Support? Criticism? The IMF's view of the UK offers something for everyone

http://www.guardian.co.uk/business/2012/jun/03/support-criticism-uk-imf

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At our house, as at many others, it has been school exam time. I don't know if the head of the International Monetary Fund figured in any economics questions, but it might have been tempting for an examiner to pose this: "The managing director of the IMF supports the British government's deficit reduction programme. The managing director of the IMF does not support the British government's deficit reduction programme. Which statement is correct?"

Recently, at a press conference in the Treasury, Christine Lagarde threw her weight behind George Osborne's strategy, saying: "When I think back to May 2010, when the UK deficit was at 11%… I shiver."

This was remarkable public backing for our chancellor, though less remarkable when one recalls that it was Osborne who was Lagarde's crucial supporter for the IMF job. And her show of solidarity sits uneasily with other comments made recently, not only by her staff but also herself.

Thus the IMF annual report on the UK stated: "Policies to bolster demand should help close the output gap faster." It warned against "weak demand that leads to persistently slow growth and high unemployment". True, the IMF said fiscal easing should be used "if downside risks materialise and the recovery fails to take off", but that is precisely what has happened since it issued a similar warning over a year ago. Indeed, Lagarde herself stated bluntly: "Growth is too slow and unemployment, including youth unemployment, is too high. Policies to bolster demand before low growth becomes entrenched are needed."

Within a week, leading international investors in the bond market of which Osborne is so frightened were reported in the <em>Financial Times</em> as having indicated "they would back heavier spending to encourage growth by governments with very low borrowing costs, warning that austerity alone will not restore their budgets to health".

We also learn that the prime minister and deputy prime minister have told the Treasury to produce a growth strategy. However, unfortunately for David Cameron, Nick Clegg and the rest of us, Osborne has staked his rapidly diminishing reputation on Plan A, in which the markets are losing faith.

Now, let us return to the "output gap" that the IMF believes should be closed faster. If we eschew technical terms, what we are talking about is the gap between present output and the potential output of the economy that could be achieved without aggravating inflation. Younger readers may like to know that the traditional obstacles to the pursuit of expansionary policies are essentially twofold: fear of inflation – especially of what is known in the trade as "accelerating inflation"; and concern about the trend of the balance of payments for overseas trade – ie, Britain's ability to pay its way in the world.

It seems to suit Osborne to believe the output gap is small, that we have far too much "structural unemployment" and that measures to stimulate demand would not only upset the bond markets, but also be inflationary. This is almost certainly baloney, and in recent weeks three high-powered economists have made a major contribution to the debate on the anti-Osborne side.

The first was Professor David Miles, a member of the Bank of England's monetary policy committee, in a talk to the Society of Business Economists. He emphasised that nearly all the upward pressure on UK prices in recent years has come from commodity prices and VAT increases, "not domestically generated pressures, which amount to 1% per annum in recent years".

Miles is sceptical of the measures of "capacity utilisation" that come from business surveys that suggest there is limited scope for expansion of supply, given the demand. So am I. For years I covered these business surveys and the responses about "capacity" were always suspiciously pessimistic.

This point is also made by former City economist Bill Martin and Professor Robert Rowthorn in a fascinating new study entitled "Is the British Economy Supply Constrained?"

They reproduce a very telling observation from US economist George Perry of the Brookings Institute. In 1973 he observed that the apparent cyclicality of economic potential arises from a bias in how businesses respond to surveys: "Respondents 'find' capacity when output rises sharply, and 'lose' it when output slackens," he said.

Martin and Rowthorn take issue with the Office for Budget Responsibility's view that most of the deficit is structural, not cyclical, and would not disappear as output recovered. This is important, because the OBR analysis is part of the rationalisation of Osborne's deficit strategy. This view is connected with the poor performance of productivity in recent years.

But Martin and Rowthorn argue, convincingly, that "output is well below potential because workers, while cheaper to employ, are not working to potential. More output could be produced, but not sold. There is an effective demand failure, high unemployment and, within companies, under-utilisation of the… workforce – a form of labour hoarding."

The irony, as the authors say, is that the longer demand is depressed, the more likely it is that real structural damage will be caused to the economy. The government seems to be warming to the need for more investment, but private sector investment only takes place when business sees the prospect of rising demand.