In a democracy, willingness to inflict economic pain is rarely a route to credibility. Investors will refuse to believe that the policies will survive. Once they reach that conclusion, credibility disappears.
I learnt this in 1992. With the U.K. economy in recession, the credibility of the government’s commitment to membership of the exchange rate mechanism of the European Monetary System came into question. Many thought that a willingness to raise interest rates when sterling came under pressure would restore credibility. It did the opposite: few believed the pain could be sustained. The government could not enhance the credibility of an incredible commitment.
This experience informs my view on the options for the British government. The arguments put forward for continuing with the planned fiscal tightening are that, in its absence, credibility will be lost and interest rates on government bonds explode. I suspect the reverse will ultimately prove to be the case. In the absence of policies likely to restore economic growth, the planned fiscal tightening will itself be incredible. Investors will believe that attempts to cut fiscal deficits in a prolonged slump will ultimately force a change of course. Commitments to delivering the incredible weaken credibility.
The background to such thoughts is news that the first estimate of gross domestic product showed a fall in the first quarter of 2012 and so a technical recession on the popular definition of two quarters of negative growth. Far more important is the fact that the U.K. economy has stagnated for a year and a half. GDP is stuck at more than 4 per cent below its pre-crisis peak, close to where it was back in the third quarter of 2006 and 9 per cent below its 1970-2007 trend. True, the unemployment rate of 8.3 per cent is not high, given the length and depth of the slump. But one in five young people between the ages of 18 and 24 is out of work.
Yet the fiscal squeeze has barely begun. According to the Office of Budgetary Responsibility, net borrowing fell by just 1.8 per cent of GDP between 2009-10, just before the coalition government came into office, and 2011-12. A further tightening of 7.2 per cent of GDP is due by 2016-17. The assumption that this will coincide with economic expansion is, in today’s economic conditions, bordering on the heroic.
Remember that official short-term interest rates are half a per cent, 10-year government bonds yield 2 per cent and index-linked gilts yield zero. Yet, despite these extremely low costs of funds and the benefits of commitment to sustainable public finances, the corporate sector ran a huge financial surplus (excess of retained earnings over investment) of 5.3 per cent of GDP last year. The view that the fiscal retrenchment will now generate a surge in private spending seems improbable. More likely is stagnation, if not worse.
So can anything be done to avoid the immediate and long-term costs of a further prolongation of the slump?
The response of those who insist that no change may be considered in the government’s plans is that credibility would be destroyed. Indeed, they claim that today’s low interest rates are themselves proof of credibility. Yet remember that when the chancellor announced his fiscal plans in 2010, net borrowing was supposed to be just £206-billion between 2012-13 and 2015-16. In the March 2012 Budget this was up to £317-billion. Did that colossal failure to hit his target destroy credibility and so lead to explosive increases in bond yields? No. But why not? The answer is that with a central bank sure to keep the gilts market liquid and a floating exchange rate, low interest rates are what one would expect in an economy with such huge private sector surpluses. The slump, not the credibility, delivers these low rates.
Worse, the biggest danger to credibility is a prolongation of the slump, which might indefinitely delay the closing of the deficit. How might this risk be addressed? The answer is to convince private decision makers that the economy will grow, which requires policies aimed at demand. The trick is to introduce them without threatening the long-term sustainability of public finances. The best way to do this is to combine the commitment to reducing the share of current public spending in GDP with flexibility on taxation and greater public investment. Both of the latter can credibly be temporary. At current interest rates, even a large medium-term increase in borrowing would almost certainly pay for itself in the greatly enhanced present value of current and future output. The best tax cuts would increase investment, consumer spending and the incentives to hire idle workers.
The mistake made by the government was to announce fixed plans for so many years ahead. The recovery has not materialized. Flexibility in response is no sin. On the contrary, it is a great virtue.