Public sector cuts aren’t depressing growth – but private sector austerity is

 
Ryan Bourne
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AMONTH tomorrow, George Osborne will deliver his Autumn Statement. On current policies, the Office for Budget Responsibility will suggest he will fail to meet his target of a falling debt-to-GDP ratio by the end of the parliament. This leads to a question: should Osborne announce further fiscal consolidation or should he abandon the target?

Nick Clegg has nailed his colours to the second mast – sticking to existing spending plans. On cuts, Clegg has said, “not a penny more, not a penny less”.

Alongside him are those who think that austerity is self-defeating and that the government should just spend more. Recent National Institute of Economic and Social Research work, for example, suggests that coordinated EU austerity is depressing growth so much that the UK’s debt-to-GDP ratio will be 5 per cent higher in 2013 than if no country was cutting.

But this is a straw man argument. The government has no control over Eurozone policy, where the euro is the underlying problem. And even if you think stimulus does improve growth today, there’s scant evidence that government spending generates a self-sustaining recovery. At best it can bridge – a point recognised by stimulus champion Paul Krugman in 1999. Collective can kicking is futile.

So what about cutting more? Between 2009-10 and 2011-12, tax revenues increased in real terms by £31bn compared to an increase in real GDP of just £40bn. Real government spending fell by only £16bn (capital spending fell by £24bn and current spending rose by £8bn). We’ve seen more private sector austerity than public sector austerity. Yet our deficit targets require much stronger revenues still.

According to Harvard economist Alberto Alesina, the optimal way to close a deficit is through spending cut-based contractions (where spending cuts account for more than 50 per cent of the consolidation), alongside pro-growth reforms. Examining 17 deficit reduction episodes between 1980 and 2005, he finds spending cut-based consolidations less damaging for output growth than tax-based consolidations. The former lead to either no recession or a short recession. The latter lead to plunging confidence and investment, and usually no recovery within three years.

Though the UK deficit reduction plan is cut-based consolidation overall, its tax hikes were heavily front-loaded – 80 per cent of the planned increase in the tax-to-GDP ratio by 2014-15 has already occurred, compared to 23 per cent of the fall in current spending. Private investment and confidence have indeed struggled.

Deeper cuts to current expenditure now – to meet the target and free-up funds for tax cuts – would divert more resources for private sector enterprise and investment. Having been reliant on cheap credit and public spending, our economy must rebalance. The more the private sector is squeezed through tax and regulation, the more difficult this adjustment becomes.

Ryan Bourne is head of economic research at the Centre for Policy Studies.