Memo to Vince Cable: lack of credit demand, not supply holds back UK economy

Talking about the risk of a double-dip in the UK economy, Vince Cable argued in yesterday’s Sunday Times that the top economic priority now is making banks lend again. His prescription is based on a completely wrong diagnosis of the current economic problem.

 It is clear there has been a significant loss of economic momentum not just in the UK but globally. This suggests global causes – not UK banks’ lending practices – are at work. I would highlight two problems.

First, high oil and food prices. These have squeezed households’ spending power and companies’ profit margins, resulting in weaker domestic demand across developed economies (in the UK, retail sales have been flat for the last year). As a result, manufacturers have seen orders fall and they are now cutting production in response.

Second, the withdrawal of fiscal stimulus – either actually (as in the UK with the VAT hike and cuts in public spending) or in prospect (as in the US). This is taking demand out of some economies and creating uncertainty about future demand which makes companies reluctant to recruit new staff and to expand their investment plans. It is likely, therefore, that the banks are right when they say that the problem is not their willingness to lend, but the willingness of households and companies to borrow.

 What are required therefore are measures to support demand.

Governments have limited room for manoeuvre on fiscal policy, but that does not mean they have none at all. Bond yields in the UK are at record low levels and the economy has grown by just 0.2% over the last three quarters.

In these extreme circumstances, the Coalition should ease the pace of fiscal tightening through tax cuts. A cut in VAT is appealing because it could be implemented very quickly – and the evidence from 2009 is that it would support demand. Alternatively, a cut in income tax targeted at the less well off, who are likely to spend most of the proceeds, would be more effective in boosting demand, though it would take longer to implement and feed through to the economy.

The Monetary Policy Committee also needs to do its bit. Last week it passed up on the opportunity to increase the scale of quantitative easing (QE) from its current level of £200 billion. There are grounds for doubting the effectiveness of additional QE on its own when consumer and business confidence are slumping, but combined with tax cuts it could help to support demand and growth in the economy.

These measures – a tax cut and an increase in QE – would not, on their own, guarantee the UK avoids a double-dip recession. That will also depend on the oil price, the verdict of the credit rating agencies on US sovereign debt and whether speculators are successful in widening their attack on Europe debt markets to encompass Italy, or even France. These global headwinds are outside our control. But policymakers here should use what room for manoeuvre they have in a coordinated attempt to counter them.