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Osborne’s cuts will nip growth in the bud

At this critical point, the government needs to spend to make the banks lend.

And then it was Nick Clegg's turn to say something stupid about the economy. "I don't think anybody could have anticipated then quite how sharply the economic conditions in the eurozone would have deteriorated and that the need to show that we are trying to get to grips with this suddenly became much greater," he said in an interview on the BBC. "That is why we need to show at a more accelerated time­table than I had initially thought that we are going to get to grips with this great black hole in our public finances."

Not only was it an unconvincing explanation for why he has changed his views since his shotgun marriage to the Tories, but he couldn't have been more wrong. The deteriorating conditions in the eurozone have made it even more dangerous to cut spending now.

In any case, according to the Office for National Statistics, the Budget deficit now stands at £7bn lower than previously expected, which obviates cuts in 2010 - if, indeed, there was any need to cut in the first place. The improving public finances suggest that the stimulus package is working. But it needs more time and there needs to be more of it, especially when there are still few signs that the private sector is standing on its own two feet without government support behind the scenes.

Down like dominoes

In a letter to the Observer on 23 May, four police authority chiefs signalled the strength of opposition to the government's plan to introduce directly elected police commissioners across England and Wales. The quartet said that they "fear that the public is unaware of the turmoil that may be unleashed by these fresh proposals". Ditto on the economy. Trade union leaders are preparing to fight against these cuts, as they will be disastrous for working people (see the guest column by the TUC leader, Brendan Barber, on page 19 of this magazine).

The outgoing Labour government's plans were based on pretty bullish growth forecasts, which look very unlikely to be fulfilled - not least because growth in the eurozone, Britain's major trading partner, will probably be much lower than anticipated, judging by the events of the past few weeks. The rescue package agreed on 10 May, which came on top of the inadequate one announced just three days earlier, seems unlikely to solve the crisis; there is still a risk that Greece will default on its debt. I suspect this is just the start of a series of rescue packages that will be demanded as other dominoes begin to fall.

Worryingly, on 22 May, the Bank of Spain had to step in to rescue CajaSur, one of that country's largest regional lenders. And Germany's move to ban "naked" short-selling may backfire, leading markets to suspect that there is more to be concerned about in the German banking sector than previously thought, which suggests there will be ongoing downward pressure on the euro.

If the pound thus appreciates against the euro, the progress that the stimulus achieved in the UK would be thrown into reverse and growth would be even lower.

Bank stocks in the UK and Europe have been hit especially hard by the recent crisis. The share prices of many European banks are down roughly 20 per cent since the beginning of May, including the British banks Lloyds and RBS, Spain's Santander, France's BNP Paribas and Germany's Deutsche Bank. This is not an environment in which spending cuts should be made - and this is the view taken in most of our major competitor nations, including the US, which has a similar deficit-to-GDP ratio (at roughly 12 per cent) to the UK.

My analysis is consistent with that of the Federal Open Market Committee (FOMC), which is responsible for setting interest rates at the US Federal Reserve. In contrast to the Bank of England's Monetary Policy Committee - which has been, and continues to be, asleep at the wheel - the FOMC has handled the recession in exemplary fashion, cutting rates early and making it clear that it is in wait-and-watch mode. All credit to the Federal Reserve chairman and pre-eminent scholar of the Great Depression, Ben Bernanke.

The UK could learn from the minutes of the FOCM meeting of 27-28 April. They record that "Participants expected the economic recovery to continue, but, consistent with experience following previous financial crises, most anticipated that the pick-up in output would be rather slow relative to past recoveries from deep recessions. A moderate pace of expansion, in turn, would imply only a modest improvement in the labour market this year, with the unemployment rate declining gradually."

The minutes of the meeting also note that "nearly all members judged that it was appropriate to reiterate the expectation that econo­mic conditions . . . were likely to warrant exceptionally low levels of the federal funds rate for an extended period".

Lend or spend

I was struck this past week by an insightful article on a similar theme by the economist James Galbraith, son of J K Galbraith. In the Nation on 22 March, he argued that cutting deficits without first rebuilding the banking system would inevitably lead to a double-dip recession, or even to a second Great Depression.

“To focus obsessively on cutting future deficits," he wrote, "is also a path that will obstruct, not assist, what we need to do to re-establish strong growth and high employment."

He went on:

To put things crudely, there are two ways to get the increase in total spending that we call "economic growth". One way is for government to spend. The other is for banks to lend. Leaving aside short-term adjustments like increased net exports or financial innovation, that's basically all there is. Governments and banks are the two entities with the power to create something from nothing. If total spending power is to grow, one or the other of these two great financial motors - public deficits or private loans - has to be in action.

Banks are not lending, so governments need to spend: it's as simple as that.

And then Slasher Osborne and his ex-City flunkey David Laws slashed by £6.2bn. That's no trivial sum. Even these initial cuts will lower GDP by at least half a per cent. Bad idea.

David Blanchflower is Bruce V Rauner Professor of Economics at Dartmouth College, New Hampshire.

David Blanchflower is professor of economics at Dartmouth College, New Hampshire, and a former member of the Bank of England's Monetary Policy Committee 

This article first appeared in the 31 May 2010 issue of the New Statesman, The war on the veil