Single currency bloc plays ‘beggar-my-neighbour’

By Martin Wolf

Published: May 18 2010 20:24 | Last updated: May 18 2010 20:24

Might the eurozone break up? Until recently I would have answered: absolutely no. This is not because I thought the currency union a wise idea. I thought it a risky idea, made more so by the decision to accept member countries so different from those of the zone’s northern core. But the commitment to make it work seemed fundamental to the policies of Europe’s principal powers. Is that still true? I do not know.

So what has gone wrong? What is happening now? What happens next? What does it mean for both the eurozone and the world economy?

On the first question, the European orthodoxy is that the crisis is, at root, fiscal. Marco Annunziata of UniCredit summarises it in a recent note: “In hindsight, it seems obvious that the flaw in the eurozone’s institutional setup is both extremely serious and extremely simple: first, a currency union cannot work without sufficient fiscal convergence or integration; second, the eurozone has been unable to create incentives for fiscal discipline.” Mr Annunziata’s chart shows that this view is wrong. Just consider the frequency of breaches of the rules requiring fiscal deficits of less than 3 per cent of gross domestic product. Greece is a bad boy. But Italy, France and Germany had far more breaches than Ireland and Spain. Yet it is the latter that are now in huge fiscal difficulties.

The fiscal rules failed to pick up the risks. This is no surprise. Asset price bubbles and associated financial excesses drove the Irish and Spanish economies. The collapse of the bubble economies then left fiscal ruins behind it.

It was the bubbles, stupid: in retrospect, the creation of the eurozone allowed a once-in-a-generation party. Some countries had vast asset price bubbles; many had soaring relative wages. Meanwhile, Germany and the Netherlands generated huge current account surpluses. The union encouraged a flood of capital to the surging economies, on favourable terms. When private spending imploded, fiscal deficits exploded.

Where are we now? The eurozone politicians’ response to the crisis has been predictable: blame speculators; provide financing of shaky sovereign debtors (thereby rescuing creditors); rule out debt restructuring; and insist that fiscal discipline be tightened in countries with large deficits. The European Central Bank has also invested €16bn in riskier eurozone government bonds – a small sum by the standards of recent interventions, but a powerful signal. The euro has fallen, though it remains high by historical standards (see chart). At best, the eurozone has bought a bit of time for adjustment.

What happens next? Greece is likely to restructure its debt at some point, as John Dizard has argued in the FT. That would not be the worst outcome. Once a country is in the “junk bond” category, no reputation is left. In such circumstances, the benefit of a lower debt burden for creditworthiness is likely to offset the cost of a default. The logical moment is when the primary fiscal deficit (that before interest) is eliminated, supposedly in 2012.

Yet there will be no return to fiscal stability in peripheral countries without a return to growth. For countries with large current account deficits, much of this growth will have to come from net exports. The alternative to higher net exports – a resurgence of private spending and huge ongoing capital inflows – is unlikely and undesirable.

The question is whether peripheral countries, which have lost so much competitiveness since entry into the eurozone, can generate a large structural – not just a cyclical – improvement in net exports. Historically, countries that have suffered debt crises have almost always been helped by a collapse of the exchange rate (see chart). Peripheral eurozone members do the bulk of their trade with one another. So the modest decline in the external value of the euro is little help. Inside the currency union, the way out is through falling prices (more precisely, falling costs). Ireland is on the way; others are far behind (see chart). But this is a drawn-out process and, not least, also raises the real value of debt. Proponents of structural reform ignore these facts.

What does this all mean?

First, markets are right to doubt fiscal resolve. Debt restructuring is quite likely, at least for Greece. But such restructuring cannot remedy the lack of competitiveness.

Second, the eurozone has bought itself time. Among the things it must do with that time is make its financial system credibly solvent and so able to stand a round of private and public debt restructuring.

Third, when analysing the woes of the eurozone, people persistently fail to recognise the private sector’s instability. It has saved too much in some places and spent, lent and borrowed too much in others. This has been a hugely destabilising force, inevitably exacerbated by the “one-size-fits-all” monetary policy.

Fourth, while the peripheral countries wriggle, the fisherman is determined to keep them on the hook. Thus the fundamental proposition in all discussions of eurozone reform and policy is that fiscal policy must be disciplined. Indeed, Mr Annunziata argues that “fiscal limits should be hard-coded into each country’s legislation in the form of automatic, binding and unchangeable rules”. Such rules do apply in US states. But the US has a federal budget, as well. The eurozone has not. The world’s second-largest economy is on the way to adopting the pre-Keynesian fiscal orthodoxy.

Fifth, tension is bound to remain between a Germany determined to impose such fiscal constraints and countries that deny the primacy of such discipline (notably, France) or may prove incapable of sticking to it. Given the big adjustments ahead, it is no longer evident that the eurozone will manage these tensions. German patience could be stretched beyond breaking point.

Finally, the eurozone is moving towards fiscal tightening, with the offset, at least for the moment, of a weaker exchange rate. Americans will see this as a “beggar my neighbour” policy, unlikely to help global rebalancing. How much it will detract from world recovery is unclear. But it will not help.

Despite today’s gloom and doom, the eurozone will probably survive. But the view that everything would now be fine had fiscal rules been followed is wrong. The private sector’s irresponsibility was the biggest failing. Now, the emphasis is again on fiscal tightening. If this is to work, there must also be growth. Will the austerity itself deliver the growth, as some hope? I doubt it. The hair shirt alone will wear badly.

Evaluating the renminbi manipulation

By Martin Wolf

Published: April 6 2010 22:21 | Last updated: April 6 2010 22:21

The incumbent superpower has blinked in its confrontation with the rising one: the US Treasury has decided to postpone a report due by April 15 on whether China is an exchange-rate manipulator. Since a programme of multilateral and bilateral consultations is under way, it was right to give these discussions a chance before taking any action.

Is China a currency manipulator? Yes. China has intervened on a gigantic scale to keep its exchange rate down. Between January 2000 and the end of last year, China’s foreign currency reserves rose by $2,240bn; after July 2008, when the renminbi’s gradual appreciation against the dollar – begun three years earlier – halted, reserves rose by $600bn (see chart); and reserves are now close to 50 per cent of gross domestic product. Finally, a massive effort has been aimed at curbing the inflationary effects of intervention.

Thus, China has controlled the appreciation of both nominal and real exchange rates. This surely is currency manipulation. It is also protectionist, being equivalent to a uniform tariff and export subsidy. Premier Wen Jiabao has protested against “depreciating one’s own currency, and attempting to pressure others to appreciate, for the purpose of increasing exports. In my view, that is protectionism”. The Chinese pot is calling the US kettle black.

Yet some economists deny this, offering four counter-arguments: first, while the intervention is huge, the distortion is small; second, the impact on the global balance of payments is modest; third, global “imbalances” do not matter; and, finally, the problem, albeit real, is being resolved. Let us consider each of these points in turn.

On the first, estimates of the extent of undervaluation vary hugely: some even argue the renminbi is overvalued. This is partly the result of contrasting methodologies – fundamental equilibrium exchange rates against purchasing power parity – and partly of different assumptions about the right starting point. If, for example, Chinese people were free to export their savings, the capital outflow might be even bigger than today’s intervention. But if the world were free to buy Chinese assets, the capital inflow would explode, too. Who would not want a bit of the world’s most dynamic economy?

Plausibly, the undervaluation is considerable, possibly as much as the “25 per cent on a trade-weighted basis and ... 40 per cent against the dollar” suggested by Fred Bergsten of the Peterson Institute for International Economics. The JPMorgan estimate of a trade- weighted real exchange rate is only 10 per cent above its average level since the beginning of 1994, even though China has been the world’s fastest-growing economy over this period. It has also depreciated by 8 per cent since October 2008. This is surely peculiar.

On the second point, Stephen Roach of Morgan Stanley has argued that differences in savings behaviour determine current account balances and the Chinese surplus cannot determine the US overall deficit.

I find neither argument persuasive. If the Chinese currency influences the dollar exchange rates of China’s competitors, as it surely does, it will definitely affect multilateral balances. Furthermore, one of the points I made in my (recently updated) book, Fixing Global Finance, is that real exchange rates also determine savings rates, not just the other way round. This is because governments care about GDP. The undervalued Chinese real exchange rate generated a contribution of net exports of 5.6 per cent of GDP between 2006 and 2008. The Chinese authorities had no reason to try to lower the surplus of savings at that time: it went into net exports. But when net exports plunged in 2009, knocking 3.9 points off GDP, the Chinese authorities acted to lower the savings surplus, by expanding domestic credit and promoting investment (see charts).

Mr Roach also points to today’s negligible net US savings. But this, too, is the result of a fiscal offset to a surge in private sector savings surpluses. Why was this needed? The answer is that, with a huge structural current account deficit, a rise in private savings in the US would otherwise have created a depression. In sum, savings surpluses are a policy variable, not a given.

On the third point, yes, imbalances do matter. This was partly because of the form they took. As Anton Brender and Florence Pisani argue in a brilliant study for the Centre for European Policy Studies, the salient characteristic of the capital outflow from emerging economies was that it came in the form of reserves – an overall increase of close to $6,000bn in the noughties.* This led to huge increases in demand for liquid and safe assets. Our cunning financial sector fabricated such assets wholesale, from those “subprime” ingredients, with results we now see.

Imbalances also matter because they will have a big impact on the recovery. As Mark Carney, governor of the Bank of Canada, pointed out in a recent speech, should imbalances persist, two outcomes are conceivable: either countries with big external deficits continue with their huge fiscal deficits, until “global interest rates begin to rise, crowding out private investment and ultimately lowering potential growth”; or the deficit countries start to reduce the fiscal deficits sharply, without any offsetting changes in surplus countries, in which case there is “deficient demand globally”.

On the fourth point, Jim O’Neill, chief economist of Goldman Sachs, argues that the Chinese surplus is ceasing to be a significant factor. It is true that it has halved, as a share of GDP, since 2007. The question is whether this shift is structural or the result of exceptional and temporary measures. The World Bank still expects China’s current account to stabilise at high levels, with net exports about to make a positive contribution to growth. The world’s fastest-growing economy would be exporting unemployment. Mr O’Neill is ahead of himself.

I conclude that the renminbi is undervalued, that this is dangerous for the durability of global recovery and that China’s actions have not, so far, provided a durable solution. I conclude, too, that rebalancing is a necessary condition for sustainable recovery, changes in competitiveness are a necessary condition for rebalancing, real renminbi appreciation is necessary for changes in competitiveness, and a rise in the currency is necessary for real appreciation, given the Chinese desire to curb inflation.

The US was right to give talking a chance. But talk must lead to action.

* Global Imbalances and the Collapse of Globalised Finance, CEPS, 2010

Why Germany cannot be a model for the eurozone

By Martin Wolf

Published: March 30 2010 22:47 | Last updated: March 31 2010 18:19

“The effort to bind states together may lead, instead, to a huge increase in frictions among them. If so, the event would meet the classical definition of tragedy: hubris (arrogance); Ate (folly); nemesis (destruction).” Thus, in December 1991, did I conclude an article on the rush to monetary union. I am aware of the commitment of Europe’s elite to the success of the European project. But the crisis is profound – for the eurozone, the European Union and the world. As Wolfgang Münchau has pointed out, last week’s European Council was not a solution but a fudge.

The immediate challenge is Greece. On this, the heads of government decided that “as part of a package involving substantial International Monetary Fund financing and a majority of European financing, euro area member states are ready to contribute to co-ordinated bilateral loans”. But, it continued: “Any disbursement ... would be decided by the euro member states by unanimity subject to strong conditionality and based on an assessment by the European Commission and the European Central Bank ... The objective of this mechanism will not be to provide financing at average euro area interest rates, but to set incentives to return to market financing as soon as possible.”

Germany, the most powerful eurozone member, got its way. But the outcome was unpopular elsewhere, not least in France, and with the ECB, which does not want the Fund to intervene in monetary policy. Nicolas Sarkozy, the French president, must look with horror on intervention by a Washington-based institution headed by Dominique Strauss-Kahn, a heavyweight potential rival for his job.

Yet it would be quite wrong to conclude that this is a big victory for the IMF or even for Germany. The outcome looks unworkable.

First, would this be an IMF or an EU programme? What happens if the IMF disagrees with the Commission? Such disagreement seems likely. The fiscal tightening agreed by Greece, of 10 per cent of gross domestic product over three years, looks impossible, given the absence of monetary policy or exchange rate flexibility. Maybe no programme would succeed given the unfavourable initial conditions.

Second, what are the chances that the eurozone would act unanimously in support of an IMF programme?

Finally, why should the envisaged “help” help? Greece’s immediate problem is the high interest rates it is paying (see chart). To offer liquidity at a penal rate, when Greece has no access to the market, would worsen its solvency problem. Moreover, by the time this assistance were offered, it would be far too late.

So far, so bad. It is when one looks at the big challenges that things look truly frightening. One worry is the unwillingness to accept default. More important, Germany’s views on how the eurozone should work are wrong.

Herman Van Rompuy, president of the European Council, stated after the meeting that “we hope it will reassure all the holders of Greek bonds that the eurozone will never let Greece fail”. Only two ways of meeting this commitment exist: either members write blank cheques in favour of one another or they take over the public finances – and so the government – of errant members. Germany would never permit the former; but politics would never permit the latter, particularly in the big countries. Thus, Mr Van Rompuy’s statement looks absurd.

Now turn to the bigger point. Last week’s statement also argued that “the current situation demonstrates the need to strengthen and complement the existing framework to ensure fiscal sustainability in the eurozone and enhance its capacity to act in times of crises. For the future, surveillance of economic and budgetary risks, and the instruments for their prevention, including the excessive deficit procedure, must be strengthened.”

The ruling idea here is that the weakening of fiscal positions in peripheral countries reflects a lack of fiscal discipline. That is true of Greece and, to a lesser extent, Portugal. But Ireland and Spain had what seemed to be rock-solid fiscal positions (see charts). Their weakness lay in private sector financial deficits. It was only when the private sector corrected after the crisis that the fiscal deficit exploded. Since the problem was in the private, not the public sector, monitoring must also focus on the private not just the public sector.

Yet the asset bubbles and private sector credit expansions in the periphery were also the mirror image of the absence of growth in real demand in the core (see chart). This was how the ECB’s monetary policy produced a more or less adequate rate of expansion of overall eurozone demand. So, as soon as we ask what was the underlying cause of the fiscal catastrophes of today, we must realise that they were ultimately the result of reliance on an accommodative monetary policy, employed to offset the feeble growth of demand in the eurozone’s core and, above all, in Germany.

Such a discussion of internal eurozone demand and imbalances is not one German policymakers wish to have. So long as that is the case, the prospect for the “improved economic co-ordination” mentioned in the Council statement is nil. Worse, Germany does wish to see a sharp move by its partners towards smaller fiscal deficits. The eurozone, the world’s second largest economy, would then be on its way to being a big Germany, with chronically weak internal demand. Germany and other similar economies might find a way out through increased exports to emerging countries. For its structurally weaker partners – especially those burdened by uncompetitive costs – the result would be years of stagnation, at best. Is this to be the vaunted “stability”?

The project of monetary union confronts a huge challenge. It has no easy way of resolving the Greek crisis. But the bigger issue is that the eurozone will not work as Germany wishes. As I have argued previously, the eurozone can become Germanic only by exporting huge excess supply or pushing large parts of the eurozone economy into prolonged slump, or, more likely, both. Germany could be Germany because others were not. If the eurozone itself became Germany, I cannot see how it would work.

Evidently, Germany can get its way in the short run, but it cannot make the eurozone succeed in the way it desires. Huge fiscal deficits are a symptom of the crisis, not a cause. Is there a satisfactory way out of the dilemma? Not so far as I can see. That is really frightening.

Why China’s exchange rate policy concerns us

By Martin Wolf
Published: December 8 2009 22:53 Last updated: December 8 2009 22:53

A country’s exchange rate cannot be a concern for it alone, since it must also affect its trading partners. But this is particularly true for big economies. So, whether China likes it or not, its heavily managed exchange rate regime is a legitimate concern of its trading partners. Its exports are now larger than those of any other country. The liberty of insignificance has vanished.
Naturally, the Chinese resent the pressure. At the conclusion of a European Union-China summit in Nanjing last week, Wen Jiabao, the Chinese premier, complained about demands for Beijing to allow its currency to appreciate. He protested that “some countries on the one hand want the renminbi to appreciate, but on the other hand engage in brazen trade protectionism against China. This is unfair. Their measures are a restriction on China’s development.” The premier also repeated the traditional mantra: “We will maintain the stability of the renminbi at a reasonable and balanced level.”
We can make four obvious replies to Mr Wen. First, whatever the Chinese may feel, the degree of protectionism directed at their exports has been astonishingly small, given the depth of the recession. Second, the policy of keeping the exchange rate down is equivalent to an export subsidy and tariff, at a uniform rate – in other words, to protectionism. Third, having accumulated $2,273bn in foreign currency reserves by September, China has kept its exchange rate down, to a degree unmatched in world economic history. Finally, China has, as a result, distorted its own economy and that of the rest of the world. Its real exchange rate is, for example, no higher than in early 1998 and has depreciated by 12 per cent over the past seven months, even though China has the world’s fastest-growing economy and largest current account surplus.
Comments on Martin Wolf’s column and contributions by leading economists
Do these policies matter for China and the world? Yes, is the answer. Mark Carney, governor of the Bank of Canada, notes in a recent speech, that “large and unsustainable current account imbalances across major economic areas were integral to the build-up of vulnerabilities in many asset markets. In recent years, the international monetary system failed to promote timely and orderly economic adjustments.”* He is right.
What we are seeing, as Mr Carney points out, is a failure of adjustment to changes in global competitiveness that has unhappy precedents, notably during the 1920s and 1930s, with the rise of the US, and, again, during the 1960s and 1970s, with the rise of Europe and Japan. As he also notes, “China’s integration into the world economy alone represents a much bigger shock to the system than the emergence of the US at the turn of the last century. China’s share of global gross domestic product has increased faster and its economy is much more open.”
Moreover, today, China’s managed exchange rate regime is quite different from those of other big economies, which was not true of the US when it rose to prominence. Thus, China’s managed exchange rate is shifting adjustment pressure on to other countries. This was disruptive before the crisis, but is now worse than that in this post-crisis period: some advanced countries, notably Canada, Japan, and the eurozone, have already seen big appreciations of their currencies. They are not alone.
Unfortunately, as we have also long known, two classes of countries are immune to external pressure to change policies that affect global “imbalances”: one is the issuer of the world’s key currency; and the other consists of the surplus countries. Thus, the present stalemate might continue for some time. But the dangers this would create are also evident: if, for example, China’s current account surplus were to rise towards 10 per cent of GDP once again, the country’s surplus could be $800bn (€543bn, £491bn), in today’s dollars, by 2018. Who might absorb such sums? US households are broken on the wheel of debt, as are those of most of the other countries that ran large current account deficits. That is why governments are now borrowers of last resort.
For the external deficit countries, the concern is how to lower fiscal deficits without tipping their economies back into recession. That will be impossible unless they are either able to get their private sectors spending and borrowing as before, or they enjoy rapid expansion in net exports. Of the two, the latter is the safer route to health. But that in turn, will only happen if surplus countries expand demand faster than potential output. China is the most important single player in this game.
Fortunately, these adjustment are in the long-term interests of both sides, including China. As a recent report from the European Chamber points out, China’s external surpluses have been a by-product of misguided policy.** Thus, capital was priced too cheaply in the 2000s, via cheap credit and low taxes on corporate profits, while foreign exchange was deliberately kept too expensive by currency interventions. In the process, income was transferred from households to industry. The result was an extraordinary surge in exports and capital-intensive heavy industry, with little job creation. Household disposable incomes fell to an extremely low share of GDP, while corporate investment, savings and the current account surplus soared. The short-term response to the crisis, with soaring credit and fixed investment, while successful in sustaining demand, reinforced these tendencies, rather than offset them. Another round of huge increases in excess capacity and current account surpluses seems inevitable.
China’s exchange rate regime and structural policies are, indeed, of concern to the world. So, too, are the policies of other significant powers. What would happen if the deficit countries did slash spending relative to incomes while their trading partners were determined to sustain their own excess of output over incomes and export the difference? Answer: a depression. What would happen if deficit countries sustained domestic demand with massive and open-ended fiscal deficits? Answer: a wave of fiscal crises.
Neither answer is acceptable; we need co-operative adjustment. Without it, protectionism in deficit countries is inevitable. We are watching a slow-motion train wreck. We must stop it before it is too late.

* The Evolution of the International Monetary System, November 19 2009, www.bankofcanada.ca
** Overcapacity in China, www.europeanchamber.com.cn

Britain’s dismal choice: how to share the losses

By Martin Wolf
Published: December 15 2009 22:11 Last updated: December 15 2009 22:11

The UK is poorer than it thought it was. This is the most important fact about the crisis. The struggle over the distribution of the losses is going to be brutal. It will be made more so by the second most important fact about the crisis: it has had a huge effect on the public finances. The deficits are unmatched in peacetime.
Happily, the general election would appear to offer a golden opportunity for a debate. Is that not the discussion the country ought to have? Yes. Is it the discussion it is going to have? No. What the government would do if re-elected remains, even after the pre-Budget report, “a riddle, wrapped in a mystery, inside an enigma”, as Churchill said of Stalin’s Russia.
On the Treasury’s current forecasts, the economy will regain 2008 levels of economic activity in 2012. Four years of expected growth would have vanished. In last week’s pre-Budget report, the Treasury forecast growth of 1.25 per cent next year, 3.5 per cent in 2011 and 2012, then 3.25 per cent in 2013 and 2014. Suppose that growth were to continue at 3.25 per cent a year thereafter. It would still take until 2031 before the economy was as big as it would have been if the 1998-2007 trend had continued. The cumulative loss of output would be 160 per cent of 2007 gross domestic product. If growth after 2014 were at the pre-2008 trend rate, lost GDP would be almost three times 2007 GDP by 2030 (see chart). It is easy to imagine worse possibilities.
These losses in output have had a severe impact on the public finances. Indeed, the fiscal deterioration in the UK has been far bigger than in any other member of the Group of Seven leading high-income countries.
The proximate explanation has been the collapse in government revenues. Between the 2008 Budget and the 2009 pre-Budget report, the forecast of total spending for this financial year has risen by just 4.4 per cent. The forecast of nominal GDP has indeed fallen by 9.1 per cent. But the forecast of revenue has collapsed by 18.1 per cent.
Yet the UK’s recession has not been more severe than that of other high-income countries. As Alistair Darling, the chancellor of the exchequer, noted in his speech on the pre-Budget report, the cumulative contraction in this recession, up to the third quarter of 2009, has been 3.2 per cent in the US, 5.6 per cent in Germany, 5.9 per cent in Italy, 7.7 per cent in Japan and only 4.75 per cent in the UK. The reason this not particularly dramatic decline in output, by the standards of this “Great Recession”, has had an exceptionally big impact on revenues is that, in the UK, the financial sector played a huge role in supporting consumer expenditure, property transactions and corporate profits. No less than a quarter of corporate taxation came from the financial sector alone. Receipts from corporate taxes fell by 26 per cent between the 12 months to October 2008 and the 12 months to October 2009. Receipts from value added tax fell by 17 per cent over the same period. Over and above the general effect of the recession, this is, to a significant extent, a result of the vulnerability of the UK economy to the disruption in credit and collapse in profits of financial businesses.
What does this imply for the UK’s future? A good way of thinking about this question is that the UK has not only had a financial crisis, with the usual severe impact on output and the public finances, but that the UK has also been a “monocrop” economy, with finance itself acting as the “crop”.
Countries that depend heavily on output and exports of commodities whose markets are volatile are all too familiar with the cycles these can create. In booms, export revenues and government revenues are buoyant, the real exchange rate appreciates and marginal producers of tradeable goods and services are squeezed out – a fate sometimes known as the “Dutch disease” after the impact of discoveries of natural gas on the economy of the Netherlands. Often, both government and the private sector borrow heavily in these good times. Then comes the crash: exports and government revenues collapse, fiscal deficits explode, the exchange rate falls and, quite often, inflation surges and the government defaults.
The biggest mistake one can make in macroeconomics is to confuse the cycle with the trend. In monocrop economies, the danger is particularly big, because cycles can be so large. This, in retrospect, is the mistake the UK made. Thus, the Treasury has decided that the UK’s potential output suddenly fell by 5 per cent during this crisis. This is nonsense, as Robert Chote, director of the Institute for Fiscal Studies, has suggested. What the Treasury used to consider sustainable output was, instead, the product of the bubble in the UK’s monocrop financial sector, spread, directly and indirectly, to the economy and the public finances.
If this view is right, it has three painful implications: first, properly measured fiscal policy was far looser than was thought during much of Gordon Brown’s period as chancellor; second, it is likely that the UK will suffer not only from a permanent loss of output, but also a permanent decline in the trend rate of economic growth; and, third, a huge fiscal tightening cannot be avoided.
At present, the government envisages a structural fiscal tightening of 5.4 per cent of GDP over two parliamentary terms, much of it unspecified (see chart). It now expects that a third of this will be achieved through higher taxes and two-thirds through cuts in spending. To make this credible, it envisages a fiscal consolidation plan that would, in some incomprehensible manner, be legally binding. Would a defaulting chancellor be taken to the Tower of London? But the problem with the plans is not only that they are barely credible, but also that the envisaged tightening is probably too little and the final level of public sector net debt, at around 60 per cent of GDP, too high for comfort, given the likelihood of further adverse shocks. Even so, cuts in spending are larger than in similar episodes in the postwar period.
While the chancellor has presented overall numbers, he has shied away from exploring the full implications and, still more, the nature of the choices the country faces. This is the debate the UK must have. It must start from a realisation: the country is poorer than was thought. So how should these losses be shared in ways that minimise both the harm done to vulnerable people now and to the country’s economic prospects for the longer term? Those are the big questions in UK politics. Serious politicians must not duck them.