Last weekend the Sunday Times thought it was presenting the voice of reason. Twenty economists wrote to the newspaper decrying the government deficit and calling for urgent cuts in government spending.
For the Tories it was like manna from heaven. Of course the economists were right. Across the land wise heads nodded.
Then yesterday two letters were sent to the FT. This time the total number of signatories added up to 60. And it really is a who’s who of economists. The list included Joseph Stiglitz, a former Nobel winner and chief economist at the World Bank; Robert Solow, another former Nobel winner and a man whose growth theory was unquestionably one of the most important economic ideas of the last half a century; the revered Brad DeLong, Professor at UC Berkeley; and not to mention former Bank of England Deputy Governor Sir Andrew Large and his former colleague Rachel Lomax. But there were many more ‘A’-list economists who signed the letter. It was an impressive line up indeed. To put it in Hollywood terms, it was the equivalent of Stephen Spielberg and James Cameron getting together to make a film whose cast included every leading actor and actress Oscar winner from the previous ten years.
That is not to decry the economists who signed the Sunday Times letter, but these FT letter writing guys really do sit amongst the royalty of the economic world.
They are not, by the way, calling for indefinite government spending, merely saying the cut back should not begin just yet. They are saying the timing is wrong. In this sense that is going against the Tories, who say cuts need to commence straight away.
For what it’s worth, the IMF has expressed similar sentiments to those presented in the two FT letters.
Meanwhile, the latest set of government borrowing figures were released yesterday and they were awful. It was the first time that the government recorded a deficit in January since records began back in the early 1990s. Jonathan Loynes from Capital Economics made the headlines when he said that “the UK is currently on course for recording a bigger deficit this year, as a percentage of GDP, than Greece.”
So who is right? We present the arguments for and against.
The snag with economics is that it is not always intuitive. What is common sense is not always right. Keynes showed that the common sense response amongst people in the midst of a recession is to save more.
However, if the country sees a mass increase in savings during a recession, the result would be less demand and the recession would deepen. During the times when Keynes was writing, it was worse than that because, back then, the economy had deflation. The rise in saving meant deflation got even worse, effectively increasing the real value of debts. In other words, the more that individuals tried to reduce debt in unison, the worse the debt got.
It can be like that for government debt too. If a business is in debt, then it probably makes sense for the business to cut back and maybe make redundancies. But this only makes sense because a business is so small that its individual action does not impact on the total economy – at least its impact is only tiny.
But if the government reduces debt, the result will be job losses, meaning a rise in benefit payments and at the same time a cut in aggregate demand, because those without a job are likely to spend less than those with a job. The cut in aggregate demand will lead to job losses in the private sector, meaning less tax receipts for the government and more benefit payments. So, there is a real danger that a government, by cutting its debt, may actually spark off a chain of events which will eventually lead to a lot more government debt.
Against that is the view that government spending crowds out the private sector. If workers are employed by the government, then that means less of the country’s labour resource is available for the private sector. So the anti-government-spending argument would say that while government spending can help boost an economy in the short run, in the long run the effect is less wealth creation as the more innovative and dynamic private sector is starved of labour resource.
One of the two letters to the FT made the point that: “History is littered with examples of premature withdrawal of the government stimulus, from the US in 1937 to Japan in 1997.”
Here are four arguments in favour of the Gordon Brown approach, which is to carry on spending for the time being, followed by four arguments making the contrary point. And finally there’s our conclusion.
The Brown approach, point number 1: The argument that we face a big debt crisis is Mickey Mouse economics. The world can’t go bust. For every debtor there must be a creditor. Therefore, the danger of a debt crisis is little more than media hype (and by the way, don’t fall into the trap of seeing the debt crisis as meaning power will be ceded to China and the other creditor economies. China has got its own problems – it is in the midst of seeing an investment bubble. German and Japanese consumers are also among the world’s biggest creditors, but the German and Japanese economies both have serious problems too).
Brown approach, point number 2: Government debt is affordable. Martin Wolf from the FT made this point very well earlier in the week. Looking specifically at the US he said US government debt is easily affordable, once the US economy returns to a growth rate of 5 per cent a year. The point he was making is that providing that the percentage growth in our income each year is greater than the interest payments on our debt, then our debt is affordable. Mr Wolf also pointed out that the main problem in the US and UK is that the private sector has stopped spending and is saving more. Mr Wolf says that, therefore, the government should spend more to make up for the private sector saving.
In other words, government debt is funded by private saving. So it is all affordable.
Brown approach, point number 3: The recession was caused by the credit crunch. The credit crunch meant less credit available. It is therefore the duty of the government, which can borrow money, to borrow the money that business cannot obtain and spend it on our behalf. In other words, government debt and spending is the logical response to the credit crunch starving business of funds.
Argument for Brown, number 4: UK net public debt hit 250 per cent of GDP after the Second World War. And yet the UK went on to enjoy its best ever 25-year period of economic growth. The experience of the post war years proves that government can spend its way out of recession and create sustainable growth.
Argument in favour of making imminent cuts, number 1: What is the exit strategy? Both sides are agreed that government spending must go into reverse eventually; the disagreement is really over timing. But those who want to see more spending now, seem to assume that at some point in the near future the economy will, as if by magic, right itself, and at that point growth will rise and government debt will automatically fall. But how do we know the economy will right itself?
Government debt will mean higher taxes, which will surely decease the chances of future growth. Research from Rogoff and Reinhart has shown that once public debt in an economy rises above 90 per cent of GDP, growth starts to fall.
Argument in favour of imminent cuts, number two: The economists who want to see more spending are ignoring the underlying causes of the economic crisis. They argue the real cause of the economic crisis was too much debt. How can it therefore make sense to deal with the debt crisis by incurring more debt?
Argument in favour of imminent cuts, number three: Government spending crowds out the private sector. In the short run, public spending saves jobs. But in the long run, if people find they are unemployed it will force them to consider a career change, and will make the economy more dynamic. It may lead to a rise in entrepreneurial activities. (The counter argument to that is that unemployment can be so demoralising that those affected may suffer permanent damage to their confidence.)
Argument number four in favour of imminent cuts is really a response to the fourth argument listed above in favour of Brown. The economic conditions after the Second World War were different. Back then, the global economy had yet to fully exploit the innovation that occurred over the past half a century. Two world wars and a Great Depression meant that there was vast economic potential. It is not like that now. Funnily enough, this argument builds on the work of Robert Solow, who was one of the signatories in favour of the Brown approach. For more on this idea, but applied to China, see: Why China’s real opportunity gets overlooked: the parallel with Japan
The UK is not close to going bust. According to data from the Debt Management Office, UK sovereign debt is largely funded by bonds that are years away from maturity. As Stephanie Flanders said on her BBC blog: “The average maturity of UK sovereign debt is 14 years. In the US, it’s about four years. In France and Germany it’s six or seven. In Greece, it’s even lower.” Or as Martin Wolf said in the FT recently: “The country’s private sector financial surplus is, on a net basis, financing four-fifths of the fiscal deficit. The country is not going bankrupt.”
As one of the letters to the FT pointed out, the UK’s net fiscal debt is lower than in most of the G7 economies.
The UK’s debt crisis is not a present danger. Even so, it is a danger, a very serious danger, and there remains a risk that our debt could ultimately prove to be a millstone around our neck, and could drag us back into deep recession. And we may find ourselves joined in that dark place by the rest of the G7 economies.
The biggest concern we have with the arguments for maintaining government spending lies with the exit strategy. The economists in support of Gordon Brown are assuming that this is a temporary crisis, and that somehow growth will return and our debt will fall automatically.
But if government spending is being used to prop up old non-productive sectors, how will this future growth occur? Or worse, if government spending is used to subsidise firms that are struggling to compete – a trick employed in France and Germany with much enthusiasm, but of dubious long-run benefit – then how likely is a sustainable recovery? By using government money to prop up the economy, there is a risk that we will be depriving resource to those sectors that really could create wealth.
The solution surely lies in a bit of both. Government spending is required to prop up demand at a time when business and consumers are spending less. That is agreed. But by using government money to protect jobs, there is a danger the government is sucking dynamism out of the economy.
The government should make cut backs, and it should let businesses that can’t compete fail. But the money it saves should be spent on schemes designed to boost dynamism, and entrepreneurial activity. That way demand will be propped up, but the private sector won’t be crowded out; instead, it will be boosted. The government has tried to do this, but only in a small way, putting in a few hundred million.
It needs to cut spending in some areas by billions and billions of pounds. But the money should be spent on boosting entrepreneurial activity, not on silly ideas like cuts in VAT which dealt with symptoms rather than causes.
The single biggest danger with government debt, and one that very few are pointing out, is what will happen when the baby boomers retire.
How will Japan possibly be able to afford its government debt once the population starts to fall? Europe will face the same challenge, but in a decade or more from now. The only possible solution lies in innovation now.
And for all their cleverness, the economists on both sides of the debate have not pointed this truth out.
© Investment & Business News 2013