BRITAIN´S PHONEY DEBATE ON SLASHING SPENDING / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

Britain’s phoney debate on slashing spending

By Martin Wolf

Published: October 8 2009 23:30

“Our country is facing the largest budget deficit in our modern history.” Thus did George Osborne, shadow chancellor of the exchequer in the Conservative party, start his speech at the party conference this week. He was right. The questions are what to do, how and when.

According to the International Monetary Fund, the UK’s general government deficit will hit 11.6 per cent of gross domestic product this year and 13.2 per cent in 2010. The US deficit will hit 12.5 per cent and 10.0 per cent, respectively. In 2007, UK net public debt was 38 per cent of GDP, while that of the US was 42 per cent. By 2014, forecasts the IMF, these ratios will have jumped to 92 per cent and 85 per cent. The transatlantic cousins are now the terrible fiscal twins.

In deciding what to do, we must recognise the uncertainties: we do not know how big the “structural” fiscal deficit is; we do not know how long correction can be delayed before investors lose confidence; and we do not know how far a fiscal tightening will weaken aggregate demand. But the costs of being too optimistic are likely to be higher than of being too pessimistic. That should determine how policymakers respond.

On how much needs to be done, the UK Treasury was sensibly pessimistic in its March Budget. As the Institute for Fiscal Studies noted recently, the overall tightening the Treasury plans to deliver is 8 per cent of GDP (about £100bn in today’s money) from 2009-10 to 2017-18.* This is equal to a sixth of total public spending, two-thirds of the public sector pay bill and all spending on the National Health Service in England. Moreover, if one assumes no further tightening, public sector net debt only returns to pre-crisis levels 20 years from now. The crisis casts a frighteningly long shadow.

How is such tightening to be achieved? This is a political judgment over how unexpected reductions in real income are to be shared across the population. Total government spending is forecast to hit 48 per cent of GDP. My own view is that this is far too high for politically acceptable tax levels in the UK. What is fascinating is that both Labour and the Tories agree that spending must take the hit. The IFS notes that, under the government’s plans, “much of the rise in spending on public services under Labour to date looks set to be reversed when measured as a share of national income”.

When large, long-term cuts have to be made, the best approach is to set priorities and make structural changes. Obvious examples are: big changes in unaffordable and unjust public sector pension provision; big rises in pension age, to take account of higher life expectancy; long-term constraints on the remuneration bill (but not pay levels) of the government; and deep reforms in welfare spending. The crisis is a golden opportunity to impose discipline and make reforms.

What should be done is closely related to when. These sorts of changes must not be rushed. Hasty cuts may lead to bad policies, such as the 60 per cent cut in net investment already decided; and they may also push a fragile economy back into a deep slump.

Analysts at Goldman Sachs argue that the weakening of sterling reflects the expected fiscal tightening and should also offset the adverse impact of the tightening on demand. This ought to be true, in the long run, provided the world economy recovers strongly and UK monetary policy is aggressive. Nevertheless, big swings in the structural current account balance do not happen in a year or two. But this argument does emphasise that the weakening of sterling is not itself a problem; it is an important part of the solution.

In sum, the UK is right to plan for a structural fiscal tightening of at least 8 per cent of GDP. But it is unnecessary – and almost certainly a huge error – to implement such a tightening in short order. What is needed instead is a set of structural reforms that are sure to deliver the tightening over an extended period.

Mr Osborne insists that a recovery will only follow when “you show the world that Britain can pay its way”. But with 10-year UK government bond rates at a mere 3.4 per cent, it is perfectly possible that much of the tightening can be delayed until the recovery begins. What matters is the credibility of the new plans, not the urgency of their implementation.

Mr Osborne also talked of the need to be “open and transparent”. But he has been little more so than the government: the changes he announced deliver £7bn of the needed £100bn. The motto of both parties is: “I will do such things – what they are, yet I know not – but they shall be the terrors of the earth!”. This makes for a phoney debate. It needs to become real before the general election. Only then can voters make an informed choice between the alternatives.

* Britain’s Fiscal Squeeze: the Choices Ahead, www.ifs.org.uk

Copyright The Financial Times Limited 2009.