The coalition's confidence trick

The government has put reducing the deficit ahead of growth and jobs. Ignore the scaremongering.

The government has put reducing the deficit ahead of growth and jobs. Ignore the scaremongering, urges a former economic advisor to David Cameron -- there's a common-sense alternative.{C}

When the coalition government came to power in May 2010, its overriding priority was to reduce the deficit - and to reduce it quickly.

The following month, David Cameron argued: "We had a significant deficit problem way before the recession . . . It had nothing to do with the recession."

Asserting something does not make it true. Our analysis at the National Institute of Economic and Social Research (NIESR) shows that the "structural" current deficit - the part of the deficit, excluding investment spending, that was not related to the economic cycle - was about 1 per cent of gross domestic product in 2008 before the financial crisis hit, and was, in fact, falling slightly (the Treasury's estimate is even lower). Over the next two years, however, it shot up to 5 per cent; this had everything to do with the recession (see chart 1). So although there is no doubt that the previous Labour government systematically overestimated future tax revenues and hence the strength of the public finances, resulting in fiscal policy being significantly too loose in the run-up to the crisis, this is a relatively small part of the story. The "recession and financial crisis have punched a permanent hole [in the public finances]", accor­ding to the Institute for Fiscal Studies (IFS).

Need for action?

When the coalition took office this was water under the bridge; the question was what to do about unarguably a very large deficit of more than 10 per cent of GDP, much of which was by then, indeed, structural. No serious economist disagreed with the proposition that the deficit needed to be brought down very substantially over time, and that it was sensible to aim to eliminate the structural current deficit and put the debt-to-GDP ratio back on a downward track.

So the endgame was not the issue; the time frame was. The pace of spending cuts has been dictated by the government's decision to eliminate the structural deficit over four years rather than eight. In his June 2010 speech, the Prime Minister made three substantive arguments why the deficit needed to be reduced quickly:

1 The size of the debt. "We have known for a long time that our debts are huge . . . Today, our national debt stands at £770bn. Within just five years it is set to nearly double . . ."
2 The rising debt interest bill. "In five years' time . . . for every single pound you pay in tax, 10 pence would be spent on interest. Is that what people work so hard for, that their taxes are blown on interest payments?"
3 The threat to confidence. "The more government borrows . . . the less confidence there is . . . and when confidence in our economy is hit, we run the risk of higher interest rates."

Let us take each of these arguments in turn. First, the debt. In 2010 the UK's national debt stood at about 52 per cent of GDP, considerably more than in the 1980s and 1990s, but lower than during much of the 20th century. Under the fiscal plans of the previous government, it would have risen to about 80 per cent of GDP before falling back: much higher than in recent decades, but lower than for the period from the First World War to the mid-1960s (see chart 2).

From a longer-term perspective, the debt exceeded 100 per cent of GDP for the entire period from 1750 to 1850. As this was arguably the most successful period in UK economic history, it is rather difficult to argue that such levels of debt automatically lead to disaster.

Second, despite the Prime Minister's somewhat synthetic outrage, debt interest never consistently fell below 10 per cent of public spending until the early 2000s. So there was nothing historically unprecedented about the levels of debt, still less debt interest, that were in prospect in 2010 (see chart 3).

Third, with regard to confidence and the threat of higher interest rates, and despite the large deficit, interest rates were very low and stable at the time of the 2010 election; government borrowing was as cheap as it has been for decades. There was no market panic. In the run-up to the election, senior economists in government, including me, were worried that an inconclusive result would lead to market jitters or worse. But we were wrong; even during the fraught negotiations to form the coalition, both gilt yields and the pound were remarkably stable (see chart 4).

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Panic was unnecessary. Yet panic, or the impression of it, was exactly what we got. Cameron, George Osborne and Nick Clegg repeatedly likened the UK to Greece, even though no one with even a cursory knowledge of Greece's economic position thought that such a comparison made any sense at all. Greece's debt position was far worse, with its debt-to-GDP ratio set to spiral to 150 per cent (compounded by the previous Greek government's dishonesty). Its financing problems were far more immediate, and its medium-to-long-term structural economic problems far greater.

Greece's membership of the eurozone ruled out critical options such as quantitative easing and currency depreciation, which were used by the UK to good effect under both this government and its predecessor. Understanding this point - often ignored by those who should know better - is vital. Ultimately, countries such as the UK, US and Japan, which borrow in their own currency, are far less vulnerable to loss of market confidence than those that borrow in foreign currency - which, in effect, is the case for members of the euro area, who do not control their own interest or exchange rates.

So the "confidence" argument was always vastly overstated, yet it remains key to the government's case. In a statement to parliament on 11 August, against the backdrop of turmoil in the financial markets, Osborne argued: "We must also continue to implement the fiscal consolidation plan that has brought stability to our bond markets . . . These bold steps have made Britain that safe haven in the sovereign debt storm. Our market interest rates have fallen, while other countries' have soared. And the very same rating agency that downgraded the United States has taken Britain off the negative watch that we inherited and reaffirmed our AAA status. This market credibility is not some abstract concept - it saves jobs and keeps families in their homes."

But is it "market credibility" that explains this fall? Or is it merely that, as the Nobel economics laureate and New York Times columnist Paul Krugman has argued, low long-term interest rates in the UK and the US reflect economic weakness? Does the fall in long-term interest rates in the UK reflect greater confidence, both narrowly in the solvency of the UK government and more broadly in the strength of the UK economy? Or does it reflect market views that the economy is weak and, if anything, getting weaker?

There is a reasonably simple test of the evidence here. As well as looking at interest rates, we can look at UK stock prices. In general, stock prices will go up when market participants become more optimistic about economic prospects, and down when they become more pessimistic. So if, on the day-to-day timescale to which markets work, the fall in long-term interest rates were mirrored by rises in UK stock prices, it would be strong evidence for the government's view that rising confidence is lowering interest rates. But if, in fact, falling interest rates go hand in hand with falling stock prices, it's pretty difficult to believe that it reflects improved "market confidence".

Similarly, if the UK were seen as a "safe haven" by international investors, lower yields would go hand in hand with a rising pound as capital flowed in.

The results are clear. Between May 2010 and now, the correlation between daily changes in ten-year gilt yields and daily changes in the FTSE 100 Index is strong, significant and positive. The same is true with respect to sterling - that is, when interest rates went down, so did the stock market and the pound. The falls in gilt yields were associated not with greater confidence or optimism, as the government has argued, but the reverse.

So the specific evidence cited by the government to support its argument that its fiscal plans have improved market confidence in the UK shows nothing of the sort. Low long-term interest rates reflect economic weakness and a lack of market confidence in the prospects of the UK economy.

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The impact of deficit reduction

At the time of the "emergency" Budget in June last year, George Osborne argued that "a credible plan to cut our Budget deficit goes hand in hand with a steady and sustained economic recovery". For a few months, as growth in the second and third quarters of 2010 was strong, it appeared a recovery was on the horizon, allowing the International Monetary Fund to argue last September that the UK economy was "on the mend" and that "recovery was under way".

Others were much less optimistic. The NIESR published a forecast of its own very shortly after that IMF report, stating that "the recovery will continue but it will be sluggish" because of the impact of tightened fiscal policy and depressed consumer demand.

That was still too optimistic, as it turned out. Sluggishness has become virtual stasis; growth over the past three quarters has been close to zero. Similarly for employment. In his statement on 11 August, Chancellor Osborne said: "Some 500,000 new private-sector jobs have been created in the last 12 months - the second-highest rate of net job creation in the G7." He neglected, however, to note that, because of data lags, a substantial majority of that job creation happened between March and June last year - when a nascent recovery was under way, before fiscal austerity had had a chance to bite. We estimate that, in 2011, fiscal consolidation will knock about 0.8 per cent off growth.

What is true domestically is also true internationally. What Osborne calls "the sovereign debt storm" is something rather different for most countries and the world as a whole. A sovereign debt storm would not result in interest rates at historic lows in Japan, the US, the UK and many eurozone countries. Nor in plunging equity markets in countries where solvency is not remotely an issue. Rather, what we are seeing in financial markets reflects primarily fears about future growth, resulting in a flight to the safety of low-risk assets - in fact, mostly sovereign debt.

So the right response, for both the UK and the rest of the world, is policies to restore growth. There are sincere concerns about the debt of some eurozone countries and the potential impact on the stability of the zone. But, just as with US debt, this is an issue of politics and governance far more than it is one of economics. Overall, the eurozone's debt position is perfectly manageable, if - but only if - its leaders are prepared to implement new structures of political and economic governance that will deal with the solvency anxieties. On this topic at least, Osborne is absolutely correct.

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Where next?

Although their arguments have been largely discredited, the proponents of aggressive fiscal tightening have by no means given up. They put forward three arguments why no adjustments should be made.

The first is that monetary policy should pick up the slack. The IMF made this argument strongly in its latest report (6 June 2011), saying: WAlthough consolidation will create headwinds for short-term growth, it will also assist disinflation and can thus be countered by looser monetary policy than otherwise."

No, it can't. Simulations using the NIESR's model suggest that, in the UK, the contractionary effect of spending cuts is offset in the short term only, and to a very limited extent, by looser monetary policy. And with inflation well above target, short-term rates at close to zero and long-term rates at historic lows, it is not clear that there is much scope, if any, for further effective action on monetary policy. Calling for more quantitative easing, as the Business Secretary, Vince Cable, has done, is understandable, but essentially amounts to passing the buck to the Bank of England at a time when it has limited room for manoeuvre.

The second argument is a variant of the one about "confidence and credibility". In January this year, as it first became apparent how weak the growth was, Osborne said that any deviation from the government's deficit reduction plan would be disastrous: "Imagine the reaction. The soaring market interest rates. The widening spreads. The credit rating back under threat."

Translated, this an argument for never changing policy, no matter what happens. It is the political equivalent of the Indian rope trick - climbing up a rope, pulling it up after you, and disappearing. And about as plausible. In practice, there is little or no empirical evidence that markets regard sensible policy adjustments as signalling a lack of credibility; quite the reverse. The hit to credibility comes from sticking with policies that are, whether for political or econo­mic reasons, likely to be unsustainable.

As for the rating agencies, we don't need to speculate on what the impact of a downgrade would be, because we've just seen it. Standard & Poor's (S&P) did downgrade the US, but not the UK. This has had no impact on market interest rates at all; both before and since the downgrade, US long-term interest rates have been falling somewhat faster than ours.

Let's look at S&P's record, which is remarkable. The agency downgraded Japan's credit rating in 2002, since when it has had the lowest long-term interest rates in recorded economic history. That did not, however, stop S&P rating numerous sub-prime mortgage-backed securities as AAA, or maintaining its rating on Lehman Brothers until the bitter end.

The third argument is the one made by those who recognise that fiscal consolidation will hurt growth, but who argue that such pain is inevitable. No serious economist denies the need for fiscal consolidation over the medium term in the UK (and the US) and that, hence, some pain is necessary.

However, there is also an element of econo­mic masochism. True - it is economic reality that trend output is lower than we had hoped, and we are therefore poorer as a nation. There is nothing we can do about that in the short term. But it is also true that output is below trend, and unemployment is above - and there is something we can do about that. As Krugman puts it: "Instead of a determination to do something about the ongoing suffering and economic waste, one sees a proliferation of excuses for inaction, garbed in the language of wisdom and responsibility."

We should return to basic macroeconomic principles. Not only the NIESR's model, but those of the Office for Budget Responsibility, the Bank of England and City analysts say that output is well below trend and unemployment well above the sustainable rate. None of us knows exactly how much - but we all agree that the gaps are substantial. Meanwhile, monetary policy is constrained, and the pound and the current account deficit are stable.

In these circumstances, standard macroeconomic analysis, applied in a standard way, says that aggressive tightening of fiscal policy, of the kind we are seeing now, is inappropriate and unnecessary, because it is likely to lead to an extended period of sub-par growth and employment. Stretching out the fiscal consolidation, and moderating some of the front-loaded spending cuts, is not only feasible, but sensible and prudent. In an op-ed piece published in the Daily Telegraph on 8 August, Osborne described those of us who share this perspective, including not only Krugman but also his fellow Nobel laureates Amartya Sen, Joseph Stiglitz and Christopher Pissarides, as being "on the outer fringes of the international debate".

Embarrassingly for him, a few days later, we were joined by the new managing director of the IMF, Christine Lagarde, who argued in the Financial Times of 16 August that "there is scope for a slower pace of consolidation combined with policies to support growth". This argument is neither radical nor old-fashioned Keynesianism, nor is it in any way unorthodox. It is just standard, common-sense macroeconomics; or, more simply, just common sense.

Jonathan Portes is director of the National Institute of Economic and Social Research, and was chief economist at the Cabinet Office from 2009 to February 2011