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Where Next for the UK Economy?

Economic Recovery is the urgent priority today, but getting the future structure of the economy right is equally important, says Dr Gerard Lyons, looking ahead.

That will involve the big questions – the balance of the economy, the size of the state, regional dynamics and also the incentive structure as outlined in tax and welfare payments, among others. There is, naturally, some overlap between both important issues. Each must be taken into account when judging the Chancellor’s 2012 Autumn Statement.

In the run up to the statement, much of the focus was on whether there would be another round of austerity to bring the public finances more under control. That that did not happen was good. Economic growth is the best way to improve debt dynamics. It needs both more money in peoples’ pockets and improved confidence about the future so that business will invest.

The big question remains where will demand come from, one of the big worries post the Statement. The Statement also will have focussed attention on monetary policy and the need to get more lending and credit into the economy.

I thought it the best Statement the Chancellor has given since coming to power, both presentationally and also in terms of getting across the realism about the situation the economy is in. Also the Statement had some good measures such as the increase in the personal income tax allowances (for those not on higher incomes) which, when added to the previously announced allowances which kick in this spring, will provide a welcome boost to disposable income; and also the decision to freeze the petrol level.

The decision to boost infrastructure spending was good. I would argue that there is a need to boost demand through both tax cuts, to get money into people’s pockets, and shovel ready infrastructure plans, and also, if one was looking for quick wins, it is about getting the construction sector moving, especially as one in four small firms are involved in this.

Whether the UK will lose its triple AAA status has become a key question since the Autumn Statement? In my view the UK should not be downgraded. It is harder to say what the rating agencies will do. The Chancellor’s determination to reduce the deficit cannot be doubted. It is the execution of the policy that is the problem. Long term borrowing rates are low. This reflects both the combination of the economy’s weakness and a vote of confidence from the market in the Chancellor. The trouble is, unless there is growth soon the market may lose faith in the policy. Also, often not appreciated, the UK’s borrowing is not short-term, with average maturity of government debt being about 14 years which gives the UK a lot more room for manoeuvre. Even if the UK did lose its triple AAA status I don’t think it would push borrowing costs up too much – it would be likely to have more a political than a market impact.

There has been much noise about the decision to not raise benefits in line with inflation. It is vital to have an appropriate welfare and benefit system in place that offers protection and support to those most in need. Yet at the same time it is important to ensure that the size of the bill is manageable and that the right incentive structure is in place. In 2012/13 current government spending is set to be £660.7 billion, of which social spending is £207 billion. In addition, health and other social services are another £163 billion. In contrast, education is £91 billion and defence £39 billion.

Finally, the input of the Office for Budget Responsibility (OBR). They forecast a small recession of -0.1% this year, implying that the economy contracts in the fourth quarter, followed by a weak recovery in 2013 around 1% and a stronger recovery in 2014. These forecasts make sense. So the economy may be past the worst but a very weak recovery lies ahead.

It is another aspect of the OBR’s analysis which is, in my opinion, a bigger worry. That is their assessment of how much spare capacity there is in the economy – this is the so-called ‘output gap’, the difference between actual and potential output. The OBR puts this at 2.7%. Now, no-one really knows what the true figure is and some people put it at smaller, others larger. Trouble is, this matters a lot.

Is the deficit cyclical (due to the weakness of the economy) or structural? The reality is it both. The question is how much is cyclical and how much is structural? A structural deficit needs to be addressed by the combination of tough choices on government spending and austerity. A cyclical deficit is better addressed through economic growth, not austerity. The OBR believes there is a small output gap and thus the deficit is largely structural and needs to be addressed by austerity.

In contrast if you believe there is a bigger output gap (as I do) then that would mean the deficit has a large cyclical component to it and reflects weak demand and thus a weak economy. The economy is about 14% below where it would be if the pre-crisis trend had continued. It doesn’t mean the output gap is 14%, but it probably means it is bigger than what the OBR thinks.

This debate also helps explain why the Chancellor did not tighten further this week. Even though the economy was weaker over the last year the OBR said this weakness was cyclical and thus the Chancellor did not need to engage in fresh austerity. That was the right thing to do. But it still leaves the bigger questions for further ahead, particularly the need to cut taxes, to address the size of government spending, to get the right incentives in place and to reposition the UK in a changing global economy.

*Dr Gerard Lyons is a member of the Politeia Business Advisory Council.

Dr Gerard Lyons

Dr Gerard Lyons is an international economist and Chief Economic Strategist at Netwealth Investments, having previously served as Chief Economic Adviser to Boris Johnson while he was Mayor of London. He was Co-Founder of Economists for Brexit and is co-author with Liam Halligan of Clean Brexit (Biteback, 2017). For Politeia he was co-author of Banking on Recovery: Towards an accountable, stable financial sector (2016).

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