Andrew Lilico is Policy Exchange's Chief Economist.
This morning’s GDP data constitute a horror story for businesses, for unemployment prospects, and for the public finances. Contrary to the expectations of only a few weeks ago that the second quarter might have been flat (neither growth nor contraction) or even of the consensus expectation this morning of a 0.3% contraction, GDP in fact contracted by 0.8%. Government Ministers have attempted to spin this as a “considerable easing in the downturn”. “Easing” of this sort, if sustained for the rest of the year, would result in a full year contraction of above 5.2% of GDP – worse even than the peak of the Great Depression in 1931.
It is clear now that in Q2 we have only the shrivelled yellow shoots of recovery, probably largely as the result of an inventory snapback (in the final quarter of 2008 and the first quarter of 2009, companies produced little and ran down their inventories to very low levels, so that in the current quarter it was necessary that firms should increase their production, just in order to avoid running out of stock). Looking forward, it is now less likely that the third quarter will see growth, but my view remains that we will get growth in the fourth quarter and perhaps also in the first quarter of 2009.
This will mean that, going into the likely General Election period, the Government will be able to claim that growth has returned. It will probably seek to take credit for this growth, as a result of Government policy. It will be correct, and that is a problem. Because the growth over those six month will, in my view, be the inevitable lagged effect of a one-off massive policy stimulus consisting of interest rate cuts of more than 5%, a doubling (perhaps by then a tripling) of the monetary base (the quantitative easing programme), and a £200 billion budget deficit. If economic stimulus on this scale does not result in at least one or two quarters of growth then the economists might as well go home.
So the question is not whether we might get a quarter or two of growth. It is what happens next. Precisely because this growth will indeed be the result of policy, it will not be sustainable or sustained. Consequently, the economy will probably already be contracting again by the time of the General Election and an incoming Conservative Government is likely to be faced with an instant further phase of recession to add to its challenges. I believe that this will be much more mild, however – probably only lasting six months and taking only 1-1.5% off GDP.
Any incoming Tory Government must not allow this further phase of recession to deter it from the urgent action required on spending. Indeed, the depth and extended nature of the recession makes it all the more urgent to cut spending quickly - and means that ultimately spending cuts will need to be greater. An emergency Budget should schedule spending cuts of the order of £40 billion in the first year, and probably of order £20 billion in each of the following two years. Further cuts for later years will be necessary and appropriate and can be announced subsequently.
As Policy Exchange has argued previously, even the 2009 Budget schedules implied aggregate spending cuts of around £95 billion, with most of them scheduled from 2014-18 – far too slow and rather too little. I believe that around £80 billion of cuts in the first three years, announced almost immediately upon taking office, is the minimum required to retain credibility in financial markets (this is up from the £55-£65 billion Policy Exchange argued as the minimum in its recent paper, because the recession is proving even worse than expected then). There must of course be tax rises as well, but the overwhelming balance of fiscal adjustment must fall on spending cuts, and such cuts must happen straight away. They are now a matter of financial necessity.
