Why A Slower Pace of Government Deficit Reduction Isn’t a Big Problem

Posted on 18/10/2010

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With the unequivocal manner in which some UK Coalition Government have been speaking recently, people might be forgiven for thinking that the pace of government deficit reduction set out by George Osborne in the 10th June 2010 emergency budget had instead been handed-down to him by God at Mt Sinai.  However, as noted at a recent conference by Harvard economist Greg Mankiw, “Any economist that says he or she definitely knows the answer to the current economic ills should be avoided.”  And therein lies the key issue.  UK Government Ministers are peddling the thesis that the budget deficit must be cut as quickly as possible in order to avoid economic catastrophe.  They may turn out to be correct.  However, the alternative view – that governments should use fiscal policy to stimulate the economy to close the output gap – may also turn out to be correct.  Note: this doesn’t endorse the Labour Opposition’s current policy; fiscal policy stimulus could take the form of temporary tax cuts, or fixed capital investment projects rather than continued spending on public services.  What I would argue, is that there has been a one-sided debate in UK policy-making circles, with no credible politician making a well-argued case for for a further 12-18 months of stimulus.

On 16th October the Institute of Public Policy Research released a document proposing a slower pace of deficit reduction based upon the following plans:

  • Maintain investment on capital projects such as transport and housing at 1.8% of GDP, as this will promote economic growth and higher employment.
  • Reduce the underlying deficit more slowly, in six years rather than four – the financial markets can be reassured without a faster reduction.
  • Maintain a 65:35 ratio between spending cuts and taxes.
  • Accept that the 20% rate of VAT will not be reversed.
  • Tax universal benefits such as Child Benefit and winter fuel allowance, rather than means-testing them, and remove free bus passes for better-off older people.
  • Lift the ring-fence on NHS spending to ensure all departmental areas, except international development, are considered for cuts. If all areas are considered for cuts, ippr estimates no single department would need to reduce its budget by more than 10%, compared to 25% for some departments under the government’s plan.

The result of these plans on the national debt to GDP ratio can be seen in the chart below.  Given the extent of the financial crisis, the depth of the recession that we find ourselves in, and the government debt/GDP ratios of other developed nations, I don’t necessarily think that this pace of deficit reduction would be the economic disaster that politicians on the right make it out to be.  The result is that debt/GDP peaks at 76% in 2014/15 instead of 70% in 2013/14.

In addition to protecting public sector jobs and government services in the medium-term (or if Labour is brave enough to match the government cuts and argue for stimulus via additional capital spending or tax reductions), such a fiscal policy also brings with it a lower risk of driving the economy back into recession.  As noted in a previous post, Bank of England MPC member Adam Posen believes the UK is currently at risk of entering a prolonged period of Japanese-style deflation, while former Bank of England MPC member David Blanchflower recently stated in an interview with Bloomberg that “we are desperately in danger of a double dip and the last thing you do in a recession is make things worse.  This [the government’s currently fiscal policy] looks like it’s going to turn the economy right down and I think it’s going to be a terrible, terrible mistake.”

To summarise, the current deficit reduction plans are not “the only way”, a credible alternative plan put forward by the IPPR shows that the consequences of slower deficit reduction are not overly problematic for the national debt and that slower deficit reduction could boost economic growth/avoid a double-dip (caveat: the govt must spend the money wisely).  Finally, at the very least the government should keep an open-mind and be prepared to reconsider the plan in light of future economic data releases.

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Posted in: Economy, My Thoughts