I don’t wish to examine the structure of George Osborne’s emergency Budget, but to analyse its logic. On the structure I have only this to say: the balance between increased taxes and reduced spending is probably right. It is right to demand sacrifices from all sections of the community, though I doubt the attack on welfare benefits (designed to save £11bn a year by 2014-15) will be seen by many as fair. And there are a number of useful measures to encourage enterprise. My objection is to its overall fiscal – and ideological – stance. It is deflationary – not as deflationary as the Chancellor’s rhetoric demanded – but deflationary all the same.
At a time when the UK economy has an estimated “output gap” – the gap between what the economy is producing and what it has the potential to produce – of between 4 and 6 per cent (the Government’s figures), I do not believe the Government take money out of the economy; it should pump it in. I don’t understand how you help growth by reducing spending. But let’s start on the macroeconomic analysis.
First, a short lesson in Keynesian macroeconomics. I make no apology for starting here, because what is at issue are two opposing theories, or “models” of the macroeconomy. The message of John Maynard Keynes’s General Theory of Employment, Interest and Money (1936) comes in three parts. First, the community’s level of income and output is determined by the level of aggregate demand, or purchasing power. Second, consumer demand, especially investment demand, can fall short of the supply of goods, so that the community’s available stock of labour and plant can exceed the demand for their services. Third, this situation can continue indefinitely, in the absence of an outside stimulus to replace the missing private sector demand.
Now compare what happened in 1929-1932 (the Great Depression) and what has happened since 2008 (the Great Recession). In both periods the world economy declined at the same rate for five quarters. But whereas the Great Depression economy went on declining for another seven quarters, the Great Recession economy’s decline stopped after five quarters, and there has been a very modest recovery. Almost all analysts agree this was because this time, unlike in the earlier period, governments all over the world poured a huge amount of extra money into their shrinking economies. Many allowed their deficits to expand from about 2 per cent of GDP to 10 per cent; and their central banks flooded the banks with new money.
This was good old fashioned Keynesianism. In a slump, Keynes said, governments should increase, not reduce, their deficits to make up for the fall in private spending. Any attempt by government to balance its budget in a slump would only worsen the slump.
Compare this to the key sentence on the first page of HM Treasury’s Budget 2010: “Reducing the deficit is a necessary precondition for sustained economic growth” – an almost exact reversal of Keynes’s theory. We have to understand that the Treasury is under new management and what it believed three months ago is not necessarily what it believes today. What we do know is that its new master, George Osborne, never believed in the stimulus. On 30 October 2008, six weeks after the collapse of Lehman Brothers, he compared a fiscal stimulus to “a cruise missile aimed at the heart of the economy”. For the last two years he has been calling for the elimination of the stimulus as quickly as possible.
What theory of the economy makes sense of Osborne’s attitude? He has never allowed himself the luxury of explicitly offering a theory. But his “model” can be inferred from his pronouncements. It can be boiled down to three propositions of expanding generality: (1) in the absence of the fiscal stimulus, the economy would have rapidly recovered to full employment; (2) following a shock, economies quickly self-adjust back to full employment in the absence of counter-productive government efforts to revive them; (3) markets are optimally self-regulating in the absence of government interference. Osborne has never said any of this precisely, but his pronouncements make no sense unless he believes this. So it is between these two views – Keynes’s and Osborne’s – that we are invited to choose. Let’s see how far the new Treasury view endorses the Osborne view.
What the Government aims to do is to add an extra £40bn to Labour’s deficit reduction plan, both by starting earlier and by cutting faster. That is, it aims to have removed, by 2014-15, £40bn a year from the private sector in addition to the £73bn which Labour had wanted to remove by then: a total fiscal tightening of £113bn, or two-thirds of the current deficit. This augmented degree of fiscal tightening should eliminate entirely the “structural” deficit by 2014-15, leaving only a vestigial public sector net borrowing requirement of 1.1 per cent by 2015-16; it will also cause the decline of public sector net debt from a peak of 70.3 per cent of GDP in 2013-14 to 67.4 per cent of GDP in 2015-16. In a nutshell, Osborne aims to balance the Budget by 2014-15.
Two questions arise: why does the Osborne Treasury suppose that the UK Government’s deficit had reached £155bn, or 11 per cent of GDP by 2010? And by what mechanisms does it suppose that removing increasing amounts of money from the economy will help the recovery.
To answer the first, let’s look at some more figures: between 2002-3 and 2007-8 the Government’s annual deficit averaged 2.5 per cent of GDP. In 2008-9 it shot up to 6 per cent and in 2009-10 to 11 per cent. Between 2002-3 and 2007-8 the national debt rose from 32 per cent of GDP to 36 per cent, still well below 40 per cent, which Gordon Brown had laid down as the “prudent” maximum, before rising to 44 per cent in 2008-9 and 62 per cent in 2008-10. This deterioration in the national finances has been mainly caused by the decline in the economy, so the Government has been getting less revenue and is having to spend more on social benefits. One might suppose that most of it would be reversed as the economy recovers, without any change of policy.
But this is apparently not so. The Treasury now argues that its Comprehensive Spending Review of 2007 assumed “unsustainable revenue streams” based on a property boom and excess profits in the financial sector. Worse, for years, the Treasury had been overestimating the sustainability of its revenues and therefore of its spending. Or, put another way, the Treasury’s pre-recession projections of taxes and spending assumed an inflation rate of 2 per cent, or nominal GDP growth of between 4 and 5 per cent. Once the recession hit and inflation started falling, nominal GDP fell faster than real GDP, leaving a larger than expected gap between revenue and spending.
What the recession did was “reveal that the public sector was living beyond its means”. This is an odd way of putting it. Whenever you have an economic collapse, you are “revealed” to be living beyond your means, as the revenue side of your balance sheet falls. But does that mean you had previously been living beyond your means? Surely not. That you can’t support yesterday’s spending with today’s income does not mean you could not do so yesterday. The only thing the slump reveals is that some event has cut your income and you need to adjust your spending. Moreover, the private sector was just as guilty of “living beyond its means”, a fact conservative commentators prefer to avoid. Both levels of indebtedness was about 100 per cent of income.
Was the boom the fantasy, the slump the reappearance of reality? The answer is that the boom was neither more nor less real than the slump. The idea that asset prices in the boom were too “high” presupposes that there existed a set of objectively correct prices from which boom prices deviated. But where do such objectively correct prices come from and why are they more correct in a slump than in a boom? Expectations are only wrong in retrospect. Assets are worth no more and no less than buyers are willing to pay for them – regardless of whether we are in a slump or a boom.
My second question is: how does the Government suppose that taking money out of the economy is going to help recovery? We get an initial answer on page nine of the Budget statement: the deficit reduction plan “should underpin household, business, and market confidence”. Notice the “should” here. The Treasury, unlike the Chancellor, is hedging its bets.
In the “medium term”, ie over five years, deficit reduction will: “reduce competition for funds for private sector investment…” thus lowering long-term interest rates and boosting private sector investment. This has long been the Chancellor’s main argument. It is loaded with fallacies. First, it assumes there is a fixed supply of saving, so that the more saving borrowed by the Government, the less will be available to be borrowed by the private sector. This is true at full employment, but untrue when there are unemployed resources. If the economy is underemployed, an increase in the government deficit does not encroach on existing saving; it creates additional saving by raising the national above what it would have been. This additional saving helps finance the increased borrowing.
Secondly, the “crowding out” argument assumes that interest rates adjust the supply of saving to the demand for investment: the more saving “released” for private investment, the lower long-term interest rates will be. Keynes denied that interest rates adjusted the supply of saving to the demand for investment. Rather, interest rates adjusted the supply of money to the demand for money. If the demand for money, or more generally liquidity, is going up as a result of increased uncertainty, then the interest rate will go up, whatever is happening to saving. It may even resist attempts by the Government to lower it by flooding the banks with money. This is what has been happening: banks and money markets are awash with cash, but little of it has been trickling through to the business sector. Investment has fallen by 20 per cent since the start of the recession.
The Treasury’s “crowding-out” argument is bogus. Its argument about the beneficial effect of accelerated deficit reduction hinges on its effect on confidence. The proposition is that it will reduce the perceived risk of investing in Britain. This psychological boost will be sufficient to offset any negative effect of accelerated retrenchment on demand.
I would not for a moment decry the importance of psychology. We live in an uncertain world in which decisions to invest depend on subjective estimates of risk. Osborne’s argument is that deficits do positive harm by destroying business confidence. This may come in several forms – fear of higher taxes, fear of default, fear of inflation. Deficits thus delay the natural (and rapid) recovery of the economy from an unexpected “shock”.
However, this view has an unpalatable corollary. It implies that markets must always be appeased, even if they are wrong. What market participants believe to be the case becomes the case, not because their beliefs are true, but because they act on their beliefs. In short, it may not be the case that government borrowing crowds out an equal amount of private investment. But if markets believe it does, then government borrowing should be curtailed. This is equivalent to demanding a capitulation of governments to market ideology.
How far does Osborne’s Treasury buy the Chancellor’s argument? The answer is: by no means completely. The basis of its scepticism is reinforced by a body which Osborne set up to monitor the Treasury’s projections: an independent Office for Budgetary Responsibility (OBR) chaired by former Treasury official, Sir Alan Budd.
The OBR’s central economic forecast is for “the economy to rebalance, with net exports and business investment making a greater contribution to growth than in the recent past, and government spending making a negative contribution to growth as fiscal consolidation is implemented”. To translate into English: tax rises and spending cuts will tend to reduce growth in the near future by reducing consumer demand, but this may be offset and even outweighed in the medium term by increased confidence. Specifically “reassuring the private sector that concrete measures have been put in place to limit the rise in government debt could prompt households and companies to reduce precautionary saving, increasing consumption and investment relative to what they would have been otherwise”. The bottom line here is the conclusion that “fiscal consolidation will negatively effect the economy in the short term”, but this could be offset by favourable effects on business confidence. The blow to demand is definite; the psychological offsets are hypothetical.
But the Treasury does not rely on “confidence” alone. It is also placing its hopes on the supply-side reforms of the Budget. “Measures to promote enterprise will reduce regulation and tax rates and refocus support towards infrastructure, the low carbon economy and regional development. Measures to create a fair tax system will reward work and promote economic competitiveness.” These measures will promote “sustainable” growth, not the “artificial”, deficit-created growth. And so they may. But they do not address what happens in the short term.
And, finally, if confidence doesn’t do the trick, the Treasury looks to monetary easing to offset the effects of fiscal austerity, even though the policy of “quantitative easing” has failed so far to bring down long-term interest rates enough to stimulate private sector borrowing.
So that’s the gamble on which the coalition has staked its fate, and that of the British economy. An important footnote is an exchange between President Roosevelt and Keynes in 1938. From 1933 to 1937, America had experienced four years of recovery since the Depression, with unemployment falling from 25 per cent to 14 per cent. Keynes attributed this recovery to the solution of the credit and insolvency problems and establishment of easy short term money; establishment of adequate relief for the unemployed; public works and other investment programmes helped by government funds or guarantees; the surge in private investment, and the momentum of the recovery. By the time of Keynes’s letter to Roosevelt on 1 February 1938, however, the American economy was experiencing a “double dip” recession: unemployment had gone up from 14 per cent to 18 per cent, industrial production had fallen by 21 per cent and real GDP by 3.5 per cent. Keynes attributed this to the premature curtailment of the public works programme, as Roosevelt tried to “balance the budget” in 1936-37. Keynes’s letter marks the start of the “Keynesian” phase of the New Deal which, by 1941 had reduced unemployment by 8 percentage points.
Whose judgement – or ideology – do we trust, Keynes’s or Osborne’s?