As already noted the decline in investment is the driving force behind the recession and the subsequent failure to recover to the previous peak level of output. Private sector investment accounts for 79.8% of that total shortfall. As the chart shows public investment moved in the opposite direction, increasing through 2008 and rising sharply in 2009 and peaking in Q1 2010 – the last quarter of the Labour government.
By the time GDP began to recovery modestly in Q4 2009, public sector investment had risen by an annualised £10.5bn. This was far greater than the initial rise in GDP, which was just £6.1bn higher. Therefore the rise in public sector investment was entirely responsible for the recovery.
Private sector investment did not rise as soon as the economy began to expand. It began to rise only after recovery had begun. Since all private investment is determined by anticipated profits, this inability of the private sector to lead the recovery is no surprise.
However, over the course of 2010 private sector investment was the biggest single contributor to growth rising by £22.3bn. Private sector investment increased as a result of growth fostered by the sharp increase in the level of public sector investment.
But instead of understanding that public sector investment was leading to economic recovery, including stimulating private sector investment, both the Coalition government and the OBR subscribe to the idea that government spending ‘crowds out’ the private sector and if public spending is cut, private investment will increase. The opposite is the case. Government investment ‘crowds in’ private investment.
This false idea is also demonstrated by the negative reaction to the subsequent cut in public sector investment. Public sector investment peaked in Q1 2010 where it was 38.4% higher than at the end of the prior business expansion. It began to fall as soon as the Coalition government took office in Q2 2010. Shortly afterwards, in Q4 2010 GDP began to stagnate. Immediately afterwards, private sector investment began to contract once more.
Technical Issues
For those readers interested in these topics, this next section deals very briefly with some interesting technical issues highlighted by the recent zig-zagging of the British economy- from recession to recovery to stagnation. Other readers can skip straight to the Conclusion.
Leading and lagging indicators: Public investment has clearly behaved as a lead indicator for the economy as a whole. Private investment is a lagging indicator. While public investment rose continuously throughout the recession, the significant increase did not take place until after the March 2009 Budget, when the rate of increase doubled. GDP responded two quarters later, in Q4 2010. Private sector investment responded 3 quarters later by recording its first rise in Q1 2010.
Similarly, public investment began to fall in Q2 2010. GDP contracted two quarters later, in Q4 2010. Private investment fell once more 3 quarters later in Q1 2011.
Multipliers: The OBR concedes a point that is almost unanimous in the literature – that the multiplier effect of government investment is greater than all other types of government spending. However, hamstrung by the notion of ‘crowding out’ and determined to promote it, the OBR’s multiplier for government investment is just 1, meaning that there is no more economic effect than simply the government spending itself. Its multiplier for cuts in welfare is 0.6 and for a VAT hike is 0.35, meaning that both of these have far less than the effect of government cuts or increased spending. Bizarrely, the logic is that private agents, both households and businesses, become more confident because of the cuts, and so offset their effects by increased spending and investment.
The economy’s recent gyrations provide evidence to the contrary. It is impossible to determine the precise effect of increased government investment in stabilising the economy prior to actual recovery. But it has already been shown that a cumulative rise in public investment of £10.5bn led to a rise in private sector investment of £22.3bn. This alone is a multiplier of 2.12. The rise in investment will also have boosted household incomes a well as government income (both via increased tax revenues and lower welfare outlays than otherwise). But, as a minimum, it can be stated that the multiplier from government investment is higher than 2, and is likely to be considerably higher.
Conclusions
The recession was driven by the collapse in private sector investment. The fall in household consumption was also important, much more so than in the OECD as a whole.
The resumed private sector investment strike now accounts for close to 80% of the entire output loss since the recession, and the economy remains more than 4% below its prior peak level.
The government and the OBR promote the notion that cuts to government spending will lead to spending in the private sector from households and businesses. The opposite has been the case. The entire recovery was engendered by the rise in public sector spending and private investment followed later.
The Coalition government has reversed the rise in public investment through its cuts policy. This has led first to stagnation and now contraction of private investment in Q1 2011. The fall in private and public investment combined more than accounts for the entire slowdown in the British economy in the last two quarters. Tory policies have wrecked the recovery. Only a rise in public investment can revive it.
First posted on the Socialist Economic Bulletin >
Notes
1. OBR, March 2011, Economic and Fiscal Outlook
2. Treasury, June 2010 Budget, Table C8.