THE RISKS OF PREMATURE TIGHTENING / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

The risks of premature tightening


By Martin Wolf

Published: September 16 2010 21:50


Mervyn King, the governor of the Bank of England, is among the world’s most influential central bankers and leading policy economists. I greatly admire both his intellect and his integrity. Mr King has also played a big part in persuading the UK’s coalition government of the urgency of what he calls “a clear and credible plan for reducing the deficit”. To his great credit, he has just said this to the Trades Union Congress, the most unfriendly audience he could find. He went on to say: “I would be shirking my responsibilities if I did not explain to you the risks of failing to do so.” Indeed, he should say what he thinks. But is he right to think as he does? I have doubts.

That will come as little surprise to those who read my endorsement of points made by Ed Balls , former adviser to Gordon Brown and current Labour leadership candidate, two weeks ago. I am more fiscally hawkish than Mr Balls, as I said at that time. But I am not as hawkish as Mr King. Yes, I agree that there are risks to cutting the fiscal deficit too slowly. However there are also risks in cutting it too fast. Similarly, while there are risks in not having a credible plan, there are also huge risks in having an inflexible one. The UK needs an adaptable plan for fiscal cuts, one that takes account of the huge uncertainties that result from the fragility of the private sector.

What is the core of Mr King’s argument? It is that “market reaction to rising sovereign debt can turn quickly from benign to malign ... It is not sensible to risk a damaging rise in long-term interest rates that would make investment and the cost of mortgages more expensive. The current plan is to reduce the deficit steadily over five years – a more gradual fiscal tightening than in some other countries. As a result of a failure to put such a plan in place sooner, some euro-area countries have found – to their cost – a much more rapid adjustment being forced upon them.”
I have argued before that the UK is in a very different position from, say, Greece: it has a far lower ratio of debt to gross domestic product; it borrows in its own currency; it has the means to promote its own recovery, which is vital for managing public debt; it has a modest current account deficit; it has a history of managing its public debt well; and current indebtedness is lower, relative to GDP, than the average of the past three centuries. Markets have also been remarkably relaxed about funding these deficits: interest rates on index-linked gilts have been 1 per cent, or less, for more than a year; the yield on 10-year gilts has remained below pre-crisis levels and is now close to 3 per cent; and spreads over German bunds have been 1 percentage point, or less, throughout the crisis.

The government argues that borrowing costs have been contained only because of its commitment to austerity. In fact, spreads over bunds have stabilised since February and fallen by just 0.2 percentage point since the election. This suggests that the coalition’s strong fiscal stance has brought modest credibility gains. What would have happened if Labour had won we cannot know.

None of this would matter if the risks went only one way – from a failure to tighten rapidly. This is not so. The danger on the other side is that the economy weakens sharply under a structural retrenchment averaging 1.6 per cent of GDP a year over five years. This would be bad for output and jobs. It would also offset the structural fiscal tightening with cyclical loosening: the UK would have to run to stand still.

Consider what we do not know: how much of the 10 per cent gap between actual GDP and the extrapolation of past trends is permanent; how big an impact another slowdown would have on potential output; how the private sector will respond to the fiscal tightening; and how effective monetary offsets will be.

I am astonished by the certainty people feel about such uncertainties. As Andrew Smithers of London-based Smithers & Co has noted, one possible – even likely – offset to rapid fiscal tightening would be a collapse in corporate savings or, in other words, profits. In the context of a sharp fiscal tightening, with interest rates at rock bottom, that seems a far more plausible outcome than a surge in corporate investment as a way of achieving the needed reduction in the corporate financial surplus, which was 6.1 per cent of GDP in the first quarter of 2010. Why would that be a good thing?

It would be far more sensible to make plans for fiscal retrenchment that are explicitly contingent on how the economy recovers. Should growth remain at or below 2 per cent, cutting spending should be slower or, alternatively, there should be offsetting cuts in taxation, perhaps national insurance contributions. If growth rises above this rate, cutting can be accelerated and fiscal offsets reversed. Such a flexible plan would ultimately be more credible, not less: it is quite hard to convince markets one is prepared to commit political suicide. The Chinese say one should “cross the river while feeling the stones”. When we know as little as we do, that sounds excellent advice.

Copyright The Financial Times Limited 2010.