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  • Why Larry Summers Is Wrong About the British Economy

    Harvard economist Larry Summers claims in The Washington Post that aggressive fiscal austerity in the U.K. is the primary cause of its continued economic stagnation. But the former Obama advisor understates both the necessity for a credible British fiscal plan in 2010 and the structural factors that have been a drag on British growth since 2010. Most importantly, he significantly overstates the extent to which Britain has actually practiced “austerity.”

    When Britain’s Conservative-led coalition government was formed in 2010, the nation was running a deficit of over 11 percent of GDP (larger than Greece). The Bank for International Settlements forecast that, on unchanged policy, the national debt would rise to over 300 percent of GDP by 2025. According to the Organisation for Economic Co-operation and Development (OECD), the state controlled over 50 percent of the nation’s economy. With the eurozone crisis at one of its periodic peaks, markets were unsurprisingly becoming jittery about the sustainability of Britain’s finances.

    The incoming government responded by laying out a plan to eliminate the structural component of the deficit—the part of the deficit that was not the result of the recession that began in 2008—and start to reduce the debt-to-GDP ratio within five years. This robust-sounding strategy was rewarded with an immediate 50 basis point reduction in yields on British government bonds. International institutions, such as the International Monetary Fund and OECD, praised the decisiveness of the government action. The strategy was heavily weighted towards spending cuts, rather than tax increases, in line with international evidence.

    Since then, growth has been much slower than expected. In fact, the British economy is more than 4.5 percent smaller in 2012 Q2 than 2008 Q1. But the independent Office for Budget Responsibility ascribes this slower growth to other factors: high commodity prices, the eurozone crisis, and the fact that the financial sector had larger structural problems than anyone realized in 2010. None of the standard Keynesian models predicted this continued stagnation, even after the austerity was factored in.

    But the adjustment process has not been helped by the government front-loading damaging hikes to the Value Added Tax (Britain’s national sales tax) and the capital gains tax, while cutting investment expenditure. On the other hand, the promised cuts to wasteful current spending, which exploded during the Labour years, have yet to materialise. This all means that despite all the talk about huge spending cuts, spending has actually increased in real terms since 2010, while new tax hikes have been piled on top of the tax rises implemented by the previous Labour government.

    In short, while Britain has talked a lot about spending cuts—or public austerity—it has not actually practiced it. Instead, it has employed private austerity: Citizens have less income because they are paying more taxes. Even a Keynesian like Summers should recognize that this is not likely to produce growth.

    The result is that Britain’s deficit is still above 8 percent of GDP today (almost exactly the same as the U.S.’s), and on optimistic forecasts its debt will have increased by another £600 billion by 2015, taking government debt to 92.7 percent of GDP. If Britain started borrowing even more money, its cost of borrowing would likely go up, and its credit rating would go down. For now, Britain can borrow as cheaply as Germany despite a deficit the size of Greece and a debt larger than Spain. But this is not sustainable.

    The credibility Britain gained by setting out its plan in 2010 bought it short-term breathing room. But a significant reversal of policy—of the type Summers advocates—in an open and already highly indebted economy like Britain’s, would increase the size of its deficit, and, crucially, cause interest rates to spike, which would put further downward pressure on investment and growth. The government cannot create sustained growth, though it can certainly slow it down. What is needed to restore prosperity in Britain—as in the United States—is a robust supply-side strategy to raise flagging productivity and accelerate the private-sector adjustment, alongside a continued commitment to rein in government largesse.

    The approach that Summers is recommending, on the other hand, is a return to the strategy that landed Britain in this mess in the first place: Borrow a lot, and let the future look after itself.

    Ted R. Bromund, Ph.D., is Senior Research Fellow in Anglo–American Relations in the Margaret Thatcher Center for Freedom, a division of the Kathryn and Shelby Cullom Davis Institute for International Studies, at The Heritage Foundation. Ryan Bourne is head of economic research for the U.K.-based Centre for Policy Studies.

    Posted in International [slideshow_deploy]

    One Response to Why Larry Summers Is Wrong About the British Economy

    1. Small l liberal says:

      Why do you think a supply side solution will work?
      Under the current conditions interest rates will suddenly spike???
      How significant an issue would capital gains have broadly across the population.
      Government can't create jobs or demand ????
      Military, teachers, municipal workers, hospitals and medical workers etc.
      Do hires in these areas really squeeze out private sector spending????

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