John Maynard Keynes, whose work is often cited as justifying our fiscal incontinence, would in fact have been horrified at the scale of the deficit and our over-sized state sector, which the OECD puts at 52 per cent of GDP. Keynesians argued that governments should allow the budget to go into the red in a recession by a few percentage points of GDP, with 3 per cent usually the maximum – perhaps 4 per cent if things were truly desperate. Nobody ever claimed one could prudently rack up three or four times that level – and crucially, proper Keynesians supported budget surpluses in the good years. Brown’s constant structural deficits even at the height of the bubble would have been anathema to them.
It is depressing, therefore, that so much of the commentary around the deficit is informed by a crude and out of date view that higher borrowing will always have a stimulatory effect. In reality – as a paper from Policy Exchange argues – a large body of recent economic evidence demonstrates that cutting state borrowing leads to higher growth, at least where borrowing is high. The report – The cost of inaction: Why cutting spending will boost the recovery, even in the short term, by Andrew Lilico, Neil O’Brien and Hiba Sameen – cites numerous econometric analyses which show that such anti-Keynesian effects dominate even at much lower levels of borrowing than the UK is now undertaking.
A 12 per cent budget deficit usually raises government bonds costs by around 2 per cent, transferring taxpayer cash to foreign investors. Higher gilt yields invariably spills over to private sector borrowing costs, crowding out demand and investment. An urgent policy to cut spending would lower the cost of borrowing and be extremely expansionary – far more so than any renewed quantitative easing. The evidence also suggests that the best way to reduce the deficit is to cut government consumption (rather than investment on infrastructure such as roads). Tax hikes have damaging side-effects and should be avoided.
One European Commission survey of 49 countries that cut their deficits found that 24 of these fiscal consolidations promoted growth even in the short term – even when deficits were considerably lower than 12 per cent of GDP. The higher the deficit, the more likely that cutting it will boost growth immediately – a conclusion implied in a February 2010 study from the European Central Bank which found that the crisis has caused markets to punish irresponsible fiscal behaviour even more severely than before.
It’s quite simple: we need to cut the budget deficit as fast as possible by reducing spending. That, rather than messing around printing yet more money, would provide the best, most effective stimulus for the UK economy.