Moody’s put the UK’s triple A sovereign debt rating on negative watch this week. Does this matter? No. The agency is telling us nothing a well-informed person does not know well: the UK has large fiscal deficits, rising public debt and a macroeconomic predicament.
The implication of this warning is about the longer term, not about the fiscal deficits being run right now. As Robert Neild, emeritus professor at Cambridge university, points out in the Royal Economic Society’s newsletter, “the application again of the balanced budget policy of the interwar years, justified by alarmism, is leading us into an unnecessarily deep recession”. He is quite correct. Prof Neild also writes: “Britain, a leader in the management of government finances, has maintained a national debt without default for more than three centuries. The ratio of debt to gross domestic product has often been far higher than it is today.” Why do so many regard this successful history as nigh on irrelevant and the dire experience of Greece or Italy inside the euro zone as far more relevant?
Yet what is clear from UK history is that growth is a necessary condition for successful management of public debt. The huge spending cuts of the early 1920s failed to lower the ratio of debt to GDP, for example, because the economy then collapsed. This is consistent with Moody’s analysis, which also stresses the factors causing weak prospective economic growth in the UK.
The government’s measures are expected to cut the fiscal deficit by 8.1 per cent of GDP by 2016-17. How is it to obtain such an enormous fiscal consolidation, along with strong economic growth? The answer, in principle, is simple: large offsetting cuts in the financial surpluses of the other sectors of the economy - households, business and foreigners - must occur. Moreover, these shifts have to happen not via a collapse in incomes, which would be a catastrophic and unsustainable way of bringing the needed adjustments about, but by a combination of lower desired savings and, better still, much higher spending, especially on investment. The focus should be on how such changes are to happen.
To set the stage, in the four quarters ending in the third quarter of 2011, the government’s fiscal deficit was 8.8 per cent of GDP. What were the counterparts? Households ran a modest surplus of 0.9 per cent of GDP, foreigners one of 2.7 per cent and corporations one of 5.5 per cent.
As Andrew Smithers of London-based Smithers & Co. notes in a recent report (”UK: Narrower Profit Margins and Weaker Sterling Needed”), if the fiscal deficit is to disappear, offsetting adjustments must occur, above all, in the foreign and corporate sectors. There needs to be a mixture of lower profits, higher investment and significantly smaller current account deficits. Increases in government investment and private housebuilding would also help. But highly indebted UK households should not run large deficits again.
I accept this logic. Large fiscal deficits were a necessary way to support demand in the aftermath of the crisis. Nevertheless, in the longer run, the solution must be to generate large and permanent changes in the financial balances of the rest of the economy, while sustaining growth.
As Mr. Smithers notes, the solution to the external imbalance has to include a weaker real exchange rate. In a demand-deficient world, a country with big private and public debt overhangs has to pursue beggar-my-neighbour policies. I am sorry about that! The problem with the quantitative easing is that it is not yet making sterling weak enough.
As Mr Smithers notes, “perhaps the single greatest challenge to economic policy over the next decade will consist of how to turn the corporate sector’s cash surplus into a deficit without pushing the economy into recession”. Weaker sterling should itself raise corporate investment by making production of manufactures more profitable. But it is also necessary to look at the profits of the corporate sector.
First, we must understand why UK corporate profits have been so strong and business investment so weak. Mr Smithers suggests this is due to perverse incentives - particularly the linking of executive pay to share prices. In the short run, lower investment and higher prices of output boost both share prices and remuneration of management. Moreover, the short run is what management has. UK corporates are run not for long-term health, but for executive wealth, with bad results for the businesses themselves and, still more, for the entire economy.
Policy, then, has to focus on the incentives driving today’s vast corporate financial surpluses. By focusing on these, we would also relearn the most important lesson of John Maynard Keynes: the fiscal position cannot be viewed separately from what is happening in the rest of the economy. The big challenge is to bring financial surpluses down elsewhere, but by raising growth not by depressing the economy. That is the only way to achieve an enduring fiscal consolidation. The government needs to think big. It is more than another penny-pinching household.