[This is cross-posted on Freethink, where there have been many posts on the subject. ]

When to start cutting the deficit? or “the sequencing of fiscal strategies”, as Adam Posen might have put it.  Last week the Tories took what they happily described as a gamble in laying out in (misleading) depth how they would cut the deficit.  Some of it sounded nasty, and for that reason might deserve applause (which I gave, grudgingly). The Economist has been more fulsome.

The temptation was to continue to spout generalities rather than specify cuts, for fear of scaring the voters. Instead [Osborne] spelt out some of the harsh medicine needed to deal with the huge budget deficit . . . He shirked neither the scale of the problem nor the harsh measures required to solve it. Most public-sector pay would be frozen in 2011, various middle-class breaks would go, rich people’s taxes would rise and everyone would have to wait a year longer before getting their state pension

Sure, really tough decisions have to be faced at some point in the next 5 years.  But when? Are the Conservatives – doctrinaire and dangerous to quote Kettle – so determined to start on Day One that they might scupper the economy in the process? What if they are possessed of a faulty economic ideology, one that fetishizes 1981, and thinks that any amount of fiscal cutting can make no difference?  See Osborne, September:

Ben Broadbent, Chief UK Economist at Goldman Sachs, wrote recently that fiscal tightening in an open economy “has little appreciable impact on aggregate output” because it tends to rebalance demand away from non-traded goods and services and towards the traded sector.

And David Smith:

The second implicit assumption that should be challenged is that pruning public spending and government borrowing will inevitably create a hole in demand that needs to be counter-balanced by a laxer monetary policy. There is evidence  that Type 1 packages – which do not raise taxes, do not cut government investment but do rein in government consumption and welfare payments to the population of working age – are followed by an officially unanticipated burst of output growth

Are they right? Do we need have no fear for getting the timing wrong? No, they are wrong.  Whatever international case studies Smith is using, they do not/cannot include conditions like THESE.  Because unless they are all about 1929-39 economies, they cannot include conditions like these: collapsed banking, overwhelming balance sheet issues, deflation.  And Ben Broadbent’s model relies on a falling currency, economic demand from overseas, and monetary laxity.   How can that happen now?

The very best discussion of this so far is from Chris Giles, today:

Economic theory and history are not nearly as clear as Mr Osborne. In the standard macro-economic model , a fiscal consolidation should reduce national income, but some of that reduction would be offset by a lower exchange rate and lower market interest rates . . .It is hard, however, to know how much further monetary policy can be eased . . .  The level of quantitative easing is already high, and David Cameron, Conservative leader, is against any more. ” Printing money leads to inflation, ” he says.

And, as Duncan has blogged, Cameron’s words on QE ending are already alarming people.

Instead, we need a credible plan – but flexibility about the timing.

It is amazing how far apart are views on this. On the one hand you have Dillow (the deficit will take care of itself). On the other, Worstall thinking the multiplier is zero.    In the Economist, they report a US advert:

A classroom full of children stand as if to recite the pledge of allegiance, but the words are different: “I pledge allegiance to America’s debt, and to the Chinese government that lends us money, and to the interest, for which we pay, compoundable, with higher taxes and lower pay, until the day we die.”

I don’t take a dogmatic view.  What distresses me is the inability in some influential quarters to actually look at the facts on the ground, rather than the political-base-pleasing policy prescriptions that you hope will work for all seasons.   In 1981, cutting the deficit helped: real borrowing rates were 8% and there’s not many investments that make sense at that level.  We needed to win the credibility.  Now we have the credibility.  We’re charged 1% and there is no other source of demand right now.  (QE is not providing demand, it’s providing liquidity, selectively.) Is this hard?  What am I missing?

The Tories were more honest than Brown who ignored the elephant in the room entirely. If he is such an experienced macroeconomist, he ought to be better able to explain these issues.  But by fixating on 1981-era approaches, they risk making a worse mistake.

UPDATE: Larry Elliott competes well with Chris Giles on the best analysis of this issue, and a further reason to be annoyed with Cameron’s speech:

Only by the most convoluted reasoning can the crisis of the past two years, and the events that led up it, be described as a failure of big government . . . He is right, certainly, to argue that governments cannot run budget deficits of £175bn a year permanently. He is also right when he says that Britain was running a structural deficit of 2-3% of GDP going into the downturn.But the deficit is the symptom of an economic problem, not its cause. The bulk of the deficit is accounted for by the contraction in the economy since the start of 2008, which has sharply eroded tax revenues and pushed up the cost of welfare spending.


2 thoughts on “That issue again

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