The Duncan Weldon Economics Matters Column
The strongest economic case against the government’s aggressive deficit cutting agenda is that it risks being self defeating – as demand is sucked out of the economy by falling government spending and tax rises, could lead to weaker growth and higher unemployment. Less people in work leads to less tax revenue coming in and higher spending on unemployment benefits – the money saved from spending less could be outweighed by the fall in receipts and the extra costs to the welfare bill.
Today’s figures from the Office of National Statistics suggest that this could in fact be occurring. Despite January’s rise in VAT and the beginning of the bulk of the cuts programme, government borrowing in the first two months of this financial year has been higher than in the previous financial year.
Government borrowing in April and May 2011 has been £27.4bn, against £25.9bn in the same two months of 2010 – an increase of £1.5bn. Perhaps the most interesting figure though comes not in the headline borrowing but in the underlying data. Central government spending on ‘net social benefits’ rose by £1.9bn in April & May 2011 compared to 2010 – in other words the overshoot in borrowing is being caused by a rising welfare bill, exactly the charge levelled against Osborne when he set out his detailed plans one year ago.
None of which is to suggest that action doesn’t need to be taken to bring the deficit down, but the approach Osborne has adopted is highly unlikely to succeed – and even if it does it will come with an unnecessary social cost in terms of higher unemployment.
Last year the IMF’s Chief Economist Oliver Blanchard wrote ‘Ten Commandments’ for fiscal adjustment, the second of which was “you shall not front-load your fiscal adjustment, unless financing needs require it”.
George Osborne has chosen to front load his own adjustment. As Ed Balls argued last week at the LSE this reflects a political timetable – he aims to get the pain out of the way by 2014, allowing him to offer tax cuts and better times in the run up to 2015. Whilst he may argue that the UK’s ‘financing needs require’ a front loaded adjustment, there is little evidence for this. The yield on UK government bonds (the cost of government borrowing) has stayed at near historic lows – there was no sign that the markets were calling for such an aggressive programme before Osborne came into office.
“The government claim that cutting the debt will lead to ‘expansionary fiscal contraction’ and a ‘rebalancing of the economy towards net exports and investment’. This is unlikely to be correct, the evidence (see this post for example on recent IMF work) suggests that austerity policies lead to weaker growth – especially if interest rates are already low or cannot fall further. I’d have much more time for Osborne if he acknowledged that the cuts will hurt growth but argued that not cutting as fast and deep as he plans would risk a loss of market confidence and problems funding the debt. That’s a justifiable and reasonable position to hold.
We face a trade-off between cutting and hence harming the economy and not cutting and hence risking a loss of bond market confidence. The real debate, away from the shouty world of Westminster, is about the balance of risks.
Taken together I think the UK’s low stock of debt, the low interest rates it attracts and the debt profile outlined above more than offset the high deficit. I think the risk of cutting as fast and deep as the government intends is far worse than the risk of a loss of confidence. I certainly don’t say that there is no chance the markets would lose faith in a British government that’s adopted a different approach, I just think the balance of risks points towards a less extreme and more growth friendly fiscal package.”