WHY NEW CHALLENGES NEED NEW PEOPLE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Why new challenges need new people

By Martin Wolf

Published: December 17 2009 19:49

“As the last of the official Q3 data came in, the UK found itself in the unenviable position of being the only economy in the [Group of 20 leading economies] to remain in recession”. Thus did Consensus Forecasts summarise the UK’s plight. With the third-largest economic decline, after Japan and Italy, the most indebted households, the biggest fiscal deterioration and the greatest dependency on the financial sector among the Group of Seven leading high-income countries, the UK has suffered a huge economic shock.

Fortunately, the UK also possesses assets. Among these are: a government with the capacity to act; the ability to borrow in its own currency; a flexible exchange rate; a credible monetary regime; a modest initial level of public indebtedness; privileged access to the European market, the world’s biggest; a greater number of top-class universities than any country, apart from the US; and an economy that has shed its most vulnerable manufacturing activities.

What the country requires is a strategy for what I have called the “post post-Thatcher era”. What should be its elements? Growth with stabilisation is the answer.

What then should be the elements of the strategy for growth?

First, those parts of public sector spending that sustain the long-term health of the economy should not be sacrificed. Yet that is precisely what is happening, with the planned slashing of net investment from 3.5 per cent of gross domestic product in 2009-10 to just 1.3 per cent in 2013-14.

Second, the government must protect the economy from financial volatility. As David Miles, a member of the Bank of England’s monetary policy committee, noted in a speech earlier this week, over the past four decades, bank assets have increased 10-fold, relative to GDP. That must now go into reverse. This will happen, as a result of higher capital requirements. As home to the world’s most important international financial centre, the UK must also support global efforts at regulation.

Above all, the government should focus on supporting diversification of the economy. The welcome and necessary depreciation of the exchange rate will help. But it is not enough. The journalist and author, Will Hutton, has laid out the challenges in a recent pamphlet.* I do not agree with all of it. But it does set out the long-term agenda for both government and business.
While trying to sustain growth, the government must also pursue a credible strategy for fiscal stabilisation. In determining the path, the government has to answer two questions: how and when?

On “how”, the first challenge is to decide the balance between spending cuts and tax increases. As a result of the shock, receipts are forecast at only 35.3 per cent of GDP this year, while spending is at 48 per cent. By 2014-15, these numbers are forecast to be 37.7 per cent and 42.2 per cent, respectively. This would bring the ratio of revenue to GDP to where it was before the crisis and impose much of the adjustment on spending. That makes sense to me.

The second challenge is over the balance within the cuts. The government has decided to protect aid, health and “frontline” schools. Given the rise in debt interest and social security spending, this guarantees deep cuts in defence, transport, housing and higher education, as the Institute for Fiscal Studies points out. Yet this is irrational. It implies that spending on health and schools, at the margin, was much more valuable than in other areas, before the crisis. A better approach would be cuts across the board, but focused on the wage bill and poorly-targeted benefits.

Even more difficult than the “how” is the “when”. Here there is a difficult balance to strike.

On the one hand, markets may not have the patience to wait for the deficits to be brought back under control over two parliaments, as the government plans. Developments in the bond markets suggest concern, with the jump of 20 basis points in spreads on 10-year gilts over German Bunds since early December. The stimulative effects of fiscal deficits could be swamped by higher long-term interest rates, particularly when quantitative easing ceases.

On the other hand, in an economy undergoing private sector deleveraging, the early withdrawal of fiscal support could destroy any nascent recovery. The benefits of fiscal consolidation seen elsewhere may well not apply in the UK.

The best strategy is to plan for still faster cuts in the deficits, but with an override in the event of another downturn. But the big requirement is that the consolidation be credible. If credibility can be decoupled from speed, the government should attempt it.

The next election needs to be won by the party that can most readily appreciate and respond to the massive changes in the UK’s circumstances. That would normally require a fresh government, untainted by the past mistakes. It is up to Gordon Brown to prove that he has the flexibility to recognise new challenges. If he fails to do so, the time has surely come for a change.

* The Landscape of Tough Times, www.theworkfoundation.com

Copyright The Financial Times Limited 2009.