We need to invest in infrastructure if we are going to reduce the deficit

The public sector cuts have led to a lack of investment, and now we are paying the price as the deficit refuses to be reduced, writes Cormac Hollingsworth.

The Financial Times (FT) reported this morning (£) that it projects the coalition will borrow more because of the “downgrades in the output gap”. The output gap is the estimate of the gap between expectations of aggregate demand (demand from all sectors of the economy – businesses, not-for-profits and the public sector) and where aggregate demand actually stands.

A downgrade in the output gap suggests a fall in expectation of aggregate output. It’s the latest sign of what we’ve been worried about since July: the public sector cuts collapsing aggregate demand which feeds into higher borrowing.

If it’s just that some “output gap estimate” that’s wrong, then there’s nothing for the coalition to worry about as they can just blame their whipping boy, the Office for Budget Responsibility, for the wrong predictions, while they slash another chunk off aggregate demand with another round of cuts.

The FT also notes the downgrade of the output gap by the IMF and Bank of England recently. As a result of less output generating fewer tax receipts, the newspaper believes that the structural deficit for 2011-12 will be £12bn.

It is useful for the Monetary Policy Committee to estimate the output gap – a smaller output gap would lead to  the committee considering the raising of interest rates.

The output gap is a reflection of the collective decisions of producers. It reflects their decisions on whether or not to invest, and whether or not to keep hold of their employees. In other words, if businesses, not-for-profits and the public sector increase investment and employment, this will encourage greater expected demand.

 The Bank of England said in its Inflation Report in August (where it downgraded the output gap) that there are mixed signals on the productivity of our companies:

“Labour productivity remained well below the level associated with a continuation of its pre-crisis trend, perhaps indicating a substantial amount of underutilised capacity within companies.

“That contrasted with survey measures of capacity utilisation, however, which pointed to there being only a small margin of spare capacity.”

Companies have been hoarding labour and cash – that is holding on to employees and saving – waiting for a pick-up in demand. On the one hand labour hoarding is occuring. Firms are holding on to their employees at the present time because they expect to need these workers once the economy properly recovers.  

The employment figures are higher than they should be at this stage of the cycle due to this labour hoarding, but investment has collapsed as a result of the public sector cuts as employers save instead.

Both are consequences of the collapse in confidence that the coalition engineered ahead of the Comprehensive Spending Review a year ago . While labour hoarding increases spare capacity, the fall in investment and the depreciation in capital has caused spare capacity to fall.

The overall fall in spare capacity is what is closing the output gap and causing expectations of output to fall. The Bank of England, while downgrading the output gap acknowledge the effect on low expected aggregate demand and how it feeds through to the productive capacity of our economy:

“[The strength of the recovery] will also depend on whether the desire of companies to initiate deferred projects or to increase capacity in those sectors benefiting from the rebalancing of the economy is sufficient to support a recovery in business investment, against a general backdrop of only modest economic expansion.’

It all comes back to the public sector cuts – the downgrade of the output gap is because of the collapse in aggregate demand.

One final point – if the output gap is low, then that means we have capacity to improve the supply side by investing in infrastructure. That’s what we’ve been calling for on Left Foot Forward for a number of months now, with each growth downgrade it becomes more urgent.

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