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The importance of hope

Once again, turmoil has hit financial markets. Once again, hard questions are being asked of political leaders around the world. And once again, we see both the power of market forces and the need for clear political leadership. The leadership has been found wanting, both in Europe and the US. What message should Labour have?

Investors have been concerned that some countries have not done enough to put their public finances on a sustainable footing. The financial crisis and subsequent recession saw an increase in government borrowing; the alternative was another Great Depression. As households unwound borrowing and businesses stopped investing, economies shrank. If government spending had not been maintained during that period, the situation would have been much worse.

Now, faced with high debt-to-GDP ratios, countries are adopting so-called austerity measures and reining back spending. The question has been whether or not these plans are credible. If investors have doubts, they will assume the risk a country will default on repaying its debt has risen slightly (or, in the case of Greece, a lot). That means the interest rate a government will have to pay to sell new debt may rise, depending on what else is going on in markets. So borrowing can become more expensive, which means a higher interest bill, which means more debt. We are now seeing a further stage to this sovereign debt crisis. Governments are tightening their austerity packages. For example, last week Italy brought forward its deficit cutting plans. But governments may be behind the curve if there is a growing focus on growth.

If governments cut spending and raise taxes too far and too fast, they risk undermining the economic recovery. Lower growth usually translates into lower tax revenues and higher unplanned spending on areas such as welfare, putting upward pressure on government debt. If a government goes too far in this direction it can end up with high debt levels but little or no growth. Markets will not reward governments with impressive plans to cut spending if they worry that growth has been undermined and a second recession is likely. Bond investors can change their focus more quickly than governments can act. Finance ministers have to perform a delicate balancing act. They cannot ignore financial realities and must encourage recovery now while being credible on public finances. Their plans can be derailed if other countries hit growth prospects.

So far, the UK has remained aloof from the turmoil in Europe and the US. Yet GDP grew only 0.2 per cent in the second quarter and some of the more recent data looks poor. It could be that the world is going through a pause in activity, perhaps linked to the disruption to supply chains caused by the Japanese earthquake. It is too soon to tell. But the events of the past few weeks could dent economic confidence. In practice, that could mean that businesses put on hold their plans for the future because the uncertainty is too great. If their fears of another recession grow, they might reasonably decide that investing in new equipment or expanding into new markets is too great a risk. Families and individuals may continue to rein in spending if they perceive that wage growth will remain muted while taxes will rise and spending cuts continue.

In such situations, political leaders must act decisively. At the moment, they are reacting to events and following a neoliberal agenda on deficits. Yet if growth falters, we may be in a difficult position indeed. Governments need to reduce uncertainty by providing a clear framework for sustainable growth alongside a credible – but not ideologically driven – plan to control debt. In doing so, they can help boost confidence. What message should an opposition party have in these times? As I have suggested before, Labour, out of government, needs its economic policy to focus on how we can invest for our future, translating that into practical outcomes for people. Hope is an overused word in politics but there is a need for an economic policy that has at its core a firm hope in our future potential.

This article was first published on the Progress website, on 8 August 2011.
Progress, 8 August 2011, 09/08/2011

Not an easy task given uncertainties, especially if energy and commodity prices do fall later in the year. Ultimately, radical economic reform required.
Central banks are struggling to head off general inflation while dealing with price shocks that will be negative for growth. They waited too long, which has made their tasks more difficult.
The Bank of England has raised interest rates, but that does not mean it has been most effectively managing inflation risks.
The Bank should signal it will act if higher prices look likely to translate to higher inflation rate.
The IMF's Fiscal Monitor is actually quite radical.
Spare a thought for finance ministers, and the opposition counterparts who aspire to replace them. The conventional wisdom was that they should at least make an attempt to follow fiscal rules. Now, there are no rules.
My letter in the Financial Times on the need for a framework for economic policy decision-making.
Responding to Brian Griffiths' article in The Article on the risks of inflation.