New world disorder

24 Jun 10
Think we've got problems? This weekend's G20 summit in Toronto will put Britain's austerity Budget in context. Dan Corry reports on the global economic tensions that threaten to undermine the recovery
By Dan Corry

25 June 2010

Think we’ve got problems? This weekend’s G20 summit in Toronto will put Britain’s austerity Budget in context. Dan Corry reports on the global economic tensions that threaten to undermine the recovery

Discussion of the first Budget of the ­coalition is inevitably dominating the debate on economic policy in the British press. Have they done enough to keep the markets happy? Is the mix of tax and spend right? Have the Liberal Democrats been too willing to sacrifice their policies? Indeed, is this the Budget Britain needed or a coalition compromise to try to get the pain out of the way well before the next election?

But while these are important issues, the economic event that probably matters more to the future of jobs, public services and general prosperity in the UK is ­happening far away in Toronto, Canada, this weekend. For that is where the heads of government of the 20 leading ­economic countries are gathering to discuss what should be done about the ­global ­economic situation. And the ­decisions that G20 meeting takes will ­affect us all.

At present, most of the world – at least the western part of it – is obsessed with restoring fiscal credibility by slashing spending and raising taxes. Certainly, some countries’ unsustainable fiscal ­positions had been lurking for some time before they were fully exposed – and action is needed. Greece is the most ­glaring example, with national accounts that seem to have been designed to be misleading.

But much of the increase in deficits – and hence debt – across the world was the inevitable consequence of an extremely deep recession. Governments made conscious decisions to let deficits rise to counter the effects of the recession and stop a calamitous fall in private sector activity, which would have affected jobs and output.

The ‘automatic stabilisers’ were ­allowed to work fully – so tax revenues fell, and spending on unemployment and other benefits rose. But a lot of discretionary measures, such as tax breaks and additional spending, were also taken to support economic activity. These efforts to avoid a repeat of the banking crisis-induced Great Depression of the 1930s were, by and large, successful.

As the recent report from the new Office for Budget Responsibility, led by Sir Alan Budd, commented: ‘Real household disposable income was relatively strong through the recession, as weaker wages and salaries were supported by tax changes, such as the temporary cut in VAT, and the automatic stabilisers ­provided by the benefit system.’

It is perhaps ironic that the very ­financial markets that caused the crash and therefore, if indirectly, the deficit rise, now demand action to cut public spending and the living standards of public sector workers in many debt-burdened countries. Those targeted by the markets and speculators have felt forced to act, often in a very severe way.

Greece aims to cut its deficit from around 13.6% to 3% by 2014 and has announced wage freezes, higher VAT and a new business tax as well as clampdowns on tax evasion. This has led to deep social unrest and real concerns over the government’s ability to carry out its programme. There have already been violent protests on the streets of Athens.

Portugal is often thought to be the next weakest of the five struggling European economies collectively labelled by their acronym ‘Piigs’ (the others are Italy, ­Ireland, Greece and Spain). Portugal has also announced cuts to try to get its ­deficit down to under 3% by 2013.

Ireland got off to an early start. Its aim is to save up to 2.2% of gross domestic product through cuts in public sector pay ranging from 5% to 15%; reducing child and unemployment benefits; and increasing fuel taxes. Italy has announced cuts amounting to €25bn. Meanwhile, the strongest of the Piigs, Spain, recently forced through by only one vote major cuts to public spending to slash its deficit from 11.2% of GDP last year to 9.3% this year and 3% by 2013. This also involves cuts in public sector pay and has already provoked strikes and demonstrations.

The UK, which is under much less ­pressure from the markets, is also planning to slash public spending. This week’s Budget will result in non-protected government departments facing real-terms cuts of 25% over four years, while welfare spending will be reduced by £11bn by 2014/15.

As Nobel Laureate Paul Krugman put it in the New York Times, this ‘conventional wisdom’ on the need for cuts even in countries such as the UK is ‘not because the markets are currently demanding it… but because we think that markets might demand it (even though they shouldn’t) some time in the future’.

Necessary much of this retrenchment might be, but a consequence of all ­countries doing it to a fast timetable and all at once is that demand in the world economy will inevitably shrink.

Optimistic theories see fast attacks on deficits as a way of restoring private sector confidence, reducing debt interest payments and keeping interest rates lower over time. This would in turn revive private sector demand, the theory goes,  to replace the public sector demand lost through fiscal tightening.

But as
­Financial Times economic guru Martin Wolf points out: ‘What makes these policy­makers sure that business and consumers will spend in response to austerity?’ This is especially questionable at a time when monetary policy cannot realistically be eased much further to take some of the strain. So the pace of all this is unlikely to see a smooth transition from one to the other form of demand. And that really matters for the UK.

For, despite all the rhetoric in our ­papers and from our politicians, Britain is in fact a smallish economic power these days and it is above all – as it has always been – an open, trading nation. We prosper when other countries prosper, buy our products, open themselves to our investment and invest here in return. We might be an island but we are linked umbilically to the European and world economies.

That means we need growth in the world economy if we are to prosper. It is that growth, as much as any tax increases and spending cuts, that will help reduce our deficit. Seeing the UK coalition government apparently aping the ‘successful’ Canadian and Swedish experiences of cutting might fuel hopes of a similar outcome. But while those countries were cutting domestically, they were supported by strong growth in economies crucial to them – the US in ­Canada’s case and Europe in the Swedes.

For the UK, it is growth in Europe that matters most, since 60% of our exports go there and, for good or bad, we still export more to Ireland than to the fast growing economies of China, India, Brazil and Russia combined. The US also remains a major engine of growth for the UK economy – and for the world – and its decisions on deficit reduction will have widespread effects.

One institutional innovation during the financial crisis has been the rise of the G20, which includes countries such as China, Brazil, Turkey, India and Indonesia. Previously we simply had the G8 group of ‘older’ leading economies, which excluded many of the emerging players. But during the crisis, the G20 established itself as the forum that allowed the international community to come together, to look at the interconnections between their domestic actions, and to reach a ­degree of consensus.

The UK-chaired London summit of April 2009 focused on urgent steps to avoid recession and to secure growth. A $1.1 trillion package of measures to restore growth and jobs and rebuild confidence and trust in the financial system was agreed. Resources of the International Monetary Fund and regional multilateral development banks were boosted to support countries in trouble – for ­instance, in Eastern Europe.

The feeling at the time was that the whole world was on the edge of an economic precipice and that individual actions by individual countries would not work. This bound leaders together in the realisation that they all needed to work in similar ways to keep up global demand as well as to tackle the banking failures. And they did succeed in staving off catastrophe. But that consensus and will to work together has fallen away and they have gone back to looking after themselves.

The danger is that we will end up with a classic ‘fallacy of composition’, of the type Keynesian economists are always eager to point out. For each country acting on its own, cutting spending and raising taxes appear to make sense. Yet if they all do it simultaneously there will be trouble.

Economist Nouriel Roubini, of New York University, who forecast the financial crash of 2008, has warned: ‘If everybody is doing fiscal contraction, there’s going to be another double-dip depression… So many things have to be done in addition to fiscal austerity.’

Equally, each country might feel the antidote to the domestic consumption-fuelled boom of the past decade is to have a strategy that depends on increasing exports instead. But not everyone can export their way out of recession, especially if cuts mean world growth is subdued. Economic policy made without regard to these ‘externalities’ will lead to a vicious cycle and a slide into prolonged ­stagnation, Japan-style.

These issues were apparently debated vigorously at the June G20 finance ministers’ meeting in Seoul, Korea, held three weeks before the leaders’ Toronto summit. Some UK commentators took the overall Seoul communiqué to be urging immediate cuts, and so supporting the British coalition government’s strategy. In fact, it was far more nuanced as it called for ‘credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances’.

All reports suggest that the Americans, in the shape of Treasury secretary Tim Geithner, are very anxious not to end up creating momentum for deflation. Just before the Seoul summit Geithner wrote to his G20 colleagues saying that ‘the necessary and inevitable withdrawal of fiscal and monetary stimulus needs to be calibrated to proceed in step with the strengthening of the private sector recovery in our economies’. He repeated such thoughts in the post-G20 press conference.

The Americans are saying that what ­really needs to be tackled are the imbalances in the world economy – huge surpluses in China and southeast Asia and large deficits in the US. Many economists see the growth of imbalances as part of the pathology that led to cheap money and a search for high returns and from there to derivatives, sub-prime mortgages and other risky techniques and practices that nobody fully understood – and finally to the financial meltdown of 2008/09.

China and other Asian economies built up their economies and hence trade surpluses through strong exports, not through strengthening demand at home. And the Chinese are keeping their exchange rate low to help achieve this, a major source of tension with the US, which sees the practice as protectionist.

In Europe, there is a similar situation with the powerhouse of the economy – Germany. It has always seen strong exports as its way to growth and now, when it is needed to power the whole European economy, it has decided to make cuts itself. Chancellor Angela Merkel recently pushed through €11bn worth of cuts for next year, flying in the face of Geithner’s view that we need to ‘try to make sure that the strongest, richest countries in Europe keep acting to support recovery’. This has caused tension with other European countries, especially France, some of which surfaced at the European Union summit in Madrid on June 17.

In many ways, Germany is the major beneficiary of the stable exchange rates and internal market that the euro has brought. But it has been reluctant to support Greece or help the euro through the turbulence that the markets are placing it in. This maintains the fear of Greek collapse, domino effects and hence slow ­European growth.

To add to this general malaise, there are disagreements on how to handle bank regulation. All countries accept that reform is needed and the London Summit agreed the basic principles. But there are deep disagreements about how to act, how fast to act and how co-ordinated to be. Countries such as Canada, which chairs the G20 (and G8), and Australia are resisting too much new action as their banks did not get into much trouble during the crisis. Indeed, it appears that co-ordinating any taxation of the banks  – to stop them playing governments off against each – was seen off at the Seoul meeting. So, in the absence of co-­ordination, action and decision, the uncertainty hanging over our banking sector means it is ever harder to get them to lend – with major consequences for economic ­activity and businesses.

The G20 is a big international stage for anyone. It includes the big cheeses of ­Europe – Merkel, French president ­Nicolas Sarkozy, and Italian prime minister Silvio Berlusconi – and the Americans, who we need to take the issue seriously and not retreat to their traditional isolationalism. In addition, there are the major ‘new’ players, including Brazil, South ­Africa, Russia, China and India.
It will be a big test for coalition Prime Minister David Cameron. Where his predecessor Gordon Brown had built up a reputation and relationships with most of these characters and was familiar with the language of international finance and negotiation, Cameron is inevitably new to it. Where Brown could metaphorically bang the table and demand outcomes rather than wordy communiqués, it is unlikely that Cameron will be able to form the necessary alliances and ­dominate in the same way on his first outing.
And nobody knows how the coalition issue will play out – does Conservative Cameron have to consult his LibDem deputy Nick Clegg before signing a communiqué? But, in any case, will the British PM be looking for steps to boost world growth or for political cover to suggest that painful cuts at home are simply ­following the international consensus.

Many of these international meetings sound esoteric. Most of the British press will not get far beyond discussion of who ‘won’ the summit and a few photo opportunities of Cameron on the world stage for the first time. Hard deficit reduction measures in the Budget are much more comprehensible, immediate and ‘local’ – so the focus will be on that. Yet the experience of the 1930s shows what can happen if the world acts in ways that put solving apparent domestic short-run problems before the long-run health of the world economy. Those interested in the future of our public services and of our economy should keep at least one eye this weekend away from Westminster and ­focused on Toronto.

Dan Corry is a former senior adviser on the economy at Downing Street

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