Saturday, 2 July 2011

How To Wreck A Recovery- Tory policy and Q1 GDP Data

By Michael Burke

The latest publication of the British GDP data for the 1st quarter of 2011 (Q1 2011) is unrevised - the economy expanded by 0.5% having contracted by 0.5% in Q4 2010.

However the much fuller data provided in this third estimate of growth, as well as revisions to prior quarters, gives a clear picture of the dynamic of the economy. The economy has effectively stagnated since the Tory-led government introduced the Comprehensive Spending Review in October (in fact it has marginally contracted). In the previous four quarters to Q3 2010 the British economy had expanded by 2.5%. By examining the data in detail it is possible to determine the causes of that stagnation.

Cause of Recession

The peak of the last business cycle was in Q1 2008 and the trough of the recession was in Q3 2009. From the beginning of 2008 to that latter date the economy contracted by £88.6bn in real terms, on an annualised basis. Household consumption fell by £41.5bn, one of the biggest percentage declines of the major economies, a drop of 4.9%. In the OECD as a whole the fall in household consumption was a more modest 1.5%.

By contrast government current spending rose by £7.4bn. Net exports also rose entirely as a function of collapsing demand for imports, which fell faster than exports. Combined net exports made a positive contribution to growth of £16.4bn during the recession. But investment (gross fixed capital formation, GFCF) fell by £43bn. Of this decline in investment, the private sector is responsible for £51.1bn, as government investment expanded during the recession by £8.1bn. Therefore of a total decline in GDP £88.6bn the decline in private sector investment accounts for £51.1bn, or 57.7% of the total.

These main aggregates of the national accounts in the recession are shown in figure 1 below.

Figure 1

clip_image002


Despite a recovery that began in Q4 2009 the level of GDP remains well below its peak. At the end of Q1 2011 GDP is still £56.3bn below its previous peak level three years ago in Q1 2008, a shortfall of 4.1%. Household consumption has recovered to some extent so that it is now £36bn below its peak level. Government current expenditure and net exports have both risen, by £13bn and £17.3bn respectively. Investment has resumed its decline in the last two quarters. It is now £36.1bn below its peak, fractionally more than the decline in household consumption. Of this decline in investment, the private sector is responsible for £44.9bn as government investment has risen by £8.8bn. This private sector investment strike accounts for £44.9bn of a total loss of output of ££56.3bn – this is 79.8% of the total.

The main aggregates of the national accounts in from the end of the prior boom to date are shown in Figure 2 below.

Figure 2

clip_image004

Cause of Recovery

As previously stated, recovery began in Q4 2009 and lasted four quarters - the economy expanding by £32.8bn. Consumption rose by £11.7bn, up 1.4%. Net exports did not add to growth, but subtracted from it by £12.6bn. Government current spending rose by £3.8bn. Investment rose by £12.5bn. The private sector contribution to this was £15bn, as government investment has been contracting under the impact of the new government’s policies.

This may have lulled the government and the Office for Budget Responsibility (OBR) into the false idea that that recovery would be driven by investment even as government spending was cut. (The other officially projected component of growth is net exports, but the rise in net exports currently remains entirely a function of the slump in import demand. British exports in Q1 2011 remain below their pre-recession peak despite the sharp rebound in world trade).

The OBR forecast1 in March this year that private investment would rise by 6.7% this year. Currently it is moving in the opposite direction. In Q1 private sector investment fell 3.8% from the final quarter of last year.

To see why the government and the OBR have been proved wrong in projecting higher private sector investment the dynamic underlying the recovery and subsequent stagnation must be examined.

In Figure 3 the trends in GDP and investment are shown in relation to the end of the expansion in Q1 2008.

Figure 3

clip_image006

As already noted the decline in investment is the driving force behind the recession and the subsequent failure to recover to the previous peak level of output. Private sector investment accounts for 79.8% of that total shortfall. As the chart shows public investment moved in the opposite direction, increasing through 2008 and rising sharply in 2009 and peaking in Q1 2010 - the last quarter of the Labour government.

By the time GDP began to recovery modestly in Q4 2009, public sector investment had risen by an annualised £10.5bn. This was far greater than the initial rise in GDP, which was just £6.1bn higher. Therefore the rise in public sector investment was entirely responsible for the recovery.

Private sector investment did not rise as soon as the economy began to expand. It began to rise only after recovery had begun. Since all private investment is determined by anticipated profits, this inability of the private sector to lead the recovery is no surprise.

However, over the course of 2010 private sector investment was the biggest single contributor to growth rising by £22.3bn. Private sector investment increased as a result of growth fostered by the sharp increase in the level of public sector investment.

But instead of understanding that public sector investment was leading to economic recovery, including stimulating private sector investment, both the Tory-led government and the OBR subscribe to the idea that government spending ‘crowds out’ the private sector and if public spending is cut, private investment will increase. The opposite is the case. Government investment ‘crowds in’ private investment.

The false Tory/OBR idea is also demonstrated by the negative reaction to the subsequent cut in public sector investment. Public sector investment peaked in Q1 2010 where it was 38.4% higher than at the end of the prior business expansion. It began to fall as soon as the Tory-led Coalition took office in Q2 2010. Shortly afterwards, in Q4 2010 GDP began to stagnate. Immediately afterwards, private sector investment began to contract once more.

Technical Issues

For those readers interested in these topics, this next section deals very briefly with some interesting technical issues highlighted by the recent zig-zagging of the British economy- from recession to recovery to stagnation. Other readers can skip straight to the Conclusion.

Leading and lagging indicators: Public investment has clearly behaved as a lead indicator for the economy as a whole. Private investment is a lagging indicator. While public investment rose continuously throughout the recession, the significant increase did not take place until after the March 2009 Budget, when the rate of increase doubled. GDP responded two quarters later, in Q4 2010. Private sector investment responded 3 quarters later by recording its first rise in Q1 2010.

Similarly, public investment began to fall in Q2 2010. GDP contracted two quarters later, in Q4 2010. Private investment fell once more 3 quarters later in Q1 2011.

Multipliers: The OBR concedes a point that is almost unanimous in the literature - that the multiplier effect of government investment is greater than all other types of government spending. However, hamstrung by the notion of ‘crowding out’ and determined to promote it, the OBR’s multiplier for government investment is just 1, meaning that there is no more economic effect than simply the government spending itself2. Its multiplier for cuts in welfare is 0.6 and for a VAT hike is 0.35, meaning that both of these have far less than the effect of government cuts or increased spending. Bizarrely, the logic is that private agents, both households and businesses, become more confident because of the cuts, and so offset their effects by increased spending and investment.

The economy’s recent gyrations provide evidence to the contrary. It is impossible to determine the precise effect of increased government investment in stabilising the economy prior to actual recovery. But it has already been shown that a cumulative rise in public investment of £10.5bn led to a rise in private sector investment of £22.3bn. This alone is a multiplier of 2.12. The rise in investment will also have boosted household incomes a well as government income (both via increased tax revenues and lower welfare outlays than otherwise). But, as a minimum, it can be stated that the multiplier from government investment is higher than 2, and is likely to be considerably higher.

Conclusions

The recession was driven by the collapse in private sector investment. The fall in household consumption was also important, much more so than in the OECD as a whole.

The resumed private sector investment strike now accounts for close to 80% of the entire output loss since the recession, and the economy remains more than 4% below its prior peak level.

The government and the OBR promote the notion that cuts to government spending will lead to spending in the private sector from households and businesses. The opposite has been the case. The entire recovery was engendered by the rise in public sector spending and private investment followed later.

The Tory-led government has reversed the rise in public investment through its cuts policy. This has led first to stagnation and now contraction of private investment in Q1 2011. The fall in private and public investment combined more than accounts for the entire slowdown in the British economy in the last two quarters. Tory policies have wrecked the recovery. Only a rise in public investment can revive it.

Notes

1. OBR, March 2011, Economic and Fiscal Outlook

2. Treasury, June 2010 Budget, Table C8.

No comments: