Politicians are prioritising plans to reduce the budget deficit in the run-up to the election. But they should hold off major spending cuts until growth picks up
The government’s finances are in a terrible state. To reduce borrowing, public spending will have to be cut and taxes will have to increase by more than suggested in April’s Budget. But it is too risky to start now. In the Pre-Budget Report on December 9, the chancellor needs to set out a detailed and plausible plan to reduce the fiscal deficit by the middle of the next decade. But he should not announce additional spending restraint or tax increases for 2010.
In the first half of the 2009/10 fiscal year, government borrowing was a whopping £77bn. It is on track to match, or even exceed, the Budget forecast for full year borrowing of £175bn (equivalent to 12.4% of gross domestic product). Borrowing cannot stay at this level for very long; otherwise debt – and future interest payments – will soar. This could lead to a loss of confidence among investors and a cut in the UK’s credit rating, which would add further to future interest costs. Earlier this month, Fitch Ratings identified the UK as the major economy ‘potentially most at risk’ of a credit-rating downgrade.
The Conservatives have made the case for immediate action to reduce public borrowing to avoid this fate. And Mervyn King, governor of the Bank of England, has expressed similar sentiments.
But it is not that simple. Cutting spending or increasing taxes will reduce demand in the economy, unless there is an offsetting increase in the private sector’s – namely, households’ and companies’ – willingness to spend or an increase in overseas demand for British products.
The Conservative view is that monetary policy can be used to boost private sector spending. The problem, though, is the Bank of England has already got its foot down to the floor when it comes to providing monetary support to the economy. Official interest rates have been at a record low level of 0.5% since March.
After its November meeting, the Monetary Policy Committee announced that it plans to increase the amount of money it is pumping into the economy, through its quantitative easing policy, from £175bn to £200bn.
In normal times, an easy monetary policy works by increasing the availability of credit in the economy and the willingness of households and companies to borrow and spend. However, these are not normal times. Banks are more concerned with repairing their balance sheets than increasing their lending, and households and companies are so worried about the scale of the crisis that they are unwilling to borrow. As a result, monetary policy is having only a limited effect on private spending.
Meanwhile, the fall in sterling relative to other major currencies makes UK firms more competitive. Together with signs that the global recession is ending, this should enable British firms to sell more overseas in coming quarters. This might help lift the economy out of recession in the final quarter of the year but it is unlikely, on its own, to restore the economy to healthy growth in 2010.
It is crucial, therefore, that the government does not remove its support for the economy too soon. It already plans to increase the main rate of VAT from 15% back to 17.5% from the beginning of 2010 and to increase income tax on very high earners from April 2010.
Government investment spending will also be lower in 2010/11 because some planned spending was brought forward into 2009/10. That is enough fiscal restraint for now.
After the Great Depression, the US opted for deficit reduction too quickly in 1937 and tipped the economy back into recession. Japan repeated the mistake when it cut spending and increased taxes in 1997. At a time when the UK economy is still in recession – figures show that it contracted by 0.3% in the third quarter – it would be foolish to follow suit.
Of course, government borrowing will have to be cut drastically over the medium term and there is nothing to stop the chancellor using the Pre-Budget Report to specify in some detail how he thinks that should be achieved. In fact, this would be welcome. But significant cuts should be delayed until 2011 when, hopefully, an economic recovery will have been secured. And if it hasn’t been, then we really are in serious trouble and the delay will be neither here nor there.
Tony Dolphin is senior economist at the Institute for Public Policy Research
