Britain's false deficit impressions

FT.com

Very near the beginning of his speech introducing the comprehensive spending review, George Osborne attempted to frame the exercise in the simplest of terms: "We are going to ensure, like every solvent household in the country, that what we buy we can afford; that the bills we incur we have the income to meet.” Either you accept the chancellor's analogy or you do not. I do not. Of course the deficit matters. But it should be a policy variable rather than targeted to meet a dim accountant's idea of balance.

The number of international authorities the chancellor selectively quoted in support of his view does not make it valid. "Selectively”, because the International Monetary Fund, for instance, which he cited, is obviously split. All the chancellor needed to do was to fill in the detail of his predecessor Alistair Darling's project to cut the deficit by half over five years, which the latter was not allowed to give for political reasons, with the addition of provisions for flexibility in either direction.

I do not agree with some of my media colleagues that this is the biggest economic policy shift since Henry VIII's Dissolution of the Monasteries. As the Centre for Economics and Business Research, among other analysts, has pointed out, even if the government succeeds in reducing managed public expenditure from its current level of 48 per cent of gross domestic product to just under 40 per cent by 2015-16, this still leaves the ratio higher than in the early years of the recent Labour government. The projected cut is much less steep than the 3.9 percentage point cut in a single year, 1977-78, after a Labour chancellor, Denis Healey, applied to the IMF.

None of this will be of much comfort to someone in the public services fearing the sack. Osborne's statement, which was mainly a list of numbers, did not provide much idea of the detailed implications. These will emerge from forthcoming departmental announcements – and of course from leaks. We already know that David Cameron intervened to trim the defence cuts, although nothing the prime minister does in this area will restore the instinctive rapport that existed between Hillary Clinton, the US secretary of state, and Labour.

The CSR contained no supporting macroeconomic analysis, although this is promised in an Office for Budget Responsibility report on November 29. In the meantime, we have to turn to a speech by Mervyn King, the governor of the Bank of England. We should note, however, that although King supports fiscal austerity now he was one of the famous 364 economists who protested against the Thatcher government's fiscal clampdown in 1981, when domestically generated inflation was in the double-digits and there was a much better case for such measures. This week he announced that "we” would have to save more to make up for an earlier drop in the gross national savings ratio and to take account of increasing life expectancy. He recognised the need for a recovery in demand and called for more than half a million jobs to be created in businesses selling overseas to "close the gap between exports and imports” and to compensate for job losses in the public and private consumption sectors. He recognised the need for monetary policy to provide a temporary stimulus to demand while the rebalancing takes place. He nearly spoilt it all by adding the absurd ritualistic clause that this was to reduce the risk of inflation falling below target in the medium term. The true reason is, of course, to lessen the risk of a slump, when on his own estimate output is already 10 per cent below trend.

The real rub came later in his speech, when he stressed that lower domestic demand in deficit countries such as the UK must be accompanied by strong growth in the surplus countries if the world economy was not to slow down. What was needed was a shift from their reliance on exports and a corresponding increase in domestic demand. He called for a "grand bargain” in the Group of 20 leading economies in which the surplus countries boosted domestic demand, together with exchange rate adjustments and, surprisingly, "rules of the game” to control capital inflows. He admitted, however, that the spirit of co-operation to prevent a world slump, evident in the October 2008 G7 meeting, had "ebbed away”; to restore it would "require a revolution”. Until that revolution occurs, would it be so bad if the UK government borrowed a bit more when world interest rates are unprecedentedly low?

Controversies about the Bank of England's own contribution to maintaining demand, called "quantitative easing”, are nothing but a rerun of very old arguments about whether central banks can "push on a string” in depressed conditions by maintaining the money supply. Milton Friedman and Anna Schwartz, in their justly famous Monetary History of the United States, established that the Federal Reserve did not choose to do so at the onset of the Great Depression of the 1930s. They did not – and could not – establish what would have happened had it tried.

Copyright The Financial Times Limited 2010. Reproduced with permission.