Monday, 19 March 2012

The Budget 2012: Should George Osborne learn from Barack Obama?

This was the question that Larry Elliott asked on The Guardian's Economics Blog yesterday. He was of course referring to fact that the USA has implemented a major economic stimulus package whereas the coalition government here has instead (with the tacit encouragement of the Treasury) been implementing a policy of cuts and austerity. As a result the USA has had falling unemployment for most of the last year whereas in the UK unemployment is still rising. In the USA economic growth is well over 1% and approaching 2%. In the UK it is barely above zero. So has Obama got it right and Osborne got it wrong?

To answer this we must first take stock of what it is exactly that the US government has done. Its stimulus package has in fact been in three parts. First it reduced its short-term policy rate (just as the Bank of England did). Then it introduced Quantitative Easing (QE), just as the Bank of England did. Then last autumn it launched Operation Twist. This involved buying long-dated bonds to bring down long-term interest rates and replacing them with short-dated bonds, but as Operation Twist is such a new initiative can it really be held responsible for a US recovery which has been underway for over a year now? Probably not, and as Larry Elliott suggested in his column, it is difficult to see how Operation Twist could really effect aggregate demand. So is the real explanation for the difference in recovery rates between the US and the UK just down to the size and length of the stimulus. Perhaps not.

Perhaps the real reason that the US economy is growing faster is not just down to the federal stimulus. A point that is too often overlooked has been the scale and the effect of the housing crash in the US over the last four years. Unlike in the UK where house prices fell by only about 20% from their 2007 peak and are still at historically high levels, in many parts of the US the fall has been much more dramatic. Could this be part of the reason that the US economy has seen a better speed of recovery?

In case you had forgotten, it was the boom in the housing market in both the USA and Britain (and Ireland and Spain for that matter) that led to the financial crash in 2007, rather than just a failure of bank regulation. In all of those countries mentioned the housing bubble was the result of either rising inequality or increasing economic imbalances and, in the case of the US and UK, stagnant growth in real wages for the less well off as well. As a result an excess of investment funds got misdirected into creating bubbles in asset prices (i.e. property) instead of being use to create new means of production.

What is different about the US response to the crisis, compared to the UK one, is that the US allowed their housing bubble to implode. We did not. In fact government policy in the UK is still more concerned about supporting house prices than it is about keeping people in work. That is the big mistake. Negative equity is only an economic problem if people start losing their jobs.

In the USA by contrast, by allowing the housing market to crash the policy makers have forced the debt holders to take a "debt haircut" and thus allowed the economy to partially reset itself. Thus the USA has benefited from a combination of a debt haircut and a stimulus. In the UK we have had a weak stimulus primarily for the banks but no haircut. In the Eurozone (e.g. Spain and Ireland) they might get a small debt haircut but no stimulus. Thus it is the combination of stimulus and debt write-off that is the necessary remedy. Those countries that only take half the medicine either take much longer to recover, or don't recover at all.

However it is not just about the size of the stimulus either. It is also about the shape of it. The correct economic response to the current crisis is not just to provide a stimulus, but to direct that stimulus towards correcting the original cause of the problem, namely the housing market. By building more social housing the government would not only have created jobs, it would also have reduced house prices and private sector rents and thereby increased disposable incomes for the majority of families. That would have magnified the effect of the stimulus and helped to eradicate the core problem. Instead we are having to endure an economic policy that protects the haves at the expense of the have-nots. That is just a repeat of the very economic policies that caused the whole sorry problem in the first place.