Open letters seem to be the standard method of communication nowadays — well, if you happen to be an economist anyway. Earlier this month, 20 of them wrote to the Sunday Times recommending that policies to reduce the UK’s burgeoning budget deficit be brought forward. Almost immediately, another open letter was sent to the Financial Times in response, this time signed by no fewer than 60, asserting this was entirely the wrong approach. This is a good example of the old “if you put two economists in a room, you get three opinions” adage, although this time we have 80 economists involved, and the stakes are somewhat higher…
Like so many within economics, this issue is a complex one without an objective yes or no answer, and as an economist coming to a conclusion on this issue, you are equally likely to be influenced by your views on the role of the government and the strength of free markets than actual empirics from the UK economy. However, I feel a far more important issue to consider here is a behavioural one — to what extent consumers and business leaders understand the economic situation, and how they would respond to potential policies and, perhaps more crucially, to newspaper headlines. This is far outside the realm of Classical economics, but, fortunately, more and more economists are realising the limitations of assuming economic actors are the ultra-rational ‘Homo economicus’ that possesses perfect information about everything around them.
It’s hard enough for economists to understand the current state of the economy, let alone the man on the street, wading through conflicting and confused newspaper articles about whether you should be worried by the recession and the UK’s position in the world. Because of this uncertainty, consumer and business confidence is inherently volatile at the moment. However, whilst people may not understand the economy, what they will understand is Huw Edwards describing service cuts and tax rises on the Ten O’Clock News and exaggerative articles in the papers explaining How This Will Affect You.
Strong and buoyant confidence is so crucial to the success of this recovery, and the current signs of steady improvement in this area are looking good. However, to jeopardise that important bedrock by announcing contractionary fiscal policy in this early stage of the recovery is a risk no one should be willing to take.
It is perhaps easy to see our current position as further along in the recovery than we had thought: inflation reached an annualised 3.5% in January (for which more open letters were required, this time between Mervyn King and Alistair Darling), and unemployment levels are reaching a plateau, but crucially, ceasing their upward trend. Although these statistics will not fool economists, they may fool the man on the street or the man in the suit. However, the unfortunate fact is that we still have a long way to go before we are at a stage when contractionary measures can even be considered. To put it another way: I feel the risks associated with cutting the deficit now are far greater than the risks of sustaining it for a few more years.
What I am not saying is that the engorged state of the deficit is not a problem; rather that it is one that cannot be solved today. After all, it is arguably the biggest political hot potato going into the general election; it has been thrown around ad infinitum by the parties, but held onto perhaps longest by the Conservatives, resulting in David Cameron’s frankly scary nationwide billboard campaign. But what politicians across the spectrum have forgotten to tell you is that a huge amount of their forthcoming heroic efforts to reduce the deficit will happen…well, automatically. As we rise from recession, tax receipts will revive, on the tails of increased employment and business activity, and spending on unemployment support will fall. It’s the concept of automatic stabilisers and the countercyclical nature of fiscal policy, and you learn it in A-level Economics. Some even say it will account for over half of the work required to halve the deficit by 2014.
Perhaps the key issue then, if we are not to make cuts now, is how and when to make them in the future. Policies to reduce the deficit are inevitable and indeed required, but this should be at a stage where the economy is far more stable, if not fully recovered to the trend rate of the noughties. When this point is reached, some real political and economic intelligence is needed, to devise inventive medium-run policy changes to ease our reliance on debt.
Although the Homo economicus may be indifferent to equivalent spending cuts and tax rises, it has been found in empirical studies that people respond far less to spending cuts, so work on currently bloated government expenditure is the way forward. Cuts should be canny and targeted: for example through easing the budgetary pressure borne of the state pension, by ‘extending working life’ and more actively regulating employer pensions. This is one example of less damaging cuts amongst many, but, incidentally, proposed cuts in education spending do not fall into this category: a recovered economy will be the ideal scenario for longer-run policies to improve structural conditions, and cutting education spending betrays this need.
To sum up, there are two issues to consider: ‘when’ and ‘how’. As for ‘when’, the only answer is ‘not now’. We are on the road to recovery but not yet at a stage where cuts would not be of detriment to the economy. When we are at such a stage of greater stability, the question shifts to ‘how’. Sadly, it is likely that the focus will be on short-run spending cuts and tax hikes to inch back the deficit, but if we want to reduce it without undermining the current and future state of the UK economy, targeted middle- and long-run policies are the only real solutions.
“There is no disagreement that fiscal consolidation will be necessary to put UK public finances back on a sustainable basis. But the timing of the measures should depend on the strength of the recovery.”
- Lord Skidelsky et al