsustainable bubbles as has been the case in many countries, rich and poor, and any subsequent collapse could slow GDP growth for years, hitting the population hard, especially so with no welfare safety-net in place.

Measures to enable a more rapid growth of rural incomes and productivity in China are also important. These would likely allow further rural-urban migration and could help to slow or reverse the rampant inequality in the country. China still seems to have substantial surplus labour in terms of the ‘Lewis Model’ of development which keeps rural wages down and encourages migration to urban and industrial regions. It also predicts that wages in industry are kept down by this process. As surplus labour is gradually exhausted, a process that has been set back by the current slowdown, competition among employers will bid up wages in industry and newly-developing services and stimulate increased consumption in the economy and new sources of demand and growth.

750 million people still live in rural areas in China, out of a total population of over 1 billion, which indicates that the country has a long way to in its continuing industrialisation and urbanisation. It is not clear that China needs to fully liberalise (whatever that means) its economy yet, as the past thirty years have been dramatically successful in terms of a number of development goals (increase in incomes, reduction in poverty etc).