By Robert Skidelsky
Published: December 22 2009 20:30 Last updated: December 22 2009 20:30
It is not surprising that Britain’s largest economic downturn since the war should have seen the largest ever peacetime government budget deficit. By the end of this year Britain’s output will have fallen by about 5 per cent since the crisis started; in the same period the budget deficit will have risen by between 5 per cent and 8 per cent of output. Arithmetic so simple that even a child can understand it: smaller output, smaller revenues, larger deficit. And the corollary: larger output, larger revenues, smaller deficit.
The deficit for 2009-10 is projected to be £178bn (€200bn, $287bn), about 11 per cent of gross domestic product. There is some dispute as to how much of this is “structural” and how much “cyclical”. The “structural” deficit is the gap between government revenue and spending that will have to be closed by higher taxes or lower spending. The “cyclical” deficit is the gap that will automatically disappear when the economy has recovered. Those who say the downturn has added 8 per cent rather than 5 per cent to the deficit argue the recovered UK economy will be smaller than the pre-recession one, hence the recovery will leave a gap of £132bn rather than £100bn. Whatever the right number, no one doubts that there will remain a sizeable fiscal problem, even after the downturn has been reversed.
But why has the financial press been almost unanimous in condemning the modest pre-Budget measures announced by Alistair Darling, chancellor of the exchequer, to protect total spending in the face of a massive collapse of private demand? Why are the markets howling for “fiscal consolidation” now – ie cutting fiscal support to the economy immediately – when it has plainly not yet recovered?
To understand “market sentiment”, one has to go back to two ideas in the minds of most financial analysts which almost unconsciously shape their arguments. The first is the belief that economies are always at full employment. The second is the belief that even if they are not (obviously contradicting the first), they very soon would be if only governments would stop bailing them out.
The first is perhaps the most pervasive. It takes the form of denying that there is an output gap. That is, at all points in time output is no more or less than what the economy is able to produce. If this is so, government attempts to close an imaginary output gap by running a deficit will either take money better spent by the private sector or be inflationary. (Output-gap deniers always see the microbe of inflation in the air.) Either way deficits are bad, which is why “fiscal consolidation” needs to happen immediately. In the early days of the crisis this deep theoretical commitment to the existence of continuous full employment was temporarily overcome by common sense. But as the fear of apocalypse receded normal intellectual service was resumed.
The more cautious version of “output gap denial” is the view that the pre-crisis level of output was the result of bank-financed debt, and that much of it went for good with the credit crunch. Public finances cannot rely on a recovery of output to produce a stream of revenue to reduce the deficit because – wait for it – there is little or no output to be recovered.
Even the normally sober Martin Wolf has fallen for this line (FT, December 16 2009).
The pre-crisis UK economy, he says, was a “bubble economy”. The bubble made UK output seem larger than it actually was! This is old-fashioned Puritanism: the boom was the illusion, the slump is the return of reality. However, experience of past recessions suggests that, once the corner is turned, output recovers vigorously from slump conditions (as do prices). Between 1933 and 1937 the UK economy expanded by 4 per cent a year, much higher than its “trend” rate of growth. Yet in 1931 orthodox economists were denying there was an output gap at the bottom of the greatest depression in history.
The second theoretical commitment of most financial analysts is that economies, if disturbed, revert quickly back to full employment if not further deranged by government actions. Thus contrary to the commonsense view that massive government intervention last autumn stopped the slide down to another Great Depression, the new conservative commentators (having got their breath and confidence back!) now argue that ill-conceived government measures have stopped, or are hindering, the natural recovery mechanisms.
For example, it is argued that massive government borrowing is keeping yields higher than they would otherwise be. Thus government efforts to stimulate spending have the effect only of retarding a natural fall in the rate of interest. If its borrowing is not rapidly reduced there will be a “gilt strike” – investors will demand higher and higher prices for holding government paper. Faced with the evidence that, despite increased government borrowing, gilt yields have been at a historic low, the critics say that this is only because the gilts are being bought by the Bank of England. Once the Bank stops buying government debt, interest rates will shoot up.
A parallel argument is that the expansion of the fiscal deficit is preventing a natural fall in the exchange rate sufficient to boost exports. The tortuous logic seems to be that “fiscal consolidation” will cause the rate of interest to fall and the fall in interest rates will cause the exchange rate to fall, thus increasing the demand for British exports. It is often alleged that something like this happened in 1931 when Britain left the gold standard for the last time.
Empirical evidence supporting the view that cutting the deficit causes the exchange rate to fall is very thin. A 1997 study by the International Monetary Fund showed that in only 14 out of 74 studied instances did fiscal consolidation promote a recovery via a fall in the exchange rate. In all the other cases fiscal policy either had no discernible exchange rate effect or it was the expansion of the deficit that caused the exchange rate to fall.
This only confirms what common sense and elementary Keynesian theory would lead one to expect. In a slump there is no natural tendency for the rate of interest to fall, because people’s desire to hoard money is increasing. So printing enough money to “satisfy the hoarder” is the only way of getting interest rates or the exchange-rate down.
But, of course, there is always “market sentiment” to fall back on. The government must cut its spending now, because this is what “the markets” expect. These are the same markets that so wounded the banking system that it had to be rescued by the taxpayer. They are now demanding fiscal consolidation as the price of their continued support for governments whose fiscal troubles they have largely caused.
Why on earth should we take this market sentiment any more seriously than that which led to the great debauch of 2007? Markets, it is sometimes said, may not know what they are talking about, but governments have no choice but to do what they tell them. This is unacceptable. The duty of governments is to govern in the best interests of the people who elected them not of the City of London. If that means calling the bankers’ bluff, so be it.
Lord Skidelsky is emeritus professor of political economy at the University of Warwick. His latest book Keynes: The Return of the Master was published in September
