Cutting expenditure won’t cut debt
‘There is a much better way of reducing the deficit than austerity: get the economy to grow’
The Conservatives’ plan to continue to cut public expenditure if they win next year’s general election is partly motivated by a desire to reduce the gap between the government’s income and expenditure, and partly by an ideological belief in a smaller state and lower levels of taxation. The Labour Party and the Liberal Democrats have promised to continue with policies of austerity to reduce the government deficit. Do any of these policies add up to a sensible strategy, making the best of the opportunities available?
Very probably not. Of course a deficit of almost £100 billion — about 6 per cent of GDP — is much too high, especially if growth is slow or if the economy falters. By 2015 total government debt will be approaching 100 per cent of GDP. Allowing debt to grow with little increase in capacity to service or to repay it is clearly unsustainable. It is not true, however, that the only way of getting the deficit down is to cut expenditure. There are at least two separate reasons for this.
First, it is a fallacy to believe that the national economy is the same as that of an individual, so that cutting expenditure will actually cut the deficit. Second, there is a much better way of reducing the deficit than adopting austerity policies. This is to get the economy to grow so that government revenues automatically go up while the need for its expenditure goes down.
An over-spending individual can certainly get his or her affairs back in order by getting expenditure in line with available income. The national economy, however, is different because everyone’s expenditure is someone else’s income. Cutting government expenditure runs the risk that, instead of reducing the deficit, it will just make the economy spiral downwards as tax rises and cuts in government expenditure reduce demand. The tax take will fall while pressure for welfare expenditure will increase. Government borrowing will stay as high as it was before while the capacity of the government to meet its debt obligations will go down. This is the worst of all worlds: privation, austerity and stagnation, with no end in sight.
If the economy could be made to grow much more quickly, however, the deficit problem could be dealt with in a different and much more efficient way. With this scenario, the government’s income from tax, fees and charges would go up while the need for expenditure on unemployment and all its related costs would fall.
Even if not all the deficit was eliminated, as long as the growth rate plus inflation were higher than borrowing as a percentage of GDP, total government debt, again as a percentage of GDP, would go down. The position would be sustainable as far ahead as one could see.
Dealing with the government deficit by expanding the economy is therefore clearly a much better bet than trying to remedy the position with austerity programmes. How could we get the economy to grow fast enough, however, to make this possible? There is a way to get this done — and to do it in a way which is wholly consistent with getting government borrowing under control.
The key requirement is to rebalance the economy towards investment, manufacturing, exports, and import substitution. It is these activities taken together which are far better orientated towards providing high returns to investment, the biggest increases in productivity and greatest improvement to our net trade (exports minus imports) performance than the rest of the economy.
We are so vulnerable at the moment because all these key activities are far too unprofitable to attract either the money or the good management to make them happen.
This has to change and the way to get it done is to get the value of the pound down — right down — to probably around $1.10 or €0.80. The increase in output thus generated would provide the resources for increasing both investment as a percentage of GDP and increasing living standards. As the economy started to grow much faster, the government’s revenues would go up, the need for expenditure would go down and the deficit would fall.
What is to stop us doing all this? Nothing, despite widespread misapprehensions to the contrary. The recent experience in Japan, bringing the value of the yen down by 30 per cent, shows that a determined government can get exchange rates down if it wants to do so. With a large balance of payments deficit and only a 2.6 per cent share of world trade, retaliation is unlikely but could be counteracted even if it materialised. There is no more likelihood of a lower pound increasing inflation significantly now than when we left the ERM in 1992 and prices fell. Real wages would rise and not fall. With sufficiently large profit incentives in place, there is no evidence that the UK economy would not respond to the highly profitable opportunities which a competitive pound would create.
The real problem is not practical or operational: it is ingrained attitudes. If — as seems very likely to happen before long — the current upturn in the economy falters and years of little or no growth seem to stretch ahead, the time may arrive when we have a fresh opportunity to get radical new ideas into the frame and to engineer the change of heart which we so urgently need.
It is not complicated and any government could do it. We need not just to get our fiscal policy right and in sync with our monetary policy but also to make sure that we have an exchange rate policy, all of which are pulling in the same direction. We have paid a high cost for the dismal failure to do this. We have left the exchange rate to find its own level instead of realising that it is a key policy driver. This is what has to change. Problems with the government deficit will then just melt away.