Is George Osborne’s plan working? You can see why his enemies are circling. If you take his own definition – his ‘fiscal rule’ that the debt/GDP ratio should be falling by the end of the Parliament – then no. But this is mainly because Osborne has been flexible – some would argue too flexible - following the eurozone crisis and high commodity prices, which have hampered growth prospects through weaker-than-expected net trade and higher than expected inflation (see the OBR yesterday).
Last autumn, the Chancellor had a choice between more cuts or more debt. He chose more debt, and stuck to his old spending plans knowing that the growth (and tax revenues) would not be as he had hoped. He chose to abandon a ‘deficit reduction’ policy, in favour of a ‘sticking to spending plans’ policy. That’s why his so-called ‘sado austerity’ will add over £605 billion to the national debt by 2014/15, with no balanced budget in sight until well into the next Parliament.
And let’s not pretend that Alistair Darling would have done it so very differently. Remember, the Coalition has so far hiked taxes and slashed investment spending, whilst actually increasing current spending. Yet the investment cuts were inherited from Darling, he’d have hiked National Insurance, didn’t oppose the 5.2 per cent benefit rise this year, and would not have prevented the external forces we’ve seen. Whilst it’s ironic the Coalition’s planned borrowing outturns are now similar to Labour’s 2010 forecasts, comparing the two is meaningless given the changed circumstances. The fact is, as the IFS has outlined, Labour’s 2010 plan would have entailed even more borrowing than we have seen so far.
At this stage, supporters of more stimulus spending make a leap of faith. ‘Ah,’ they say, ‘but given the bond markets haven’t reacted to the higher-than-expected borrowing so far, and interest rates are low, then we could spend even more without risking a crisis of confidence’. To be sure, the bond market has not punished Osborne for his extra debt (a few big doses of QE and the eurozone crisis help here). But does it follow that we should ramp up spending now in the way Ed Balls now suggests? Of course not. The risk of a crisis of confidence is just one argument against ‘stimulus’. There’s also scant evidence it would be desirable in the short or medium term for growth in the UK.
First, there are real risks of abandoning a fiscal plan. Despite what Balls suggests, increasing spending would not be self-financing. Our deficit is still over 7 per cent of GDP, and even if you take the new IMF fiscal multipliers as given, spending more would add significantly to borrowing. Abandoning a medium-term plan not only risks a loss of confidence and increased borrowing costs (which might be offset by QE) but alongside our current high trade deficit risks a collapse in sterling which could mean another damaging bout of imported inflation.
Second, there is little robust evidence it will be good for growth. For our short-term prospects, stimulus advocates cite the more recent IMF multiplier estimates as evidence that expansionary policy now would lead to large increases in output. But these results are highly dependent on the countries selected, which seem somewhat arbitrary and are distorted by the Greek euro-induced meltdown. Previous work suggests that for countries with high debts and flexible exchange rates, multipliers from public spending are very low indeed. The UK ticks these boxes.
What’s more, this only tells half the story. Higher debts of course mean higher interest payments and higher future taxes. Presuming you wish to balance the budget eventually, you will get negative multiplier effects of the extra consolidation required later. Robert Barro’s work suggests that the overall medium-term effect is to depress output overall. Evidence from previous recessions also suggests the private sector might even save more today in expectation of these future tax burdens.
This is one of the reasons why the work of the Reinhardts and Rogoff suggests gross public debt above 90 per cent of GDP impairs growth for a long period. We’re set to breach this by 2013/14.
Third, whilst it’s true that the deficit plan so far has been heavily weighted towards investment cuts and tax hikes, it’s important not to judge the economic benefits of investment by the amount spent. New Labour’s deficit spending does not appear to have led to investments which generated sustained future tax revenue – why should we expect different now? Furthermore, few projects are genuinely shovel-ready in the way that stimulus advocates idolise.
More importantly though, we can only judge our current plight in the context of the sustainability of the preceding boom. An uncomfortable fact for the Labour party is that the structural deficit was already 5.2 per cent of GDP when Gordon Brown left the Treasury in 2007. Having peaked at 9.7 per cent, it is now 5.4 per cent. This high borrowing, coupled with cheap credit meant that pre-crisis the UK economy was warped towards industries dependent on credit and high public spending. As Ben Broadbent of the Band of England has outlined, the combination of robust employment, moderate inflation and poor productivity suggests the economy is currently rebalancing, but struggling to reallocate misplaced capital. This adjustment would not be helped by more government borrowing.
The Government can of course look at supply-side policies to boost medium-term growth. Cheap energy, fixed banks, trade expansion, a liberal skilled immigration policy, small business deregulation, university liberalisation, and tax reform spring to mind. But expansionary fiscal policy now would bring significant risks with little long-term benefit. Debt is no free lunch. It has to be paid back, defaulted on or inflated away. Britain has only two options: Plan A, or an even more ambitious variant of it. Plan Balls is no answer for our economic challenge.
Ryan Bourne is Head of Economic Research at the Centre for Policy Studies and is responding to Jonathan Portes' post. To book your seats for the Alistair Darling vs Norman Lamont debate, a week on Monday, click here.