Why we need a new macroeconomic strategy

Our approaching triple-dip recession was a direct result of the government’s flawed economic strategy.

The case for austerity rests on two false premises: that the previous government had been spending excessively, and the government debt and deficit are the main threat to our economic stability. But the real threat to stability lies in our financial system – which, following the crash, led the UK into recession, decreasing tax revenues while pushing up government debt.

The government’s austerity strategy was founded on two other incorrect beliefs. First, the Coalition assumed that the private sector would fill the gap created by public spending cuts. In fact, business investment has grown by less than a third of the rate the government forecast in 2011 and 2012 and shows no sign of rising to the levels required to prompt an economic recovery.

Second, the strategy relied on export-led growth. Despite the pound falling over 20 per cent in value since 2007, exports have been volatile, reflecting global uncertainties, and the trade deficit shows few signs of closing. We have little chance of attracting more European export sales, and our import dependency is increasing.

Austerity is the wrong response to a demand-led recession. With both households and firms reigning in their expenditure the multiplier effect makes it foolish for a government to behave likewise, particularly given the economic uncertainty abroad.

A longer term analysis of the overall state of the UK economy finds it to be fundamentally weak:

• It is overly dependent on finance. Our uniquely large, globalised, and poorly regulated finance system makes us particularly vulnerable to external shocks.
• It is heavily indebted. The UK’s total indebtedness is continuing to rise, with the bulk of the UK debt burden arising from the private rather than the public sector.
• Relative to other large developed countries, the UK is in a poor position to deliver future growth. productivity growth in the private sector collapsed in the recession and failed to recover.
• Britain is the most geographically unequal economy in the European Union. Growth over the last decade has been heavily biased towards the South East. While Inner London is now the richest space in the EU, the Welsh valleys are poorer than Slovakia.
• The UK’s chronic trade deficit has been paid for by flows of finance from abroad. The mutual reinforcement between demand for finance and demand for imports has turned into an economic deadlock.
• Growth alone is not the best economic objective. Better metrics for assessing economic policy based on work created, real median incomes, well-being and environmental damage would help shape economic policy better.

We live in a high-carbon, high-debt economy. It used to deliver growth. Now it cannot even manage that. There are clear barriers to growth, and, worse, growth itself is unlikely to deliver for the majority. But ​“Keynesianism” alone – boosting government spending – will not reverse the course when debts remain high and the underlying economy is weak.

It is essential we carve a new path, though it will take significant effort and expenditure to do. A successful new macroeconomic strategy must recognise the path dependency of our current situation and shift to a completely new mode of operating. The first steps to ensure this will require us to:

• End austerity and sustain demand. When no one else is spending, government has to. The government must act to create jobs, boost demand and redistribute wealth to the regions. Rising inequality and a falling share of wages in output are direct drivers of economic stagnation and must be reversed.
• Shrink and reshape the financial system. The UK’s financial system is unsustainably large and requires shrinking: its balance sheets reduced relative to GDP, its employment reduced as a share of the workforce. Breaking up major banks would help them to operate differently, witha greater variety of financial institutions spreading risks and managing complexity better. Localising banks, diversifying ownership structures, and placing greater democratic and public control over banking functions will all help to transform the financial system for the better. Some debt cancellation is likely to be necessary.
• Introduce capital controls. By making movements of capital in and out of the UK more expensive, they become less desirable, reducing speculation Measures like an emergency tax on capital inflows; unremunerated reserve requirements; legal restrictions on derivatives positions and restrictions on overseas ownership of residential property could manage the flows of capital to attract more stable investments.
• Use Quantitative easing for productive activity. The effects of QE so far have been to support the existing financial system. If, instead of piling new financial assets onto bank balance sheets, QE was used to inject cash directly into the economy, it could start to act to break our economic deadlock.

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