J. K. Galbraith, the author of Crash of 1929, a book that Mervyn
King, the Governor of the Bank of England, has been recommending to all his
visitors since the start of the present financial crisis, once said that
there are two kinds of economists: those who don’t know what will happen and
those who don’t know they don’t know.
Anyone who purports to predict with confidence what will happen to the British
economy or to the Government’s finances in the next two years must fall into
the latter category. And after the heart attack that the global financial
system suffered with the bankruptcy of Lehman Brothers, most serious
economists admit that there is simply no way of telling what may happen next
year.
Unfortunately for the Chancellor, he does not have the luxury of simply
saying: “I don’t know.” In presenting what was actually a rather modest
package of measures in relation to the scale of the economic risks now
facing the country, Alistair Darling had to lay out a set of detailed
forecasts on government borrowing and finances that depend on precise
predictions about the British economy’s performance not just next year or
the year after, but for most of the next decade. The one thing we can say
for sure about these figures is that they will all turn out to be wrong. Yet
because of Britain’s bizarre political conventions, the debate about this
critically important policy statement – arguably the most important made by
any government since 1993 – will revolve around the three essential
questions posed to the Chancellor by George Osborne, his Shadow. Will
Britain’s public debt double in the next five years to more than £1
trillion? Will Britain suffer a worse recession than any other major
economy? And will the tax increases announced yesterday for the early years
of the next decade prove permanent, while the tax cuts are withdrawn?
The truth is that nobody can answer these questions, because they depend
entirely on how long and deep the recession in the British economy turns out
to be. That, in turn, will depend on the effectiveness of the economic
stimulus announced yesterday, combined with the even stronger monetary
medicine already administered by the Bank of England and the further big
interest rate cuts that are sure to follow in the months ahead.
If the combination of Mr Darling’s £20 billion fiscal boost with the Bank’s
dramatic rate cuts and the sharp fall in the pound manage to revive economic
activity after a relatively brief slump, then a reelected Labour Government
will have no great difficulty in answering the questions posed yesterday by
Mr Osborne: the national debt will remain quite manageable, Britain will
suffer less from this recession than several other European countries and
some of the swingeing tax rises announced yesterday might never be imposed.
Labour might even restore its reputation for fiscal prudence, as Mr Darling
promised, albeit after a long interregnum until 2015. If, on the other hand,
the efforts to sustain economic activity prove unsuccessful, then not only
will Labour lose the election, but the next government will inherit a fiscal
and economic disaster even worse than the one Mr Osborne described.
Normally in a debate between extreme positions adopted by the two main
political parties, the truth lies somewhere in between. But in the present
circumstances this split-the-difference approach will not work – either
the economy and the public finances perform as well or better than Mr
Darling has promised or the outcome will be even worse than Mr Osborne dared
to suggest.
The reason why the outlook is so bipolar is straightforward: the future of
public finances depends far more on the growth of the economy than on any
other factor such as the level of public spending or tax rates. So if an
economic recovery really does begin next summer, as Mr Darling has
predicted, then the seas of red ink will drain away with surprising speed.
If, however, the economy remains in recession until the end of next year or
even longer, then Britain really should prepare for a Japanese-style
outcome, as Mr Osborne implied. In the long period of stagnation after the
bursting of Japan’s “bubble economy”, government debt climbed from 13 per
cent of national income in 1991 to 91 per cent in 2007.
Japan’s experience suggests that if Britain does remain in recession much
longer than the Treasury has forecast, the projected increase in Britain’s
government debt from 36 per cent of national income in 2007 to the peak of
57 per cent in 2013 will prove a gross underestimate.
Doesn’t this mean that Mr Darling has taken an enormous gamble with the
British economy and public finances? The answer, as usual in economics, is
“yes” and “no”: “yes” in the sense that future levels of debt, public
borrowing and taxes depend entirely on whether the policies announced
yesterday succeed in pulling the economy off the rocks; “no” in the sense
that a more “cautious” fiscal policy would entail even greater risks. If,
for example, there were no cut in VAT and, as a result, the economy shrank
by a percentage point more than the Treasury has predicted, then public
borrowing next year would be at least as big as it will be after the tax cut –
and the sea of red ink would be even deeper than it will be on present
assumptions from 2010 on. That, in turn, would mean that even without
yesterday’s VAT cut, big tax increases would be needed from 2010 onwards to
get future deficits under control.
As Keynesian economists have frequently noted – and as the Japanese
proved throughout the 1990s – caution is reckless in a recession and
national bankruptcy can result from thrift. What the Tories now seem to
believe, on the other hand, is that Keynesian fiscal stimulus is doomed to
failure and the management of the economy should be through interest rates
alone.
This is a perfectly respectable position. It can quite reasonably be argued
that government borrowing should not be used as an economic stimulus, except
perhaps as an absolute last resort – after interest rates have been
reduced to zero, after the pound has been devalued much further and after
the Bank has started openly printing money to finance the Government’s
debts. What British politicians and businessmen ought to be debating,
therefore, is not the precise numbers in the Treasury’s borrowing
projections, which are not worth the paper they are written on. Instead,
they should be debating the best structure for the tax system: if extra
revenues need to be raised in the future, is it better to do this through
national insurance and income tax, instead of reintroducing a steeply
escalating energy tax? If Labour wants to raise the top tax rate from 40 to
45 per cent for redistributive reasons, it should say so, instead of
pretending that this purely is needed to control the national debt.
Politicians should also be debating what sort of long-term targets for fiscal
policy might make sense. What exactly would be the problem if the public
debt to GDP ratio increased to 57 per cent in 2013? Comparable measures of
public debt are already more than 55 per cent in Germany, France and the
euro area on average, not to mention Japan – and that is before all
these countries increase their borrowings in the years ahead.
Above all, Britain’s politicians ought to be debating the conditions under
which a Keynesian fiscal stimulus, combined with dramatic reductions in
interest rates, might or might not work.
The Tories, instead of throwing around meaningless insults about reckless
gambling and “borrowing your way out of debt”, should be more explicit about
what could be an alternative recovery programme, based on a truly radical
monetary policy: to take control of the Bank and reduce interest rates
immediately to near-zero and take legal powers forcing nationalised banks to
pass on these rate cuts, to increase their business credit lines and expand
their mortgage loans.
Mr Darling and other Labour leaders, meanwhile, should be explaining to the
public that government budgets are not the same as household budgets. At a
time when private citizens want to save more, to cut back on debt and reduce
their consumption, it would be madness for the Government to do the same.
On the contrary, it should borrow more to absorb the private sector’s savings –
and at a time when investors are unwilling to buy property, shares,
corporate bonds or other “risky” assets, there is essentially no limit on
the financial markets’ ability to absorb more government debts. Neither is
there any conflict between higher public borrowing and lower interest rates,
as long as inflation remains under control.
Those, at least, are the lessons of textbook economics, whether of the
Keynesian or monetarist style. Labour is betting that these lessons will
broadly be borne out in practice. The Tories are essentially betting that
textbook economics turns out to be wrong. Next year, we will know which of
these gambles paid off.
