British economy needs to go on a productivity diet

Nov 21 2008

An interesting report by the think tank Reform, published today, presents a compelling argument about where the British economy is today, what the Government should not do, and the longer term reforms that are needed for sustained growth in the future. Now, the report argues, is the ideal time to implement necessary reform to the public sector.

On where we are today, the report highlights the country's massive debt problem:

The long-term health of the public finances is parlous. The IFS estimates that the UK’s structural deficit will deteriorate to 3.6 per cent of GDP in 2008-09. In addition, the Government has very large long term spending commitments in respect of pensions and education. Even without any fiscal stimulus, the UK faces tax increases of 6.6 per cent of GDP, or £100 billion per year – equivalent to £4,000 for every family.

The report then argues that a fiscal stimulus would be the wrong policy option - if too much debt is a key reason why we got into this mess, is more debt really part of the solution:

The Government’s plans for unfunded tax cuts present a paradox: for an economy which has been stricken by unsustainable levels of debt they recommend as a solution a further increase in debt. A public spending stimulus would take too long to take effect and would crowd out private spending. Higher tax credits would increase the marginal cost of work for people on low incomes.

A fiscal boost is not only likely to see poor results in increased economic activity; it would be damaging in sending the wrong signals. The impact on consumption would be small and transient and likely to be offset by the loss of confidence. Just because it is favoured by the economic and business establishment does not make it right.

The report also says that now is not the time to make "crisis" cuts in public spending, as it will only lead to calls for higher spending in the future, and cites the 1990s as an example of this - the Conservatives implemented deep cuts to public spending after the early 1990s recession, which led to public support for much higher spending under Labour this decade. Rather, the report says that a longer term reform programme is needed:

In order to move beyond the obese economy, Britain has to consume less and work more. Households need a sense of direction towards a higher saving, lower tax economy. The short term objective is the same as the long term path to economic growth – to increase productivity. This should be the theme of the Pre-Budget Report and of Budget 2009, and the focus should be on three key areas:

• The first days of a recession are the best moment to set the public sector on a path of taxpayer value. In his Pre-Budget Report, the Chancellor should announce that his Budget will set out a new Comprehensive Spending Review. This three-year plan would undertake the programme of reform that the Government did not introduce in the good times.
• Private sector productivity should also be boosted. A recovery requires a sustained transfer of resources and investment into the private sector. Supply side reform, the promotion of industrial competition and deregulation in key areas are crucial to stimulate growth. The latent advantages in the economy need to be fostered to raise Britain’s competitive position.
• Individuals will be vital to an economic revival. To create a mobile economy and reduce wasted talent in the recession, individuals need to be empowered to take control of their own lives, spend more of their own money and invest in their skills and careers.

In my view, the question of whether the British economy would benefit from a temporary fiscal stimulus, globally coordinated or not, is one on which there is much reasonable debate. I personally think that the gravity of the economic crisis, the relative impotence of monetary policy at the moment, and the very real threat of deflation means that a temporary fiscal stimulus of tax cuts will make a difference to the length and depth of the recession. But Reform's report provides a powerful argument against this view.