Sunday, October 17, 2010
Putting a lid on Britain's debt
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular piece is available to subscribers on - this is an extract.

Criticisms of the government's comprehensive spending review on Wednesday will come from those who think the deficit doesn’t matter and the government should borrow for as long as it wants. Others agree it matters but not as long as the economy is fragile.

Some will say the government has got the balance wrong between tax hikes, 23% of the planned adjustment, and spending cuts, 77%, arguing taxes should bear more of the burden. Against them will be the spending hardliners, who want bigger spending cuts but at the same time lower taxes to boost the private sector.

My list is not exhaustive but there will also be those who back big spending cuts but think infastructure and other capital spending should be protected. That is the view of most business lobby groups.

Let me start with some numbers. On one side there is Lord Skidelsky, Keynes’s biographer, the great man’s vicar on earth. The government, he wrote last week, plans “the most audacious axe-cutting exercise in almost a century”, cutting spending 10% over four years and taking 5% “out of a shrunken economy”.

On the other there is the Centre for Policy Studies’ paper on Friday, talking about the “modest” cuts the chancellor will unveil and repeating the point made here, that in cash terms spending will continue to rise every year in this parliament.

What’s the truth? The generally accepted number for cuts, £83 billion over this parliament, compares what would have happened if spending were to keep pace with overall inflation in the economy with what will happen. So, though the spending “envelope” will rise from £640 billion in 2011-12 to £659 billion in 2014-15, that implies a significant real cut.

The size of that real cut is acutely sensitive to inflation. The government assumes just to stand still public spending needs to rise nearly 3% a year. That seems generous. It seems to me overall spending will be about 4% lower than if it were to keep pace with inflation, following a 10-year period in which it rose 50% in real terms.

Is the planned fiscal tightening unprecedented? It is unusual, though the Treasury notes it is similar to that in Britain between 1993-4 and 1999-2000, and over a similar period in Sweden and Canada.

Will it snuff out growth? People who make this claim appear to have read too much about the public sector accounting for half of the economy, which it does not.

Roughly speaking, taking numbers from both the Office for Budget Responsibility (OBR) and the Ernst & Young Item Club, public spending boosted the economy by an average of 0.6% a year during the splurge years from 2000, sometimes more. Over the next few years, the straight arithmetic of the cuts means spending will subtract 0.6% a year from growth.

Does that mean stagnation? Not if you believe the economy is only capable of growing by a tiny amount each year. If the private sector’s long run growth rate is 2.5% or so, which is reasonable if not conservative, it can grow by 2% even through the cuts. If, as is normal, the economy grows faster in the recovery period from recession, it can manage more than 2%. The OBR, under its new chairman Robert Chote, will give its pronouncements on this, though not until November 29.

The arithmetic may overstate the impact of cuts. Though hard to quantify, the private sector will expand into the gap left by a smaller state and low long-term interest rates will help all sectors.

Does not the aftermath of the crisis, and the damage to the financial system, mean government spending should be maintained for longer? Many people, on both sides of the debate, cite This Time Its Different, the study of past financial crises by Carmen Reinhart and Kenneth Rogoff.

To be clear, I sought out Rogoff, former chief economist at the International Monetary Fund. The lesson from his study, he said, is that governments have to be careful about their debt in the aftermath of crises.

Rising debt can seemingly have little impact, as is the case in Britain now with very low government bond yields. But the relationship is “typically quite non-linear”, Rogoff says “so interest rates can rise quite suddenly as a country hits its debt ceiling”. A plan for getting the deficit down is vital.

Even under the coalition’s plans, public sector net debt will rise from less than £700 billion 18 months ago to £1,316 billion by the end of the parliament. The old “ceiling” of 40% of gross domestic product set by Gordon Brown for government debt will not be seen again until the 2030s.

Many of those who argue blithely that the goverment should carry on spending appear content to ignore the debt issue, even though the burden for future generations will grow and Britain’s debt dynamics could yet turn nasty. The more subtle ones argue that debt will rise even faster if the chancellor cuts too soon and drives the economy into the buffers.

There is, as I have written before, a legitimate debate about the speed of cuts, with the plans the coalition inherited from Alistair Darling (halving the deficit in four years) the minimum, and the plans to be confirmed by Osborne on Wednesday probably the maximum. If the squeeze proves too intense, things can move more slowly, as some ministers have hinted.

It would be a mistake, however, to hint at a change now. A failure to follow through this week with a review that fills in the details on the numbers set out in June would be seen as a loss of nerve.

History is littered with examples of governments that have set out plans for spending cuts and failed to achieve them. We will not know for 3-4 years whether this government can do it. This is, however, its only realistic opportunity. It has to give it its best shot.

In its honeymoon, the government has boasted of getting to grips with the public finances and staving off the dreaded loss of Britain’s AAA rating. Most of the hard work to live up to that boast starts now.