Wednesday, 27 January 2010

Investment Not Cuts – by Michael Burke

The British economy may have escaped from recession in the final quarter of 2009 - just. The preliminary estimate for GDP growth in the quarter was the smallest possible statistical rise of just 0.1%. Since the recession began in early 2008 the economy has contracted by 6%. This is the sharpest recession in Britain in the post-WWII period.

Although there are likely to be revisions to the latest data, there can be little dispute about the driving force of the recession. In common with many other economies, the primary cause of the recession has been the slump in investment (gross fixed capital formation). From its peak at the end of 2007, investment has fallen at a rate four times as fast as the decline in GDP, and is down 24%, making it the major contributor to the aggregate decline - as shown in the chart below.

From a peak in Q1 of 2008 real GDP has fallen an annualized £80bn in real terms. Over that time investment has fallen by £53bn, or two-thirds of the entire decline in output. In addition, business inventories have fallen by a cumulative £10bn over the course of the recession. Taken together, the decline in investment and inventories amounts to £63bn, or nearly four-fifths of the entire decline in GDP.

Utilising the findings of modern econometrics SEB has shown how investment is the primary determinant of future prosperity. In Britain currently, it is also the immediate route back to economic growth.

The slump in investment preceded the decline in GDP and, from its peak level and by itself, it accounts for thee-quarter of the total decline in activity. Household spending is also lower under the impact of lower employment. Statistically, net exports have made a positive contribution to the economy of £13bn, at least in accounting terms, as imports have declined at an even faster rate than the decline in exports. At the same time government spending has slightly offset the ferocity of the recession, but the real increase in government expenditure has been minimal, at £5bn, compared to the £80bn fall in aggregate output.

The recession is an investment-led slump in activity. Unless and until this is reversed, there can be no guarantee that a very weak recovery will not fall back into renewed contraction.

The Public Sector Deficit

Despite the depth of the recession and its cause, much of the media debate in Britain has focused on one of the effects of the downturn, the rise in the public sector deficit. Worse, the economically illiterate notion of cutting public spending in response has gained increasing support, from both the main opposition parties as well as many in government.

As we have already seen the rise in real government spending has been paltry in the course of the recession, up 1.8% in real terms since Q1 2008. SEB has previously shown how the driving force behind the rise in the deficit has been the decline in taxation revenues .

The chart below illustrates the effect of the recession on tax receipts. In the Financial Years (FY) 1997/08 to 2007/08 current tax receipts grew at an annual average rate of just over 5.6% to stand at £549bn. [1]

A continuation of this trend would produce tax receipts of £612bn in the current FY. This compares to a projection from the Treasury of total receipts in the current FY of £498n, having previously fallen to £534bn in FY 2008/09 under the impact of the recession.[2] The difference between the trend level and the Treasury projection for this year amounts to £114bn. This is almost the entirety of the Treasury's projection for the entire budget deficit of £128bn, equivalent to 9.1% of GDP.[3] Over the same two year timeframe, public sector current expenditure is projected to rise by £71bn.[4] Even though this is partly as an automatic response to rising unemployment and increased eligibility for welfare payments, the actual rise in public sector current expenditure is precisely in line with the 2002/08 trend.

In all the clamour to reduce pay, public services and jobs in the public sector, this important fact has been overlooked. The rise in the deficit is almost entirely due to the slump in taxation receipts.

Investment Deficit

It is clear that a sharp increase in government investment could tackle the driving force of the recession - the investment decline. At the same time, any significant improvement in economic activity would reverse the deterioration in government finances.

The private sector has created a large investment deficit. The public sector could offset it. In fact, public investment is set to be 3.5% of GDP in the current FY, a cumulative rise equivalent to 1.8% of GDP since the recession began. This modest level is actually the highest level under New Labour. But it is a wholly inadequate response as the overall decline in investment has totalled 4.9% of GDP with another 0.3% deducted from GDP via de-stocking of inventories. The government also plan to cut back on investment to 2.7% of GDP next year and reduce it back below 2% in subsequent years.

A characteristic of the New Labour governments has been an unwillingness to undo the blight of Thatcherism, where government investment averaged just 1%, way below the rate of depreciation. New Labour increased that to an average 1.5%, fractionally above the depreciation rate. However, from 1963 onwards, until Thatcherism the growth in government investment averaged 5.25%. A return to those levels is currently required, amounting to £65bn in real terms.

SEB has previously shown there are large 'multipliers' attached to government investment. There is no magic in this. All businesses invest to achieve a higher return than the capital deployed, usually much higher than the initial capital outlay. Government can do the same. There is often an additional benefit. The benefits of a new private enterprise are available only to those who can pay for them, and will be closed if it becomes unprofitable. A new rail line, new housing or new broadband superhighway raises productivity for all and is a benefit to the whole of society.

The table below shows the estimates of the UK Treasury Model from a variety of fiscal stimulus. To illustrate their effect; if the recent VAT cut cost government revenues £1bn, the economy would be boosted by £300mn in the first year, and by £600mn in Year 2 and by £800mn in Year 3, and so on.

The calculations above also only takes account of the impact in the first three years, while the effectiveness of the stimulus usually persists far longer. In addition, these are only averages derived from long-term experience. Most research in this area is agreed that the effectiveness increases when any of the following conditions apply: when there is large unused capacity in the economy, when interest rates are low and when access to credit is hampered. All of these conditions currently apply so the effectiveness of any stimulus measures currently would be significantly increased.

Of course, all this increased activity provides increased taxation revenues. Again, the Treasury has estimates of how much.[5] Over two years, every 1% increase in GDP will lead to an improvement in both the level of public sector borrowing and the budget deficit of just under 0.75% of GDP. According to the Treasury estimates, this arises from a combination of increased taxes (0.5%) and lower spending, mainly welfare payments (over 0.2%).

So, to take just the Year2 impact, an increase government spending equivalent to 1% of GDP raises GDP by 1.4%. This in turn produces an improvement in the government deficit of (1.4 multiplied by 0.75) = 1.05%. Therefore, the increase in government investment is more than self-financing. It proactively reduces the deficit, as well as reviving the economy. It should again be stressed that these results, based on Treasury analysis, are only the averages that apply over the long run, not the current crisis conditions, where the effects would be much stronger.

This is the logic being applied across most industrialised nations currently. Yet, having engaged in a modest level of stimulus in 2009, Britain is the only country in the G20 which intends to do nothing to stimulate the economy in 2010.[6]

Worse, the debate here is dominated by political leaders bidding to outdo each other in their tough stance on public spending. The only serious point of dispute centres on the timing of those cuts, with the Tories promising spending cuts from day one of their new government and Nick Clegg abandoning a host of spending commitments in pursuit of savage cuts. In a recent speech Peter Mandelson argued that the lesson of the 1930s is that removing the support of government spending reduces the tax take and makes the deficit worse. He then went on to say that is exactly what New Labour would do, only later and more slowly than the Tories have threatened.

Mandelson was right in his observation, and completely wrong in his illogical conclusion. The multipliers outlined above work both positively and in reverse. Or, as the Business Minister puts it, spending cuts reduce the tax take and push the deficit higher.

The determination to avoid the appropriate policy of increasing investment leaves the authorities overly reliant on monetary policy to revive activity. It is true that a weaker currency and low interest rates have prevented an even greater collapse in activity from occurring. But bank lending is not increasing nor have exports revived. Over the medium-term a persistent ultra-loose monetary policy risks creating renewed asset price inflation, in stock markets, commodities and in house prices. A real threat to government funding could arise from rising inflation and another sharp decline in the currency.

The Bogeyman of the Bond Market

The objection raised to increased government spending is that the government depends on international bond markets for funding, and these investors will not accept the required increase in government borrowing to fund investment.

But SEB has previously shown that bond markets have a demonstrable preference for reflationary policies, as reviving economic activity is the surest way for investors to get their money back. In Europe, yields have fallen where reflationary measures are adopted - in Germany, France, Belgium, the Netherlands etc. They have also risen when 'austerity budgets' have been adopted, as in the case of Ireland's unique experiment in fiscal contraction.

For most of 2008 Ireland and Belgium had exactly the same yields. Belgium provided stimulus measures; Ireland cuts. At the beginning of this year, along with pay and welfare cuts, Irish taxpayers are paying over 1% more than Belgium in 10-year bond yields.

The chart below shows the trend in British and German government bond yields over the last four months. In 2009 the new German government surprised many, including the financial markets, by announcing a large package of measures that included both tax cuts and investment. In Britain, Alistair Darling's Pre-Brudget Report announced that there would £415mn of fiscal contraction. British bond yields have risen faster than German yields since that time.

It is notable too that in countries where speculative and rentier capital does not play such an important role as in the British economy, reflationary policies have been adopted without much controversy. The right wing governments of Germany, France, Belgium and the Netherlands and others have each engaged in a variety of reflationary measures, with success dependent on the scale and composition of the stimulus packages. Not only have they each emerged from recession earlier than Britain, they have also seen their government bond yields fall relative to British government yields and their government deficits are now expected to decline faster than Britain’s.[7]

To take just one example, Germany's fiscal stimulus measures now amount to 4% of GDP, whereas Britain's stimulus was just 1.6%of GDP and has now ended. But the IMF expects Germany's government deficit to be zero by 2014, and Britain's to be 6.8% of GDP. The most spectacular confirmation of this approach has been the Chinese fiscal stimulus, amounting to 12.7% of GDP, which caused the budget deficit to rise this year to just over 3% of GDP.

Because investment is the appropriate response to the economic crisis it is also the remedy for the fiscal crisis. For that reason, there is no borrowing impediment to increased government spending for investment.


1.Treasury Public Finances Databank, C4,

2. Treasury, Pre-Budget Report December 2009, Table B10

3. Treasury Public Finances Databank, KEY,

4. Treasury Public Finances Databank, B1,

5. Treasury, Public Finances and the Cycle, Treasury Economic Working Paper No.5, November 2008

6. IMF, The State of Public Finances Cross-Country Fiscal Monitor: November 2009, SPN/09/25, Annex, Table 2,

7. European Commission, Euro Area Report, Autumn 2009, Statistical Annex,

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