Leading Liberal Democrats, including Vince Cable and David Laws, have been defending the coalition’s policy of substantial public spending cuts in recent days, in part through an appeal to Keynes. Their central thesis is that the economy will only recover if private investment spending accelerates, that private investment spending will only accelerate if interest rates are low, and that interest rates will only remain low if the government reduces its deficit quickly.
Most economists agree that an economic recovery led by private investment spending (and exports) would be a good thing, so we’ll accept the first part. On the other hand, there is a good deal of disagreement about whether or not the UK was on the brink of a financial crisis before the coalition set out its plans to cut the deficit. For the record, I don’t think it was, but that is not what I want to concentrate on here.
The coalition argues that public sector spending cuts are a necessary condition for stronger growth in private sector investment. They think public spending must be cut swiftly and substantially, otherwise private spending will be ‘crowded out’ (in the economists’ jargon) by the high interest rates that will result from public and private sectors competing for limited funds.
This assumes there is a lot of private sector investment spending in the pipeline that will go ahead irrespective of other developments - as long as interest rates are low. This may be true, but, as critics of the coalition’s thesis are quick to point out, it may not be. They argue it is better to wait for more evidence of accelerating private sector spending before cutting back aggressively on public spending.
This goes to the heart of the current economic debate. Does the government need to make large cuts in its spending to facilitate strong growth in private sector spending, or should the government wait for evidence of a recovery in the private sector before making cuts?
There is another complication that the Liberal Democrats are skirting over. Private investment spending may not be determined solely, or even mainly, by interest rates. If companies think about the outlook for future demand when making decisions, and they believe public spending cuts (and tax increases) will lower that demand, then aggressive action to reduce government spending might dent their confidence and lead to lower private spending.
So who is right? Economists have been debating these points for many years. By the end of 2011, we might have a better idea of which side has the better of the argument.
The Office for Budget Responsibility thinks employment will be stable throughout 2011 at 29.1 million, which will require a good deal of job creation in the private sector to offset cuts in the public sector.
This would be a disappointing outcome for the second year of an economic recovery, but if this forecast proves correct, or if employment increases, then the coalition will feel able to say ‘I told you so’ in a year’s time. But if employment falls below this level, then their critics will justifiably think they have been proved right.
Tony Dolphin is senior economist at the Institute for Public Policy Research
