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Road to Recovery or Road to Recession?

The Comprehensive Spending Review will take some time to fully digest, but what is likely to be its impact on the economy's recovery course?

Holly Cook 20 October, 2010 | 7:09PM

The coalition government today unveiled its keenly-awaited plans for our new age of austerity, with Chancellor of the Exchequer George Osborne explaining to a packed and lively House of Commons his proposals to get UK Plc back on track. But the debate continues about whether these cuts are indeed necessary. And while all seem to be in agreement that the cuts will be a bitter pill to swallow, some still maintain that this pill could become lodged in the economy’s throat and cause its heart monitor to flatline—or, worse still, to double dip.

To Cut or Not to Cut?
“It’s not clear that the pace at which the debt and deficit cutting is occurring is necessary,” commented Ethan Ilzetzki, a Lecturer at the London School of Economics and Associate of the Centre for Economic Performance. Ilzetzki suspects that the government is trying to tackle two separate issues in parallel: firstly, the “objective need” to cut the deficit and public debt in the medium term; secondly, the need to reduce the size of government. However this second task is based on a subjective judgement—a judgement that Ilzetzki does not believe there is any urgency to make or address.

Indeed, it is this point that Scott Corfe, Economist with the Centre for Economics and Business Research, picks up on. “Those opposed to the coalition government’s agenda of cuts have argued that they are not based on economic reason, but on an ideological desire to shrink the size of the State,” he said late Wednesday. On close inspection, however, the measures announced today do not reveal the radical curtailing of the size of government that previous hyperbole had suggested, Corfe added. Government spending as a share of GDP should fall from its current level of about 48% to just under 40% over the four-year period outlined in the Comprehensive Spending Review, Corfe calculate. These figures are broadly in line with those from Schroders’ European Economist Azad Zangana, who sees expenditure falling to 40.9% from 47.3% once economic growth and inflation are taken into account (in nominal terms spending is set to rise to £693 billion by 2014/15 from £637 billion this year).

Put into context, this eight percentage point drop will be a disappointment to libertarians anticipating a ‘small, perfectly-formed’ State by the end of the parliamentary term, Corfe said. Edward Menashy, Chief Economist at Charles Stanley today underlined the desirability of smaller government: “Government spending in many ways is wasted spending, it is—as some economists describe it—extending the dead hand over the economy.” Shrinking the public sector should lead to healthier and more productive growth at the economy level and should therefore mean there’s “a very good chance” that the UK economy will be able to achieve annual growth of 2% or more, Menashy believes.

At Threadneedle, Simon Brazier, Co-Head of UK Equities and famed for his doom-and-gloom views on the British economy over the past few years, is pleased the government has stuck to its guns. “We have always believed that the cuts are a necessity rather than a choice,” Brazier said in reaction to Osborne’s announcement. The coalition government’s initial announcements regarding the scope of the fiscal consolidation proved that they had acknowledged the importance of getting the fiscal deficit under control, Brazier noted, and today's announcement shows that they are sticking to the task and that there remains the political will within the coalition to deliver this fiscal consolidation. However, “the next challenge is to now deliver those savings”, Brazier said.

Job Cuts, Unemployment and the Economy
The impact of today’s announced cuts on the labour market and, in turn, the economy as a whole has been one of the many items that has grabbed the headlines. “In terms of the deficit, something has to be done,” LSE’s Ilzetzki concedes, “but I don’t feel there is an urgent need to lay off a lot of public workers.”

Osborne’s CSR today confirmed that 490,000 public sector jobs will be cut and critics have claimed that the private sector will be unable to deal with the impact on unemployment. “Unemployment in the UK is lower than it normally would be in a recession of this magnitude,” Ilzetzki said. “An additional 500,000 workers searching for jobs is definitely going to slow down the decline in unemployment.” What really matters however, according to Ilzetzki, is how fast these lay-offs will occur. The private sector can absorb a certain number be harder to deal with.

Others, however, are not so concerned about the impact on overall unemployment. “Given that the economy added 323,000 private sector jobs in the first half of this year, we are confident that the economy can not only absorb the public sector job losses but also bring down unemployment,” commented Schroders’ Zangana, Schroders forecasts between 1.7 million and 2.2 million new private sector jobs could be created by 2014.

Charles Stanley’s Menashy is similarly optimistic and compared the situation to that of the early 1990s: “the private sector actually took up the fall in public sector employment; if history is anything to go by I think there’s a good chance that the private sector will provide opportunities for the public sector unemployed.”

The government has clearly thought about this and today’s CSR entailed a number of steps to encourage employment, including creating many more apprenticeships and a new ‘work programme’ with private sector involvement. Though Jane Bennett, the Head of Campaigns at the Forum of Private Business, described these as among the positive developments seen today, she also questioned whether such moves will be sufficient. “These measures alone will not be enough to allow small businesses to substantially create employment in order to replace the 490,000 jobs that will be lost in the public sector.”

Aside from job cuts and slashes to department spending, Osborne also unveiled a number of infrastructure projects, including education, transport and health—the latter will actually see an increase in real terms, albeit of 0.1% a year. “The government has I think learned its lesson from its position of the early ‘90s—that you don’t cut back infrastructure or investment” Menashy commented. Ilzetzki agrees that this is a step in the right direction: “It is encouraging that the government is choosing to protect public investment—that part is indicative of a growth-oriented approach.”

Cutting Debt While Growing the Economy?
The efficacy of such cuts on the public debt obviously remains to be seen, but what is likely to be the impact on economic growth? “Overall, the spending cuts will undoubtedly have a negative impact on the economy,” says Zangana. “Government spending has made a positive contribution to growth since the Labour party came into power. Looking ahead, the government will soon act as a drag on economic growth, though this is the cost of a lack of fiscal discipline."

Noting that it’s all a matter of probabilities, Menashy remains optimistic. “It’s debateable what impact [each cut] will have on GDP but if the economy itself grows faster than the Office for Budget Responsibility is forecasting—and there’s a good chance that this can actually happen—then the higher growth would enable the economy to proceed faster.”

The Centre for Economic Performance, a research centre headed by LSE professors, underlines the important of the fiscal multiplier in calculating the impact of fiscal measures such as today’s cut announcements on the economy at large. For a country with a high degree of openness to international trade and a flexible exchange rate, such as the UK, the fiscal multiplier is close to zero, Ilzetski explains, meaning that cuts in public expenditure would not necessarily have a significant impact on GDP growth. The key to whether fiscal austerity measures are going to be painful or not is the monetary authority’s response. “We find that one of the most important factors determining the size of the fiscal multiplier is the reaction of the central bank,” Ilzetzki says. “Normally, we would see expenditure cut matched by expansionary monetary policy, which would outweigh it.” However, with the Bank of England already holding its base rate at a record low close to zero, the only tool to hand is further quantitative easing. “The question is whether the monetary authority can have an expansionary policy in the current environment,” Ilzetzki concludes.

Road to Recovery or Road to Recession?
Of course the main aim of these spending cuts is to reduce the fiscal deficit that has been crippling the economic recovery, not least given that the interest bill alone amounts to somewhere in the region of £44 billion per year. So has today’s announcement changed our course, are we still on the road to recovery? “I honestly do believe that, genuinely,” says Menashy. “I think once you start a major trend, which actually did occur under the latter stage of the Labour government, I have every expectation that the recovery will continue.”

Ilzetzki is less sanguine but he doesn’t necessarily see the CSR pushing the economy off course. “I don’t think that a cut in government expenditure has to dampen recovery, but I think the devil is in the details,” he said, highlighting that there is likely to be plenty more bad news to come, particularly as some of the numbers don’t quite add up. “One thing that is not entirely clear was the promise that departmental budgets will be cut by no more than 19%—that implies a level of cuts in other parts of government; a lot of cuts still have not been outlined.”

Menashy has the final word: “A lot depends on what happens overseas and a lot will depend on whether we can shift our energies more into capital investment and exports rather than government spending and the consumer.”

Dea Markova contributed to this article.

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About Author Holly Cook

Holly Cook  is Managing Editor of Morningstar.co.uk