This time IS different: Why government is right to act fast on debt

Tuesday 26 October 2010

Writing in the London Evening Standard on 22nd October, Paul Krugman, winner of the 2008 Nobel Prize in economics, argued that the government is profoundly mistaken in seeking to eliminate Britain’s structural deficit over five years. The pursuit of balanced budgets, Dr Krugman says, is a fashion “fad” that is already fast losing its allure.

Like Labour, Dr Krugman believes that the cuts in public expenditure announced on Wednesday are excessive, and he likens George Osborne’s fiscal urgency to the infamous American panic response to the Great Depression. This budgetary rigour, Dr Krugman opines, “has a lot to do with ideology: the Tories are using the deficit as an excuse to downsize the welfare state”. He concludes that “premature fiscal austerity will lead to a renewed economic slump”.

Paul Krugman is a very distinguished advocate of Keynesian demand management, so it’s important to stress that our profound disagreement with him over this issue is not in any way ideological.

Far from advocating unfettered laissez-faire free market economics, we have said, many times, that excessive deregulation of the financial system caused the current mess, which is really all about the management of wholly unsustainable private and public debt mountains throughout the Western world.

Would the situation have been better without excessive deregulation, particularly in the US? Undoubtedly. Was Gordon Brown wrong to allow, through his much-vaunted “light-touch” regulation, a dramatic escalation in mortgage and credit finance, and the ensuing property price bubble? Again, undoubtedly. Believing that he had abolished “boom and bust”, Mr Brown mistook a bubble for real growth and spent accordingly, increasing government expenditures by more than 50%, in real terms, in the space of just eight years.

What we face now, in Britain and throughout the OECD, is a debt mountain of unprecedented proportions. Dr Krugman points out that Britain’s national debt remains comparatively modest in relation to GDP but, in doing so, he omits at least three critical parts of the equation. First, government has huge additional “off-balance-sheet” quasi-debt obligations, including big unfunded public sector pension commitments. Second, the private sector, too, is massively indebted, including £1.2 trillion in outstanding mortgages.

Most importantly, what matters is not the national debt in absolute but, rather, the relentless clip at which we are adding to it. In the space of just two years, the Brown government borrowed 18% of current GDP, and injected a further 14% through quantitative easing, the current euphemism for printing money. Where might such profligacy lead?

Well, in a report published in March1, the Bank for International Settlements highlighted the clear risk that public debts throughout the OECD could easily turn exponential through a combination of existing deficits and adverse trends in age-related spending.

At that point – and even in the improbable event of interest rates remaining low – the burden of servicing past debts would, in itself, drive spending relentlessly upwards. Here in the UK, for example, the independent Office for Budget Responsibility has forecast that interest on the national debt will balloon from £31 billion last year to £67 billion by 2015-16. That’s more than we spend on education.

If this was just another standard recession, Keynesian demand management might work. But it isn’t. All previous post-War recessions have been de-stocking events, in which businesses reduce capacity and unwind inventories in the face of falling demand. In that situation, stimulus can work.

What we have this time, however, is something profoundly different – it is a deleveraging recession. Following the banking crisis of 2008, consumers, businesses and governments alike have looked over the cliff-edge into a debt abyss, and have pulled back in near-panic. Logically, one cannot borrow one’s way out of excessive debt.

Of course, there are no risk-free solutions to the problems created by unprecedented indebtedness. Economic output could indeed stagnate, but that’s likely anyway if, as we believe, the debt-manacled Western economies can’t expect much better than a long period of economic flat-lining as past excesses are unwound.

If, on the other hand, Mr Osborne were to lose his nerve, markets could easily decide that Britain is a proto-Greece, not a proto-Germany. And if, as a result, rates were to rise sharply, the UK’s 11.4 million mortgage holders could pay very, very heavily for a lack of government resolve.

The cuts are painful, but they are manageable – and the consequences of backing off could include penury for millions of working homeowners.