Why is it all going so wrong for George Osborne? Only 16 months ago, the poor guy entered the Treasury full of sound principles and good intentions. He would put in order the dodgy public finances inherited from Gordon Brown’s regime, stand back and let market forces do the rest. The Office for Budget Responsibility would certify that he had.
Within a short period, the benign influence of sound finance would restore confidence in the private sector; and room for it to take up the running in promoting national economic growth would be created by reining back the bloated public sector. Tory priorities and the national interest would happily cohere to lead Britain out of crisis and recession back to the sunlit uplands, the halcyon days of yore — well, not perhaps the deep recession of 1980-86 with unemployment rising above three million, nor the Lawson boom of 1987-89, nor the ‘if it is not hurting, it isn’t working’ recession of 1990-92, but you know what we mean — Thatcher in the golden age.
This narrative always contained a heavy dose of faith, faith that sharply cutting back public-sector demand would automatically stimulate a compensating — or more than compensating — increase in private sector demand by way of rising business investment and consumer expenditure. Faith is, as the Chancellor should know, a tricky commodity, being nothing more than a nice-sounding name for believing something for which there is no good reason.
The private sector has failed the Chancellor, or at least his faith in it has been disappointed. Economic theory would have warned him of this risk, after the decisive exchanges in the 1930s between A.C. Pigou and Nicholas Kaldor as to whether or not the economy has any reliable built-in tendency to revert promptly to equilibrium at a high level of unemployment following a deflationary shock. It does not.
The Chancellor now confronts an economy which has virtually stopped growing and which is firmly in the grip of a second-stage recession (except for those who clutch at the semantic straw of Arthur Okun’s arbitrary definition of a recession as requiring negative, rather than just sub-normal, GDP change). The IMF, the CBI, the Bank of England’s MPC — all the usual suspects — are busy revising down their forecasts.
This matters, not because it leaves egg on the Chancellor’s face, but because it undermines the entire strategy based on fiscal balance and reduced public debt, at least as a proportion of GDP. When growth falters, or fails to materialise, public revenues (taxes etc) fall more than proportionately, mainly because direct taxes are progressive. This rapidly deepens the hole in the government’s finances, whether public spending is being cut or is allowed to continue at its planned level. The IMF itself confirmed this danger in its latest study of fiscal austerity.
At this point a strategy which sees fiscal balance, however defined, as the sovereign good from which all other benefits will flow is breached below the waterline. There is no prospective balance and therefore there are no benefits. And the gap between the economy’s current and required performance is enormous, and now increasing by something like a further 2 per cent a year.
Blaming the private sector for failure to respond to the opportunity which the Chancellor claims he was creating works neither politically nor economically. The businesses that do not invest and the consumers who do not spend put the blame right back on the Chancellor for conditions — above target inflation, higher VAT, reduced benefits, faltering demand — which inhibit them from spending. Such a sterile dialogue further sours the atmosphere and erodes confidence.
One may spare some sympathy at this point for the Chancellor, as he prepares to deliver a difficult speech at next week’s Conservative party conference. He acted, did he not, in good faith. He appeased the capital markets, which were hungry for blood wherever fiscal weakness could be found. He was entitled, was he not, to leave to monetary policy and the Bank of England the task of stabilising the economy in the short term while he balanced the budget in the medium term.
Yes and no. Yes, the markets matter and can do great damage, though given the antics of the American Congress and the leaders of the eurozone it is less than clear where sellers of sterling sovereign debt would have felt safer. But the task of a British government is to adopt a fiscal strategy which is and can be seen to be sound and sustainable.
This means getting two things right, both the goal in the medium term of fiscal balance with affordable debt levels and a path from here to there which is politically and financially deliverable. Bumping along on zero growth, suffering an ever-widening output gap and forgoing in uncreated wealth ever-increasing slices of GDP, is not such a path. It immiserates the public and bankrupts the Treasury.
Yes, monetary policy is normally the chosen instrument for steering the economy and is rightly the job of the Monetary Policy Committee. But an economy which fails to respond even to near-nil interest rates may need more intensive care than the Bank of England can give.
Quantitative easing by way of the Bank buying the paper which the government is creating to fund the persisting deficit may in theory prevent that government borrowing from crowding out private investment. But it does little directly to stimulate private spending, which anyway can hardly be crowded out in an economy which is a long way from being fully employed and where private borrowing costs next to nothing.
So what should our Chancellor do? First he must hold on with the utmost tenacity to his medium-term plan for sound finance and proper fiscal balance as the economy emerges from the recession(s) by mid-decade. That is necessary both for the health of the national economy and in order not to expose a vulnerable flank to the financial markets.
Nor should anyone complain that in laying out his plans for retrenchment he has included a number of measures which reflect the political philosophy of his party. After all, the Tories came first in the last election and are the senior partner in the coalition. Mr Osborne was not wrong to believe that politically it is best to strike while the iron is hot, to enact your key policies on Day One before the honeymoon ends.
Unfortunately, however, that is exactly the wrong maxim when it comes to nursing the economy out of recession and back to growth, without which the national finances will never recover. The destination of fiscal balance must be credibly proclaimed in lights; but the path to it requires a delicate balancing of that goal with careful management of demand in the short term to ensure that the gap between what the economy can safely produce and what it is actually producing in recession conditions is steadily closed. Not fine-tuning, but good timing.
That requires more demand now. Much the best tool for accomplishing such an immediate substantial, but self-limiting, jolt to the economy is an income-tax holiday. It does not upset the fiscal balance in the medium term, nor require government to impose an unpopular and therefore difficult tax increase when the job is done. It is fair because income tax is crudely proportionate to income and those who pay less than they should will enjoy correspondingly less benefit from the holiday.
Some may immediately fear that such an announcement would knock the pound. Maybe, but not half as much as a Japan-style slump, decade in and decade out. Depreciation, moreover, encourages economic recovery in the short run, which is what is needed. Such relief is unavailable to those who find themselves stuck uncompetitively in the euro.
A tax holiday is much to be preferred to any number of ingenious schemes of public works which substitute politicians’ expenditure preferences — or crackpot schemes — for those of the public in whose pockets the uncollected tax may be more beneficially left to fructify in whatever way individuals choose. Less good, but still effective, would be a VAT holiday, rather of the kind successfully used by Alistair Darling last year. As to the quantities, as Lord Derby told Benjamin Disraeli when appointing him Chancellor, ‘they (the Treasury) will give you the figures’.
This — especially the income tax version — may, despite the Gladstonian overtones, offend the Chancellor’s coalition partners; but they are dead anyway, having violated the first law of centre party survival in first-past-the-post electoral systems, namely: never coalesce with Conservatives. Doing so, as between 1918 and 1922, destroys their electoral appeal for generations (at least three), since those who approve vote Tory and those who do not vote Labour (see 1922-2005 passim). No one votes centre, whether it be called National Liberal or Liberal Democrat.
One hurdle remains — how to pay for the tax holiday. The best response here is just to round up all those who mouth this lowbrow incantation and to send them to special camps in the Highlands with daily cold baths for crash courses in recession economics, after which they will understand why it is a silly question. The short answer is that the money laid out is validated by the extra goods and services, i.e. real wealth, produced by bringing into production the resources which otherwise would have remained idle.
The long answer is that recessions happen because too little money (demand) is chasing too much potential production (i.e. workers). Accordingly, too much money cannot be chasing too few goods etc. Therefore inflation is not a threat. Ergo the government can, indeed should, in effect print the money needed to fund its expenditure in excess of its revenue. It does not need to raise it, whether by taxes or by borrowing (other than notional borrowing from the Bank of England).
All this ceases to apply as the economy recovers to non-recessionary levels of operation. Then, but only then, balanced budgets and all that come back into their own and need to be observed. But if our hero is ever to reach that happy world where once again things are what they seem and intuitive common-sense can again be trusted, he must first escape from the extended recession(s), ideally by firing a powerful rocket in the form of an income tax holiday. Six months’ income tax holiday would inject 5 per cent of GDP of extra demand, about what is needed — with multiplier effects — to restart growth.
Peter Jay was Economics editor of the Times from 1967 to 1977 and of the BBC from 1990 to 2001. From 2003 to 2009, he was a director of the Bank of England.
This article first appeared in the print edition of The Spectator magazine, dated October 1, 2011