Osborne is waiting for something to turn up

From a macroeconomic viewpoint last week’s budget contained few surprises. It was not expected to contain many significant measures because both the Chancellor and the Prime Minister had already confirmed their adherence to the strategy they had set out on taking office in 2010.

One strand of that strategy was to reduce the budget deficit and arrest the rapid growth in public debt by a combination of spending cuts and tax increases. Such measures would eliminate the structural deficit within four years. A litmus test of this approach was the maintenance of the UK’s triple AAA credit rating.

The second strand was to reduce employment in the public sector and to see a rebalancing of the economy by strong growth in private sector employment which in turn would lead to a restoration of economic growth. Even before last week’s announcements it was clear that the UK government’s strategy had been blown off course. Growth had slowed to a crawl and was far below earlier forecasts made by the independent Office for Budget Responsibility (OBR), Moody’s had downgraded the UK’s credit rating and after a promising start reduction in the public deficit had stalled.

In many ways much of the interest in this year’s budget was contained not in the Treasury’s ‘Red Book’ which accompanies the budget but in the analysis and commentary from the OBR. In 2013 GDP growth is now expected by the OBR to be 0.6 per cent compared with its earlier forecast of 1.2 per cent.

The news on the budget deficit was also disappointing. The deficit in 2011-12 and in 2012-13 was £120 billion in each year and it is forecast to remain at that level in 2013-14. When the current government took office three years ago the projected deficit for 2013-14 was £60 billion. In other words central elements of the government’s strategy in terms both of growth and of public deficit reduction are badly off course or at best way behind schedule.

Given this context it was hardly surprising that the Chancellor announced that the budget would be fiscally neutral – that is, anything he gave away with one hand would be clawed back with the other, and this has proved to be the case. Given such constraints the chancellor announced a number of small measures many of which in themselves are welcome.

What is striking is that given the scale of the challenge they are surprisingly modest and are unlikely to have a material, corrective impact on the fiscal position of the UK. It appears that the Chancellor is sticking to his strategy and hoping that the economy will turn around without further large-scale intervention from the government.

In fairness there are one or two promising indicators. Cuts in public sector employment have been more than offset by growth in private sector employment. Over the last three years public sector employment in Wales has declined by 24,000, but private sector employment has grown by 60,000. In the UK as a whole the Chancellor claims that over the last year for every job lost in the public sector six have been created in the private sector.

Private sector employment has grown by one million since early 2010 and total employment is at an all time high. While this appears to be good news, what is concerning economists is that despite this growth in private sector employment, growth in GDP has been very weak.

It is estimated that since 2008 productivity per worker has declined by 3.2 per cent and is 12.3 per cent below its pre-recession trend. This bodes ill for the competitiveness of the economy.

In terms of public sector employment the worst is yet to come. The Institute for Fiscal Studies (IFS) estimates that only 21 per cent of cuts in current public expenditure across the UK that were planned in 2010 have so far taken place. Over the next three years there will be major cuts in public spending and therefore in public sector employment.

The IFS’s worst case scenario is for total job losses of 1.2 million in the UK’s public sector by 2017-18. If this proves to be the case then Wales can expect an additional 50,000 public sector job losses. The OBR estimates a decline in UK public sector employment of one million between 2011 and 2018.

Against this grim backdrop should the UK government be doing more? Should it be changing course? In some ways it has already changed course. If it were seriously committed to eliminating the structural deficit by 2015-16 through a programme of austerity, its original goal, then it would have announced even more draconian cuts in public spending or additional tax increases. The deficit in 2013-14 was meant to be £60 billion and on a sharply declining path. In fact it is projected by the OBR to be £120 billion and the decline is currently stalled. To the extent that the UK government has not sought a return to its original plans it is recognising that too sharp a retrenchment can lead to a downward economic spiral. It now appears that not only is the recovery delayed but additional expenditure cuts are being pencilled in for the years from 2015-16 to 2017-18.

What could the government have done in this budget? One of the constraints on growth is the lack of bank lending to SMEs. It is ironical that the government is prepared to provide guarantees on bank loans for house purchase but is not prepared to take similar steps in the case of loans to business. Banks continue to reduce lending to business as a way of improving their capital adequacy ratios. Having some or part of their SME loans guaranteed by government would free up more funds for lending to industry.

Another constructive step would be a major injection of funding for capital investment. The government has announced an annual increase of £3 billion in capital investment from 2015-16 – such investment is currently running at £39 billion a year across the UK. Welcome as this is, it is too little too late. One major error the current government made on taking office in 2010 was to follow the lead given by Alasdair Darling in Labour’s last budget in spring 2010 when he committed to cutting capital spending over four years by over 40 per cent in real terms. This was a soft but wrong-headed option. What is now needed is a material injection of funding of the order of £40 billion over the next three years with a focus on infrastructure and housing. This would boost employment in the hard hit construction industry and improve competitiveness.

Perhaps one of the most significant steps in the budget, one which has not received much attention, was the announcement that the monetary policy framework is being changed. This may sound a very dry and esoteric subject. However, since Labour came to office in 1997 monetary policy has been the responsibility of the Bank of England. The bank was charged with conducting monetary policy so that an inflation target set by the government of the day was achieved.

The Bank of England Act 1998 set the objective to maintain price stability and subject to that, to support the economic policy of the government. Even then some of us were concerned that economic growth and employment were being subordinated to an inflation target and advocated terms of reference similar to those of the Federal Reserve Bank of the US which has to balance growth, employment and inflation.

It now appears that the incoming Governor of the Bank of England will have a more flexible mandate. Does this matter? Well it probably means that we will continue to live with higher inflation for some time and interest rates will continue to be low for a number of years. In the budget the Chancellor extended the Asset Purchase Facility for another year, thus inviting the Bank of England to indulge in further quantitative easing. Sceptics might assume that the government is looking to the combination of quantitative easing, low interest rates and high inflation as the answer to our economic woes.

What is striking in the Treasury’s Red Book tables that set out the fiscal impact of budget policy decisions is not only the small net effect of the policy announcements but how none of those announcements is material compared with the scale of the challenge. Most of the policy changes appeared to be motivated by political rather than economic considerations.

The Chancellor has already referred to additional expenditure cuts after 2015 and is also turning his attention to Annual Managed Expenditure (AME). A major component of AME is spending on welfare programmes and it may well be that the total expenditure in these areas will be capped.

Perhaps the Spending Review which will be published on 26 June will cast more light on the UK government’s economic thinking. In any event it is to be expected that the UK can look ahead to further years of austerity and that the ten years since the crisis of 2008 will indeed be a ‘lost decade’. In the meantime one is left with the impression that the budget reflects a chancellor who is boxed in by his rhetoric, has run out of ideas and is hoping that something will turn up.