It’s the new year, but the big questions facing the British economy – how fast should it reduce its gaping 13 per cent of national income budget deficit, and how much can monetary policy offset fiscal tightening – remain unanswered.
In the annual FT survey of British economists, the most commonly cited economic threat for 2010 was a fiscal crisis, raising the cost of servicing Britain’s public debt and raising risk-free interest rates, thus undermining the recovery. But economists were split almost 50:50 about how quickly the deficit should be reduced.
On one side of the argument, those urging caution worried about the consequences for the recovery of rapid action in raising taxes or cutting public spending. The counter view was that a failure to act soon will lead to rising costs of servicing debt and that would, itself, undermine the recovery.
I don’t have a good answer to this genuinely difficult balancing act. But the answer must relate to the following:
- The forward-looking nature of households. The theory of Ricardian equivalence – that households will offset unfunded tax cuts with greater savings knowing they will have to pay in the end – is often seen as a pessimist’s charter because it renders government policy impotent. But when deficits are unsustainable and approaching 13 per cent of national income, the theory is actually on the side of the optimists. If British households are already saving (they are) to smooth their consumption in the face of expected future tax rises and spending cuts, implementing tightening policies should not harm the recovery. Trusting the future of the economy to the forward-looking nature of British consumers, rather than their myopia, is something of a leap of faith, but should not be dismissed. Everyone in Britain knows borrowing has to fall.
- How rapid is the recovery. The more rapid the recovery, the easier tightening fiscal policy becomes. This is obvious. Today’s good manufacturing survey data and encouraging lending figures edge the debate slightly in favour of more rapid deficit reduction, as they suggest the economy will recover more like the Bank of England’s forecasts and less like most economists’ more cautious views.
- The effect of sterling’s depreciation. The lower pound makes our exports more attractive. Higher net trade means easier fiscal consolidation, as weaker household and government consumption (from higher taxes and lower spending) can be offset by demand from foreigners. Tempering this hope is Britain’s unfortunate dependence on the US and Europe for exports. This is likely to make the contribution from net trade weaker than if the UK exported to emerging markets. So far, the slow reaction of exports to the global recovery suggests caution is still required.
- The credibility of any deficit reduction plan. If markets believe the government will get the public finances back into shape, they will give them more leeway on timing (given Britain’s still-low level of public sector debt). Today’s unedifying early election skirmishes on taxation and spending prove we won’t know this until we have a new government, probably in May. If politics continues to get in the way, more rapid action is likely to be required to satisfy markets that the politicians are serious.
- The ability of monetary policy to offset fiscal tightening. In the last big deficit reductions in the 1980s and 1990s, long-term interest rates fell sharply along with the fiscal deficit. This cannot be taken for granted this time. As I have written before, this should temper enthusiasm for extremely rapid deficit reduction.
- Whether QE is a stock or a flow concept. The Bank of England has always insisted quantitative easing is a stock concept – saying it is the total quantity of asset purchases that matters for monetary policy, not the rate at which it buys assets with money it has created. But frankly, the Monetary Policy Committee does not really know whether or how QE is working. If the interest rate on government bonds rises sharply as the prospect of the MPC turning off the QE tap draws closer – as happened in November – either the Bank will have to think again or a very nasty tension could arise between monetary and fiscal policy.
- Investor appetite for UK government bonds. There has been little sign yet of investors refusing to buy UK government bonds. Although the benchmark yield on five- and 10-year government notes has risen in the past month, so has the expectation for interest rates in the overnight index swap market, so the move does not obviously reflect a demand by investors of greater rewards for the risk of holding UK government debt. This suggests there is no imminent need for a faster programme of deficit reduction, but could change.
If I had to choose, I would definitely make the existing deficit reduction plans much more credible than they are now – for example, by revealing the extent of the planned departmental spending cuts rather than concealing them as the government is doing. I have asked for these in a Freedom of Information request, but so far no joy. This would buy time even on no change of policy.
I would probably also seek to consolidate the Budget deficit more quickly, taking out a bit more insurance against a fiscal crisis even though that is not my best guess as to what will happen. But I am not at all sure this is the right stance because the balancing act is genuinely difficult. I will be returning to these issues in the months ahead as the choices become more urgent and hopefully the right path becomes more obvious.