Tag Archives: structural deficit

Are the cuts necessary?

In the latest issue of Liberator magazine there is a letter from Peter Wrigley, a retired economics teacher who blogs as KeynesianLiberal.  It’s actually about a review of David Laws’s book, but it contains a wonderful statement that summarises why some people think the the government’s strategy of cuts is wrong-headed.  It is deeply flawed, but it strikes me how very little attempt is made to explain the UK’s economic plight beyond shallow sound bites.  I will try make a small contribution to correcting this.  But first, the quote from Mr Wrigley’s letter:

Distinguished economists and commentators, including David Blanchflower, Martin Wolf, Jospeh Stiglitz, Paul Krugman and William Keegan, have all pointed out that Britain’s debts are not historically high (in fact the debt-to-GDP ratio is quite modest by comparison with many similar economies); that Labour’s expenditure was reasonably prudent up to 2008, the year of the crisis; and that the current deficit is a result of falling revenues arising from the recession rather than profligate expenditure.  Above all, we are not Greece, are not and never have been in danger from “the markets”, which are, after all, largely institutions within our own economy, including many pension funds, lending to their own government.  Clearly, the “savage cuts” are far from a matter of necessity but are ideologically driven.

The interesting thing is that the facts cited in the statement are not widely out, if you separate them from the opinions.  But the last sentence is a glaring non-sequitur. Of the various people he cites in support, all are critics of the government’s policy, but I have only followed the writings of two: Martin Wolf (of the FT) and Paul Krugman (Nobel Laureate and New York Times columnist).  Mr Krugman has not made any commentary on the British economy to anything like the detail that Mr Wrigley implies, or not that I have seen – but he does seem to come to the same conclusion – that Britain’s austerity is madness and not an example for the US to follow.  But it is the US that is his interest.  Mr Wolf has given some excellent, clear analysis (such as this article, behind the paywall I am afraid).  I don’t think he would describe Labour’s expenditure up to 2008 as “reasonably prudent”.  He actually says of the deficit before the crisis struck:

The deficit was surely too large for that stage of the cycle, even on what was then thought about prospects. But it was not a disaster.

A quibble, perhaps, since coalition politicians certainly imply it was a disaster.

Britain’s debts are indeed not frighteningly large. Yet.  But the same cannot be said about the deficit – i.e. the rate at which we are adding to the debt.  Over 10% per annum will soon take the debt up to the 90% level where most commentators suggest it really starts to weigh the economy down.  The frightening element is the estimate that 8% of the deficit is structural; in other words such a deficit won’t disappear as the economy bounces back.  This is the point that Mr Wrigley appears not to have understood, or perhaps not to have accepted.

That 8% number is truly astonishing because it suggests that much of the economy pre-crisis was built on air, and has been lost never to return.  We can’t just bounce back.  Remarkable, but it isn’t seriously disputed.  Certainly not by Labour’s last Chancellor, Alistair Darling, and not Mr Wolf either.  I can’t speak for the other commentators.  In a later post I will return to how this situation arose.

It will be necessary to close this deficit – and nobody denies that either.  A lot of people are suggesting that the government is doing so too quickly and too aggressively (and I’m sure that goes for all the distinguished names cited).  It hardly follows that the cuts “are far from a matter of necessity”.  To understand the problem it is necessary to put aside the timing issue, and to ask how will the finances be put straight when they are eventually addressed.  There are three ways: growth, taxes and cuts.

Let’s think about growth first.  To claw back 8%, the economy has to grow by at least 16% (though 20% is probably more realistic).  If we can get the economy to grow by about 4-5%pa this looks reasonably feasible, perhaps.  But if you accept the view that there is not a lot of spare capacity, then a growth rate of 2.5% is more realistic, and this, or close to it, is already built into the government’s plans.  The government can’t stimulate such high growth rates by increasing the deficit – because ultimately this growth must come from the productive part of the economy.  The argument about austerity is about the government not making things worse, not about stimulating a boom.

So how about higher taxes?  Many on the left hope that the UK can move to a more Scandinavian style of economy with perhaps 50% of income taken in taxes, rather than the typical 40% odd typical of the British economy.  Many hope this can be done by just taxing the rich more.  Actually it is hard to see how this last can be done, beyond what the government already has.  Not much money can be made from corporate taxes, contrary to popular belief, because there just aren’t enough taxable profits around.  The various soft targets postulated don’t look so soft closer up, and wouldn’t make enough difference anyway.  It is a game of diminishing returns: the more you tax, the less incremental revenue you get – and there are costs to the wider economy.  It gets worse, since if you actually succeed you become over-dependent on rich people and big corporations to fund government.  There is clearly a problem that companies are making too much money, and that a lot of people are being paid too much; but taxing this inequality even further not a sustainable solution to the country’s fiscal problems – even if you think it is right to do anyway.  To raise taxes sustainably you have to aim lower.  At the “squeezed middle”.  There are two problems.  First that this may be economically inefficient, by reducing incentives to work; so you keep having to raise the bar.  Second, and more certain, it is politically toxic.  To say the least we do not have the necessary political consent across society.

Which leaves cuts as carrying the main burden.  This seems to be what the last Labour government concluded.  And if you are going to make big cuts, to public services, and to benefits, there is a lot to be said for getting on with it to let people get used to it and move on – rather than leave the Sword of Damocles dangling – and especially with public services.

But what if you think the government is cutting the deficit too quickly?  The best thing to have done would have been to delay the increase to VAT.  The second thing would be to delay cuts to benefits.  But benefit cuts have been pretty limited so far, and may yet take place slower than planned.  Perhaps other tax cuts might be considered.  The logic of the public service cuts is powerful, I am afraid.

Which leaves with two questions.  How did we get into this mess?  And is the government right to move so quickly?  More of that another day.