Britain's Strange Recovery - Part II: A Keynesian Interlude

If Britain's recovery doesn't conform to the various explanations popularly offered about it, we are faced with the need to develop an alternative narrative that isn't contradicted by  the available data.

One solution offered simply retorts that there's no mystery, simply another demonstration of Keynesian economics: Britain was subjected to a bout of fiscal austerity which only now is being lifted.  As it is lifted, so growth renews. It is a tempting explanation, because as the chart shows, the fall in the fiscal deficit which took place between 2010 and 2012 has subsequently stabilized, and this has indeed coincided with the growth recovery. (The measure of the deficit I'm using is the public sector net cash requirement, ex-interventions). The deficit was cut by 1.1pp in 2010, 2.2pps in 2011 and 1.8pps in 2012, but by only 0.1pp in 2013, and it was only in 2013 that the recovery began to be felt.

It seems quite clear that the economy recovered during a lull in the fiscal headwinds, and that this was and currently is an encouraging factor.

But there are several reasons to doubt that this is the major factor driving Britain's recovery. The first is simply statistical: even comparing changes in the 12m movement of fiscal deficit and GDP growth since 2010 – a test so friendly to the Keynesian interpretation that I felt guilty doing it – finds no statistically significant correlation between the two. That's discouraging but doesn't doom the explanation.

But the second does: the timing simply doesn't fit with the recovery in the UK labour markets: the sharp and sustained rise in UK employment started for earnest late in 2011, a full year before the fiscal squeeze was relaxed. Normally, employment is considered a lagging indicator, not a leading indicator. Actually, the mismatch is more dramatic than that: , the recovery of private sector employment started no later than mid-2010, and continued even as public sector employment was cut – the divergence between the two continues to this day. Between 1Q 2010 and end-2013, public sector employment fell by 816k whilst private sector employment jumped by 2.145mn.

No matter what school of economic thought you bend to, it is absolutely fundamental that a cause must precede its effect – and in this case, it doesn't.

And the third reason is simply the failure of the world's Keynesian modellers to call it right: step forward Olivier Blanchard, the IMF's chief economist, who, in cutting the forecast for UK GDP famously warned just over a year ago that Britain's fiscal policy was 'playing with fire' and that there was 'the danger of having no growth, or very little growth, for a long time.' Nobody's perfect, and no economist looks smart when faced with his forecast failures. Nevertheless, if the explanation for Britain's recovery is Keynesian, it's fair to say that the Keynesians didn't spot it.