Economy

Current UK and EU stagnation are in part the consequence of deficit obsession

 

The rule of thumb
journalists use to define a recession, two quarters of negative GDP
growth, is unhelpful in many ways. If the economy grows by 0.1%, the
headline is ‘UK avoids recession’, but if it grows by -0.1% in
two consecutive quarters, the headline is ‘UK enters recession’.
Yet the difference between those two, 0.2% of GDP, is well within the
measurement errors typical associated with GDP growth. From an
economic point of view there is no material difference between 0.1%
growth and -0.1% growth, so calling the later a recession but the
former not is rediculous.

Another problem with
this way of defining a recession is that it makes no reference to
trend growth. If the economy typically grows by 3%, then zero growth
is a big difference (3% less than normal). However if trend growth is
more like 1%, then zero growth is not such a big deal (just 1% less
than normal). This can lead to serious misreporting when talking
about a recovery from a recession. For example some have claimed that
because GDP started growing in 1982 after the 1980/1 recession the
famous letter from 364 economists was wrong. As I
noted here
, growth in 1982 was around the trend rate.
The recovery, in the sense of getting back to trend, only really
started in 1983.

One final problem
with the ‘official’ definition of recession is that it refers to
GDP, rather than GDP per head. The latter is far more relevant in
almost every way.

UK Quarterly growth

Real GDP

Real GDP per head

2022Q1

0.5

0.2

2022Q2

0.1

-0.2

2022Q3

-0.1

-0.2

2022Q4

0.1

0.0

2023Q1

0.3

0.2

2023Q2

0.2

0.1

2023Q3

0.0

-0.1

As the table above
shows (source),
if we used GDP per head in the official definition of recession, then
we had a recession in 2022, and we could be heading for a second
recession in the second half of this year. Again this shows the
nonsense of being so literal about defining a recession.

A much better way of
describing 2022 and (so far) in 2023 is that the economy has
flatlined. It is tempting to ascribe this period of very weak growth
as a consequence of rising interest rates to combat high inflation.
Growth in the major EU economies has also been weak over the last two
years. However one important counterexample should make us question
this simple explanation. As the graph below shows, growth in the US
has been much stronger.

Martin
Sandbu shows
a similar graph comparing US GDP to EU
GDP. While UK GDP per capita remains at similar levels to just before
the pandemic, US GDP per capita is almost 6% higher. The UK recorded
a slight fall in GDP per capita in 2023Q3, but US GDP per capita
increased by over 1%!

As Martin notes,
this is not because US GDP per capita growth is always higher than in
Europe. Equally, as
I showed here
, UK growth in GDP per capita was at
least as strong as the US before the financial crisis and austerity.
Something has been happening in the US since the pandemic that has
not been happening in the UK and EU.

As with any puzzle
there are many possible answers, and not enough evidence to know for
sure which is correct. One answer is that the energy price shock hit
Europe much harder than the US, because gas markets are more local
than the oil market and gas supplies were restricted by Russia’s
invasion of Ukraine. If that was the case, then in 2023 we should be
seeing some rebound in Europe relative to the US as gas prices came
down, but as yet there is no sign of this. So this is only a partial
explanation.

The argument I have
made before, and Martin also makes, is that US fiscal policy has been
much more expansionary since the worst of the pandemic than in
Europe. The details are discussed at length in
that previous post
and in Martin’s
article
so I will not repeat them here, except to say
that they involve a combination of the timing of fiscal stimulus and
directing that stimulus to those who will spend more of it. Instead I
want to broaden this out to make a much more general point.

One feature of
Biden’s tenure as President is that policy has not put the budget
deficit or debt at the centre of fiscal decisions. This is in
contrast to Europe, where in both the EU and UK constraints on debt
or deficits imposed by politicians always seem to bite, and also in
contrast to previous Democratic administrations which have ‘worried
about the deficit’ to varying degrees. In my view the strength of
the US economy coming out of the pandemic owes a great deal to this
difference, and this holds important lessons for European
policymakers who remain obsessed with and constrained by deficit or
debt targets.

What do I mean by
deficit obsession? After all, I have consistently
argued
that setting fiscal policy over the medium term
to follow the golden rule (matching day to day spending to taxes)
during normal times is a good objective. Deficit obsession, by
contrast, implicitly views public debt as always a bad thing, erects
totally arbitrary targets to reduce that debt, and allows this to
dictate policy at almost all times, which invariably means
underinvestment in public services and infrastructure.

Deficit and debt
obsession matters most after a severe economic downturn,
caused for example by a financial crisis or a pandemic. After the
Global Financial Crisis the key mistake was not the absence of fiscal
support during the period when output was falling, but during the
period after that when we would normally expect a recovery from that
recession. This was because in the US and UK, Democrats and Labour
were in power. However even in Europe there was some fiscal support
during the worst of the recession. During the worst of the pandemic
all governments offered considerable fiscal support. It is after the
immediate crisis that mistakes were made. It is as if policymakers
were prepared to suspend their deficit obsession while output was
falling, but once output stopped
falling that suspension ended. In a way, they were also being misled by the ‘official definition’ of a recession.

We know from the
1930s depression that the level of output after a crisis does not
always bounce back to its pre-crisis trend. Thanks to Keynes we also
know why. If consumers and firms think that perhaps such a bounce
back will not occur, it will not, because consumption and investment
will remain depressed. In the 1930s unemployment stayed high, yet
wages and prices stopped falling. It needed a fiscal stimulus, in the
form of the New Deal or a war, to reduce unemployment. Unemployment
did fall after the Global Financial Crisis, but output did not return
to its pre-crisis trend.

We are seeing the
same pattern after the pandemic. We had a V-shaped recession, but
output in Europe has not returned to its pre-pandemic trend, because
in the EU and in the UK policymakers have returned to imposing
deficit or debt targets that leave no room for encouraging a full
recovery. The one exception is the US, and it is there that output
has returned to something like its pre-pandemic trend.

In the EU and UK
policy makers typically view the increase in debt during the crisis
as an unfortunate outcome, rather than a beneficial means of
softening the impact of the crisis. As a result, as soon as the
crisis is over they try to reduce the new higher level of debt
through fiscal consolidation rather than stimulating the recovery. We
know that is unlikely to work
on its own terms (fiscal
consolidations when the output gap is negative tend to increase debt
to GDP) , and it also risks permanently damaging average incomes.

I have been making
this argument consistently over the decade I have been writing this
blog, but for most of this time all the major economies have been
afflicted by deficit obsession so I have been unable to point to a
current example of how things could be done much better. Thanks to
President Biden and Democrat policymakers, now I can, and the results
speak for themselves.

.


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