An editorial article in the July 2010 Royal Economic Society (RES) Newsletter outlined the views of a number of critics of the Coalition’s plan for reducing the UK’s fiscal deficit, which had reached more than 11 per cent of GDP last year, the second highest deficit amongst the OECD countries. The editorial appeared to sympathise with the opponents of what it termed ‘deficit fetishism’ and feared that cutting aggregate demand would damage the recovery. It asked for supporters of the Government’s fiscal retrenchment to explain why they expected the June 2010 budget to mark a positive turning point for the UK economy.
We are far from uncritical supporters of the Government's economic policy, but we are clear that the fairly unreconstructed Keynesianism of the three articles cited provides no useful way forward.
Last June’s budget, the Comprehensive Spending Review and the March 2011 budget have laid out a programme for reducing the fiscal deficit significantly over a four to five year period. The latest figures give a total ‘consolidation’ of £126 billion by 2015-16, made up of cuts in spending of £95 billion and a net increase in taxes of £30 billion. This programme envisages a faster reduction of the deficit than planned by Labour in its March 2010 budget, and consequently deeper cuts in public spending.
The critics criticised
The three critics cited in the Newsletter article have different approaches. In a blog piece, John van Reenen draws analogies between the proposed cuts and mistaken macroeconomic policy in the United States in 1937. This is a selective reading of the past: we could point instead to the UK recovery in the 1930s following monetary expansion coupled with fiscal conservatism. The problems of the US economy in 1937 were associated with combining public spending cuts with monetary contraction and a huge increase in business regulation and marginal tax rates. Van Reenen is also dismissive of the view that a degree of austerity is necessary in order to reassure the financial markets. But since he wrote we have seen the problems which other countries — Ireland, Greece and most recently Portugal — have run into as a result of failing to produce a convincing plan to reduce the deficit. While these countries are forced to borrow from the IMF and pay high interest rates to turn over their debt, the UK’s Standard and Poor rating is still at AAA and we have faced no problems financing our debt. Van Reenan argues that the Coalition’s intention to frontload some of their cuts is an attempt to pin the blame on Labour: any cuts should be delayed until the economy has recovered. However this ignores the credibility issue. If planned cuts were delayed, they would fall more heavily in the run-up to the next election, and market participants might doubt whether the Coalition would have the political will to carry them through. It is worth noting, though, that the cuts are more ‘back-loaded’ than the tax increases — something we regard as regrettable given that fiscal contractions led by tax increases have not generally been as successful as those led by government spending cuts.
The second piece of work cited is more substantial. Victoria Chick and Ann Pettifor examine the historical record of fiscal consolidations in the UK from the beginning of the 20th century. They reach a conclusion which, they argue, runs ‘exactly counter to conventional thinking’. This is that cuts in public spending have not improved public finances (except for the period immediately following the end of WW2). They claim that ‘there is a very strong negative association between public expenditure and the public debt’. They infer that large increases in public expenditure will, presumably through some simple multiplier process, generate higher levels of output which will reduce some forms of expenditure and increase tax take. Chick and Pettifor’s empirical analysis is, however, highly suspect. For one thing its measure of public expenditure is final consumption and fixed capital formation of central and local government only: transfers are ignored. Thus their figure for public expenditure in 2009 represents 26 per cent of GDP, whereas the OECD figure for all public spending is over 50 per cent. As the ratio of their measure of public spending to total public spending has changed very considerably since the early 1920s (the ‘Geddes Axe’ episode is the first one considered), their correlation coefficient for the whole period is surely suspect. Further criticisms might relate to the lags which would surely exist in the multiplier process they posit, and also to the averaging process in which they engage to get their results.1
The third critic cited is Joseph Stiglitz. Here the source is a lengthy interview with The Independent rather than something he has written himself. Nevertheless there are numerous direct quotations and he presumably stands by the points made. Stiglitz’s criticisms are not confined to the UK, but to all other countries which are engaged in spending cuts. He has no time for the ‘foolish financial markets that got us into this trouble’ — a diagnosis of the causes of the fiscal deficit which ignores the responsibility of spendthrift governments, particularly in the UK where public spending was sharply increased well before the financial crisis. It also ignores the expansionary monetary policies and the underwriting of moral hazard by the US government right throughout the US financial system.
He also disregards the consequences of a country unilaterally ignoring the concerns of the markets. Stiglitz argues that ‘cutbacks in Germany, Britain and France will mean all Europe will suffer. The cuts will all feed back negatively…it’s a vicious downward spiral’. He mentions various historical episodes, including Japan as an example of a country which in 1997 aborted a recovery by raising taxation, and fears that fiscal retrenchment will similarly lead to a double-dip recession. However, it can hardly be said that the Japanese episode tells us that fiscal deficits are the key to economic recovery. He argues that George Osborne ignores the lessons of history because he is driven by ideology. When it comes to practical proposals, Stiglitz’s ideas, though not uninteresting, are largely irrelevant. He talks loosely about cutting military expenditure and oil subsidies, but argues in favour of increasing spending on research and development, infrastructure and education; he does not, however, consider the evidence on the poor returns in the UK from these three areas of spending. Presumably he still believes governments are good at spotting winners, for one specific suggestion is that they should set up their own banks to lend to businesses and ‘save struggling homeowners from repossession’. He also argues, perhaps in contradiction, for an even larger increase in capital gains tax than that which the Coalition has introduced.
It is difficult to see in the three sources cited a serious alternative to the Coalition’s proposals for fiscal consolidation. What emerges rather is a kneejerk and (pace Professor Stiglitz) ideological opposition to the need for a break with the past. It is rather reminiscent, although the numbers coming forward are far smaller, of the famous letter from 364 economists predicting disaster as a result of the Conservative budget of 1981.2
What is good about the Coalition approach
What do we think of the Coalition strategy? First, we welcome the fact that the Government acted decisively and stated a clear intention to cut the deficit in a reasonable period of time. This is not ‘deficit fetishism’: we believe it was imperative to do this, as otherwise we would have been seriously at risk at the hands of the financial markets following an inconclusive general election and the difficulties of other European economies. Whilst we would not have been uncomfortable with the government cutting rather faster, it should be noted that the end of the period of spending cuts will be a full seven years since the collapse of Lehmans, with most of the cuts taking place in the last two or three years of this period. Even those who believe that fiscal policy should always try to run counter to the cycle would surely have difficulty arguing that the cuts are coming too quickly. By 2015, government spending, as a proportion of national income, will have returned to 2007 levels. External monitors of the UK economy such as the IMF, the OECD and ratings agencies have pronounced favourable verdicts, meaning that we can continue to borrow on similar terms as, say, Germany. The strategy ‘stopped the rot’— the drift towards ever-higher levels of public spending with little to show for it under Blair and Brown. In the understandable emphasis on the macroeconomic effects of government spending, we should not lose sight of the fact that this spending boosted employment and pay in the largely unreformed public sector, but achieved relatively little from the point of view of the consumer.3
Second, we believe that the balance of tax increases to spending cuts was certainly not weighted too far towards spending cuts. The proportion by the end of the consolidation will be about 77 per cent cuts and 23 per cent higher taxes. This is not dissimilar to the ratio intended in Alistair Darling’s last budget, and is in line with the 80-20 which seems to have been the minimum proportion of spending cuts necessary for successful consolidations in a number of countries in the past.4 Tax increases risk damaging the supply side of the economy at the very time we need a rapid reallocation of economic resources. There is certainly no case for fiscal consolidation via very high taxes and minimal expenditure cuts, as some have suggested.
Third, although it is never wise to be too confident in economic predictions, we do not believe that the Coalition strategy poses a serious risk of a double-dip recession. Although cuts in government spending may depress demand to some extent in the short-run, we think that this tendency is exaggerated. A simple elementary Keynesian model, which seems to lie behind the thinking of some of the critics, ignores changes in behaviour which policy can induce. Even if a very strong statement of Ricardian equivalence is not accepted, it appears likely that large fiscal deficits do have some effect in deterring consumption as people anticipate higher taxes in future. Furthermore elementary Keynesianism ignores how debt is funded and both monetary policy and the openness of economies. The UK is in the fortunate position —- unlike some — of being able to control its monetary policy, enabling us to complement fiscal tightness with a more relaxed monetary stance if that is desirable. Furthermore, the exchange rate is free to adjust so that reduced government borrowing has an impact potentially on both interest rates and the exchange rate. The case that budget deficits stimulate the economy in countries with floating exchange rates is very weak. Through this mechanism, exports are stimulated. This is one reason why the private sector, and manufacturing in particular, has been holding up better than was feared in some quarters.
Despite these positive features of the Coalition’s strategy, we do have a number of important concerns.
First, to the extent that there is a reduction in aggregate demand as a result of fiscal consolidation, it is imperative to do everything we can to boost the supply side of the economy. There has been an enormous expansion of regulation in areas such as employment law, planning, and health and safety, in the last three decades. There is widespread concern that this often imposes unnecessary costs on business, and in particular those smaller businesses which are regarded as important to economic recovery. The Government recognises this, but it has not yet got seriously to grips with the issue. For instance, though George Osborne recently outlined deregulatory proposals which he estimated would save business £350 million a year, this has to be seen against increased compliance costs imposed over the last 13 years which are estimated at £90 billion.
Second, the cuts which are planned, though large by historical standards, are not as significant as is often assumed. They are in large part cuts in planned future increases in spending. Even if the fiscal consolidation planned by the coalition is successful, public spending in real terms will barely fall by 2015-6, and as a proportion of GDP will only be back to where we were in 2007. We would argue that in the longer term we should be looking to reduce public spending much further as a proportion of a larger GDP — perhaps to a figure of 30 per cent or so compared with the current 50 per cent. This would require a proper rethink of what the public sector can do better than the private sector — and open up those areas which do not feature strongly in planned cuts, such as the NHS, to scrutiny and reform.
Third, and related to this, we would argue that we should be looking permanently to reduce the proportion of GDP going in taxation. Lower tax would encourage enterprise and savings, both vital to a successful economy. It would reduce the resources devoted to tax collection on the one hand and tax avoidance on the other. It would also encourage greater honesty from politicians if taxation were much simpler — at 11,500 pages we have one of the most complicated tax codes in the world (and certainly the longest). Again, the Chancellor has shown some awareness of this in his planned reduction of corporation tax and his stated long-term objective of merging the operational aspects of collecting national insurance and income tax, but there is much more to do.
1. See G. R. Steele ‘Economic Consequences’ http://www.lancs.ac.uk/ staff/ecagrs/CP.pdf 
2. For a review of that revealing episode see Booth, P. (ed) (2006) Were 364 Economists All Wrong?  London: IEA. 364 economists (including the current governor of the Bank of England) sent a letter to The Times saying, amongst other things, that there was no basis in economic theory that deflating demand would bring inflation under control and that the government’s policies would deepen the depression. The first statement is demonstrably false. Regarding the second statement, data published later showed that the economy came out of recession in the quarter that the letter was written.
3. One study concluded that ‘much of the spending has resulted in doing the same thing at a higher cost’ N Bosanquet, A Haldenby, L Kounine, L Parsons, H Rainbow and E Truss (2008) A lost decade: Counting the opportunity cost of public spending 1999-2008 London: Reform, p. 5
4. See A. Lilico, E. Holmes, H. Sameen (2009) Controlling Spending and Government Deficits: Lessons from History and International Experience, London: Policy Exchange. Also OECD (2010) Restoring Fiscal Sustainability: Lessons for the Public Sector, Paris.