This week I wrote a post about escape velocity – the idea an economy stuck in recession needs a decisive burst to escape a liquidity trap, low spending and low confidence. If an economy can return to this normal trend rate of economic growth, we can end the period of ultra low interest rates and engage in fiscal consolidation without harming economic growth. Unfortunately, when you’re in a liquidity trap to achieve this escape velocity requires a certain decisiveness, political courage plus understanding of basic macroeconomic theory.

Unsurprisingly, this year’s budget gives not so much a decisive burst, as more an attempt to use a few plastic bands to try and patch up a leaking ship.

In the past five years, the UK economy has shrunk 3% – making the recession longer lasting than even the 1930s. The past three years have seen stagnant economic growth, with no sign of falling unemployment or rising living standards. What the past three years have shown is that in a liquidity trap (interest rates or 0%) tight fiscal policy is contractionary –  no matter how much you try to engage in unconventional monetary policy. The chancellor is still hoping that the Bank of England can work miracles, whilst he reduces government spending. The evidence of the past three years is not encouraging.

Yet, despite clear evidence of the damage done by premature fiscal tightening, the chancellor ploughs on with his plan A – seeming to spend most of his time blaming what a mess we are in. In Europe, EU policy makers have, in the past, attempted to appeal to the confidence fairies. The idea that cutting the budget deficit will restore confidence in the economy and lead to a miraculous economic recovery. The current government also tried to go along with this. The only problem is that it miserably back-fired – with confidence slumping after the 2010 election. The confidence trick of austerity has become one of the great jokes of the past few years – except it’s a joke without much humour.

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Readers Question: to what extent did the EU recession cause the UK recession?

In economics often several factors occur at the same time, and it is difficult to give a weighting to the importance of each factor. To some extent, people will emphasise the factors which best suits their outlook / beliefs.

It is no surprise that the government prefer to blame the double dip UK recession on ‘unavoidable weakness in the European economy’. It is similarly no surprise the opposition blame the government’s austerity approach adopted in 2010.

In theory, the European recession of 2012, will effect the UK economy in the following ways:

• Lower export demand. With Europe entering recession, they will buy less goods and services, including less demand for UK exports. UK exports to Europe account for around 13% of GDP and so it is reasonably significant. Lower export demand to Europe can have a knock on effect to other related industries, and a possible negative multiplier effect – causing a bigger final fall in real GDP.
• Reduced confidence. Europe sliding into recession will harm business and consumer confidence. With our main trading partner struggling, firms are less likely to invest in increasing capacity. Also the financial instability in Europe is making banks more nervous and reluctant to lend.
• Lower inward investment. A recession in Europe will create a disincentive for European firms to invest in the UK leading to lower growth.

Evaluation

But, how important a factor is the European recession?

1. Exports to Europe have not fallen significantly

UK exports to the EU increased between 2009 and 2012  by 6.5%. Exports to non-EU countries increased at a faster rate. During this period, the UK current account deficit increased – because demand for imports increased at a faster rate, and if Europe had not gone into recession, we may have seen a bigger increase in exports. But, overall this still suggests that falling exports to Europe were not the main cause of the recession. 

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