Wednesday, 9 June 2010

Cuts for the long term

It has been interesting to read the reaction of ministers under the previous government to the news that government spending is to be cut hard as soon as possible. Their position is being led by the former Chancellor Alistair Darling. His argument now, as during the recent election campaign, is that government expenditure must be maintained to keep sales churning and should only be reduced when the economy is producing more so that private sector demand is already in place to take over and fuel consumerism when government demand is reduced.

More interesting has been the position taken by the IMF and the European Central Bank in relation to the collapsing Euro-zone economies, a position echoed belatedly by one former minister in the last government. They are all citing the structure of an economy as being more important than transient issues such as this year's level of consumer demand. Yet again my mind goes back to 1976 when the previous Labour government had to beg a massive cash injection from the IMF in order to be able to pay its bills. Among the conditions attached to the IMF loan was a requirement to reduce government spending. Among the conditions attached to the bail-out of bankrupt Greece is a requirement to reduce government expenditure. Among the criticisms of his former colleagues made by ex-minister Lord Myners is their failure to recognise the need to reduce government expenditure.

Mr Darling's argument looks only at the short term. In a way that is understandable. Politicians are scared of some words, one of which is recession. If you can avoid, delay, soften or end recession any path that achieved that end is attractive to those whose careers depend on recession being avoided, delayed, softened or ended. The problem is that it looks at the wrong measure. Recession is, of itself, a pretty meaningless concept. What does it matter if Gross Domestic Product falls by 1% for two consecutive quarters? Why is that awful whereas one quarter's fall of 2% is ok provided the next quarter does not also decline? The answer does not lie in the magic word "recession" it lies in the causes of a sustained fall in economic activity. That there is a sustained fall is consistent with there being an underlying fault but it is not proof that any such fault exists, so recession of itself proves nothing. Similarly a consistent rise in economic activity does not prove that the economy is healthy because the rise might be caused by an unsustainable bubble of credit, as we have seen recently.

The long-term health of a national economy can only be assessed by looking at the overall structure of things and judging whether it is affordable in the long term. In this exercise both the quantity and quality of government expenditure figure large because government takes such an enormous share of national income. Importantly, it is necessary to look at both quantity and quality of government spending because they each have a significant impact albeit in different ways.

The quality issue is being addressed by such matters as ditching pointless quangos and other non-jobs that achieve nothing other than consuming tax revenue. It is also being addressed by trying to ensure that areas of government that do provide some benefit deliver a far larger bang-per-buck. These are not matters that can be addressed easily by international lenders because they are very case-specific and, in some instances, politically sensitive.

The quantity of government spending is a different matter. It affects the whole of the national economy drastically. Every penny government spends must come from one of three tranches of income - yesterday's tax, today's tax or tomorrow's tax. When some emergency arrives that requires exceptional government spending it can use savings made out of yesterday's tax (don't laugh, I'm talking theoretically here). If that is not enough it can channel some of today's tax into the pot and if that is still not enough it can borrow and then repay that borrowing from tomorrow's tax. None of it comes for free. Once the situation is reached of ordinary day-to-day government spending (as opposed to exceptional costs associated with, for example, essential military conflict) requiring borrowing against tomorrow's tax for year after year, you have an obvious structural problem.

Economic growth and its resultant larger tax-take can address that problem to a degree but only to a degree. As the private sector earns more there are entirely reasonable pressures for public sector salaries also to increase, thereby absorbing much of the increased tax revenue and limiting the ability of economic growth to make a significant dent in government debt. There is also the political temptation to spend increased receipts on new pet projects to buy votes at the next election. To pretend, as Mr Darling does, that it is good value to borrow at 4% to maintain aggregate demand that currently produces a 0.1% growth in GDP is to ignore three essential facts.

First, the cost is out of all proportion to the benefit. Secondly, demand is only of a long-term benefit if it results from increased wealth-production rather than from borrowing today to shore-up a standard of living you cannot afford tomorrow. Thirdly, borrowing today means interest payments tomorrow, thereby reducing the amount you would otherwise be able to spend tomorrow and, by definition, reducing tomorrow's demand. So, if you borrow today to support today's demand you do it by reducing tomorrow's demand. Unless, of course, the way you spend it today leads to greater wealth and an increase in tomorrow's demand above what it would otherwise be - something that no government in history has been able to achieve.

No international lender can descend into the minutiae of a particular borrower's economy and seek to identify individual items that will affect the overall long-term sustainability of the whole economy. What can be done is to look at the quantity of government spending, assess the long-term cost if it is maintained and say "sorry chaps, you can't afford to spend that much, I will lend provided you spend less." He is not bothered about maintaining demand this year, he is looking to the overall structure and knows that whatever the level of overall demand in the domestic economy excessive government spending will not be affordable.

If Mr Darling were right the international lenders would not be imposing any conditions on the loans they make. They would want government spending to remain as it is or even increase, they would say "spend more and boost demand, that will increase wealth". Yet they don't say that because they know it is nonsense. They know they will receive interest and the repayment of the capital sum they advance now (and the sums they might be asked to advance in the future) only if governments live within their means.

What matters is not the position this quarter or next or even the position this time next year. What matters is whether a national economy is sufficiently well-balanced to pay for itself (and thereby allow its people to enjoy the fruits of their labour) in the long term. If it is not, those who are asked to bail it out with loans will want an extra return on their money to reflect the risk of default. The institutions that lend to governments comprise other governments as well as private finance bodies, and none of these can afford to forgo interest or capital repayments. Nor do they particularly want to receive a very high return because high interest payable on government debt carries the threat of losing absolutely vast sums if default occurs. Of course they are happy to receive big profits while default is avoided but they know the best long-term investments are those that accumulate steadily not those that can make or lose a fortune over a short period.

It really does not matter if the UK slips back into recession - on any definition it is hardly out of recession anyway. What really matters is that the effect of government on economic activity is not so detrimental that the the nation cannot pay for itself. Once it slips over the edge and cannot pay for itself that imbalance must be dealt with before worrying about anything else. Maybe it will cause the loss of some jobs and a decline in overall spending power this year and next, but that merely reflects that pre-existing levels of both employment in the public sector and consumer demand could not be afforded.

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