Estonia’s lesson for Britain: Cut now and cut hard if you don’t want worse pain later

Jon Moulton
WOULD you like to live in a country with a budget surplus, a 21 per cent flat tax rate, that grew at an annual rate of 8.4 per cent in the last quarter led by manufacturing, has almost no government debt and is planning to spend 20 per cent of its budget on capital spending? Where unemployment is falling nicely and the government seems able to see well beyond the next opinion poll?

Welcome to Estonia.

Estonia did not face the issues of 2009 by kicking the can down the road with £600bn of quantitative easing and fiscal stimulus and cutting capital spending – rather, it cut public spending hard by around 10 per cent of GDP, enduring pain in the short term for the vision of a better future for the nation. GDP fell in 2009 by some 14 per cent and unemployment rocketed to 17 per cent.

It returned to growth in 2010 and unemployment is down to a still-painful 12 per cent. Assets and people were pushed into the private sector with predictable economic benefits.

The UK endured rather little pain by living well beyond its means, driving interest rates down and borrowing bucketfuls. The government spends £5 for every £4 of income. The difference is more debt – and there are only three things to be done with debt.

You can service it – the cash required to pay interest and principal will be a drain on future economic growth and stability. It is, of course, the next generation who will suffer from the debt we are forcibly leaving to them.

You can also default on your debt. Not very British and ruinous to the future economy. The country and its banks would be out of the world financing scene for quite a while.

Or you can inflate the debt away. Very tempting as a clever way to screw the people you owe money to, but at some stage they will see this happening and won’t lend you any more money or demand very high rates to lend you any more. High inflation is almost impossible to control and economies with high inflation suffer from the uncertain background it generates, with a collapse in longer-term investment. At the same time, high inflation impoverishes those in retirement through no fault of their own.

So running a deficit is a pretty immoral thing. We live better today and pass the problem to the kids.

Britain runs a deficit because its government spends too much. The state is around 50 per cent of the economy in the UK, and history shows that most economies slow down past 40 per cent, as lots of the economy is in the non-real-growth public sector. Intuitively, then, the bloated state is a big part of the reason we are currently near zero growth. And absent growth, the only way to 40 per cent is to cut spending by 20 per cent (10 points from 50 per cent of GDP) – like Estonia did.

The state does not have to be such a big component of the economy – ten years back, we were in sensible territory, but we have increased spending and inefficiency. The NHS is a good example: from 1996 to 2009, spending – in 2010 pounds – went from £51bn to £120bn, for not so different a level of service.

Despite the need for deep cuts, the coalition, despite much propaganda from both sides to the contrary, is planning to cut only marginally over its five-year term. The idea of getting income equal to expenditure within five years requires growth at near 3 per cent per year. At current levels of growth, the deficit will stay at around 10 per cent of GDP and the debt will mount up and up.

High debt levels are also historically linked to lower growth. Furthermore, even that contraction in the deficit assumes the short-term attractions of relaxing spending will be avoided by this government for its whole term – which seems unlikely.

At some point, the markets will start to wonder why they should carry on investing in UK gilts at 2 per cent with inflation at 5 per cent and the country looking less and less able to pay the interest. We already have greater debts and a bigger annual deficit than we had when we went to the IMF in the 1970s. Sometime in the foreseeable future, the spotlight will move from Spanish and Italian debt onto ours.

When that moment comes, interest rates will zoom away and then we will have to balance the books by chopping the size of the state in a brutal manner. We could take less pain now by actually doing some real cuts and get back to prosperity quicker or we can kick the can down the road again and guarantee a worse pain a bit later.

Estonia has nice clear government policies. “The medium-term budgetary objective of the government is to keep the general government budget in surplus. A conservative fiscal policy will ensure a low level of government debt which is a prerequisite for ensuring the long-term sustainability of public finances.”

Perhaps we should pay for George Osborne to spend a week there.

Jon Moulton is a venture capitalist and the chairman of Better Capital.