In his autumn statement today the chancellor claimed it was his deficit reduction plan that enabled the British government to borrow money even more cheaply than the Germans, thus saving the taxpayer £21bn in interest rate charges over five years. Ed Balls rejoined that “he still clings to the illiterate fantasy that low long-term interest rates in Britain are a sign of enhanced credibility and not, as they were in Japan in the 1990s or in America today, a sign of stagnant growth in our economy”. The intellectual debate between George Osborne and his critics hinges on this single point: what is it that makes a deficit-reduction programme “credible”?
Let’s start with the theory of the matter. “Look after unemployment,” JM Keynes said, “and the budget will look after itself.” This was a neat way of saying that a credible deficit reduction plan depends on growth. All governments have large deficits at present because their economies have shrunk. The deficits will decline automatically as their economies start growing.
But policies of deficit reduction will not in themselves produce growth. Nor will they eliminate the deficit. Trying to reduce the deficit by cutting spending and raising taxes means taking spending power out of the economy, when what a depressed economy needs is more spending. A government can always cut its own spending. But it cannot control its income. If cutting its spending leads to a fall in its revenue, it is little nearer “balancing the books” than before. One person’s spending is another’s income. If the government reduces the economy’s spending, its own income will fall.
This grisly truth is at last starting to pierce the fog of rhetoric. The latest report of the Office for Budget Responsibility predicts that the government will miss its borrowing target this year because of reduced revenues. Even though it has cut spending by more than its goal, the fall in tax revenues – £15bn less than expected this year – has knocked it off target.
The economy has not grown for a year and, says the OECD, is now likely to contract. Lower growth over the next five years means the government will have to borrow £111bn more than planned. The brief recovery is over. The shrinkage in demand is becoming a collapse. Unemployment will still be rising in 2013, real wages will continue to decline and as households stop spending, company profits will suffer. The deficit will not be gone by 2015. Even to get rid of it by 2017 – the latest estimate – will require a further £23bn of cuts. But as these will reduce growth even further, the elimination of the deficit can safely be postponed to never-never land.
We come to the question of confidence. The chancellor has repeatedly claimed the deficit reduction programme was, and is, necessary to maintain investor confidence in government finances. Confidence is very important, but also mysterious: the bond markets can believe a dozen contradictory things before breakfast. The main point is that confidence cannot be separated from the economy’s performance. As it stalls, the creditworthiness of governments declines as their debt increases, raising the likelihood of default.
A year ago bond traders, having forgotten what little economic theory they knew, were inclined to believe that deficit reduction would in itself generate recovery. For several months the Osbornites fed them the fantasy of “expansionary fiscal contraction”, the idea that as the deficit falls the economy would expand. This story is now exploded. It’s the economy that determines the size of the deficit, not the deficit that determines the size of the economy.
The chancellor is right to say that Britain is not at the “centre of the sovereign debt storm”. But for how much longer? The eurozone financial crisis – on both its sovereign and commercial bank sides – is the direct result of policies which have brought about the slowdown of the European economies. From August to September industrial production turned sharply downwards in the EU, and especially the eurozone. But our government has been pursuing the same policies, with the same results. This suggests that, without a change of policy, the price of our own government debt will start to go up.
I agree, therefore, with Ed Balls. The government’s debt-reduction strategy is not credible, either as theory, or in term’s of maintaining the markets’ confidence. The chancellor’s plan would have looked good had it worked. It has fallen so far short of it that Osborne sees the need to introduce a subplot into the main narrative. This goes under the name of “credit easing”.
He has authorised the Bank of England to buy an extra £75bn worth of government bonds – known as “quantitative easing” – to increase the reserves of the banking system. Then there is “credit easing”: banks will be given government guarantees to raise money more cheaply provided they lend to small and medium-sized businesses. The government will offer to secure part of the loans taken out by first-time buyers of new-build homes, enabling them to get larger mortgages with a smaller deposit at lower interest rates. The government also intends to “mobilise the finance” for an infrastructure programme, though how it can get the pension funds on board without subsidised interest rates and/or guaranteed income streams is not clear. These are steps in the right direction. But, according to the OBR: “It is far from clear how much additional lending [credit easing] will create.”
What the chancellor is trying to do is to increase the supply of credit. But the austerity side of his policy is choking off the demand for credit by reducing the market. The new policy is therefore incoherent. What we need is not a subplot but a new narrative, which recognises that the most important requirement for recovery is to increase total spending in the economy. In this story, increasing capital spending is the main plot, cutting current spending the subplot. The chancellor is edging towards this, but he has not arrived. Events may force the pace.