Duncan’s Economic Blog

Public Spending & the ‘Crazy People’ Camp

Posted in Uncategorized by duncanseconomicblog on September 16, 2009

I want to echo Richard Murphy in agreeing with Adam Lent’s excellent post on spending cuts.

Cuts are dangerous; a major programme of cuts risks forcing the UK back into recession and damaging our economic prospects for a generation.  It doesn’t take much economic nous to recognise that sacking tens of thousands of public sector workers and reducing the amount of money the state spends in the wider economy will increase unemployment, increase bankruptcies and other financial difficulties for companies and will reduce demand and further constrain bank lending. 

This is, of course, bad enough in itself.  But there is a further threat.  If the UK struggles on under recssionary conditions while other economies grow, we will not be able to seize global market share and we will not be able to attract new investment.  The result will be a UK economy back in the doldrums for years just as it was in the 1970s and much of the 1980s – the “sick man of Europe”. 

This is a much greater threat to our well-being and the future prosperity of our children and grandchildren than public debt.  Asia is emerging from this recession far quicker than Europe and America. China is expected to post a stunning 8% growth soon despite the global crisis.  If we take shallow economic decisions now, the UK will be left behind as the new economies rush past us in the innovation, productivity and investment stakes.

Agreeing with Adam puts myself and Richard in what Paul Krugman has dubbed the ‘crazy people’ camp.

There’s a tendency to treat worries about a double dip as outlandish, as something only crazy people like the people who, um, predicted the current crisis worry about. But there are some real reasons for concern. One is that the lift from fiscal stimulus will start to fade out in a couple of quarters. Another is that, as Yellen points out, most of the boost we’re getting now is tied to inventories. And that’s a one-time thing.

 As I’ve argued for the past few months the ‘recovery’ we are seeing is driven by base effects and an inventory build up. Unemployment is still rising.

The Osborne line, that cutting the deficit will lead to lower interest rates and hence more private investment, is an extreme form of Rubinominics.  

Rubinomics emphasizes the effect that balancing the government budget has on long term interest rates. Taxes should match government spending in the long run, and deficit-financed tax cuts are an ineffective way to increase growth. This can be seen as a form of the fiscal theory of the price level – fiscal policy affecting long term inflation (as expressed by long term interest rates).

Rubinomics has never rejected Keynesian approaches to economics, which call for the government to run a deficit in times of recession.

As the Wall Street Journal wrote last year:

Rubinomics never did have much economic basis, and even casual observation over the last 25 years has exposed its illogic. As deficits rose in the 1980s, interest rates fell. In the current decade, deficits rose and interest rates fell for a time, then later deficits fell but interest rates rose.

Even in the 1990s, the facts never matched the theory. The rate on the 30-year Treasury bond did fall in 1993 amid the Clinton tax increases, but it slowly climbed again throughout 1994. The historic market turn — in stocks and bonds — came exactly on the day in 1994 that Republicans won the House of Representatives for the first time in 40 years. Interest rates move up or down based on multiple variables, such as monetary policy and global capital flows.

Mervyn King spoke yesterday about the UK economic outlook – broadly put is forecast is low growth and low inflation.

Clearly a slower recovery implies worsening public finances and, according to Osborne’s logic, higher interest rates.

Yesterday the yield on UK two year bonds hit a record low.

12 Responses

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  1. […] and no.  Timing cuts for this year or next would be crazy.  As Duncan points out, we are NOT getting a big “no” from the markets that lend us the money.  As […]

  2. Dividing Lines said, on September 16, 2009 at 1:10 pm

    Another interesting post.

    Surely the sheer *scale* of the debt is the problem. I understand the ‘don’t cut in a recession’ point, albeit I’d be happier if it was framed as ‘don’t cut spending viciously and unnecessarily’. But surely if you *can* cut, as even Brown now accepts, surely that money ‘saved’ can be re-allocated more intelligently – including on paying down the debt. Apparently ruling out a spending review reinforces a perception of unwieldy and inflexible decision-making and a dogmatic refusal to adapt to events. ‘We did the Right Thing’ – well, as my old tutor might have said, ‘query, query’! – but even if it was ‘right’ then, is it ‘right’ now?

    I agree tax rises are inevitable – we can’t cut the deficit ‘at the right time’, ‘once the economy recovers’ etc unless we get some money in to compensate for the collapse in revenues – but it can’t ALL be paid out of taxes. So – what if growth continues anaemically for several years? How and for how long do we maintain the government-led spending?

    And isn’t investor confidence driven to an extent by our intentions? Sure, we’ve had a massive debt before, but the really bad bits were following three continental European wars, as well as the existential threat of the Cold War. There was a reason behind that debt, and it was better for us and our creditors that we ran up debts so the nation survived and could repay them.

    To borrow an expression from foreign policy, just as we had ‘elective wars’ under Blair, we have had ‘elective debt’ under Brown. We ran up debt for no better reason than because we wanted to, thought we could sustain it, and with no ill effects – and, because we didn’t think there’d ever be a bust, we don’t seem to have given much serious thought about the basis of that ‘growth’ or how it could be replaced in the event of a crash.

    So why should investors be confident that we’ll be able to repay it, especially when you’re advocating an apparently open-ended commitment to high spending? Or are they going to be happy as long as we can service the interest payments? Aren’t they increasingly likely to ask what the huge amounts of money borrowed so far has been spent on, and how future borrowings will be repaid – without resort to monetization?

    I find I am again responsible for a very convoluted post, full of what sound like rhetorical questions, but actually I’d be interested to hear your answers!

    Regards

    • duncanseconomicblog said, on September 16, 2009 at 1:48 pm

      Thanks agaion for the detailed reply.

      On the scale of the debt question, I put up a chart here:

      https://duncanseconomicblog.wordpress.com/2009/04/24/credit-uk-and-daily-mail-edition/

      I really don’t see the logic behind the ‘fixing the roof when the sun was shining’ argument. Our debt is low by international standards.

      Equally two charts here:

      https://duncanseconomicblog.wordpress.com/2009/05/11/everything-you-need-to-know-about-the-public-finances-in-two-charts/

      Now in the longer run I agree with Adam lent that:

      “None of this is to say that we do not need to address the problems of the public finances. Having to service very large interest payments over the long term is clearly not the best use of taxpayers’ money. It reduces the state’s scope for action particularly when there is a need for public investment and if any major and unexpected spending need arises. But introducing cuts in the short-term for fear of some impending crisis on the money markets (as promoted by the Tories and others) is spurious and will leave us a weaker rather than stronger nation.”

      It’s important to remember that a government, unlike an individual, in theory lasts forever.

      The key variable really is the interest rate. And yes if investors became worried we would have a problem. But gilt yields are very low by historical standards. Investors aren’t worried. It’s mainly the right wing press that is worried.

      • Dividing Lines said, on September 16, 2009 at 2:34 pm

        Thanks – especially for such a prompt response. This is a very good-natured blog, which makes a change.

        As I say, I’m no economist. But GDP seems a flawed measure of economic health, as it includes all economic activity, including consumption funded by debt, no? So any kind of retail activity funded by credit card, store card etc is included. That skews the Uk picture a bit, surely.

        I don’t buy the relative point. Just because the neighbours have a bigger overdraft, I don’t feel richer. (Sorry – I’m making the personal the political-economic again…)

        And a straight comparison is not the whole story. Japanese *govt* debt is high but they are ‘a nation of savers’ [(c) every financial journalist 2009], unlike the UK-US. Although they’ve been experiencing anaemic growth for a decade – so there might be a lesson for us in that.

        On the second chart, it might be historically low, but there’s a little tick at the end, which might or might not be ominous!

        I agree it’s a seductive illusion to compare governments with individuals, because individuals cannot inflate away debt or print their own currency, and are liable to answer to the civil courts if they attempt to. Now: I might be betraying my small-c conservative tendencies, but governments, even nations, *don’t* last longer than families; and our governments are staffed increasingly by individuals unburdened by experience – hence, at a simplistic level, asset bubbles and wars in Afghanistan. That, as a parent, is why I worry about the assumption that interest rates will remain low, that debt will always be affordable, and the consequent disregard of the need for reserves.

        The UK’s decade-long ‘boom’ was highly dependent on consumption, but I think it’s clear that’s unlikely to be repeated: we’re not going back to 2007 asset values or spending/borrowing habits. But ask what a restructured UK economy will look like, and our leaders can answer only with a shrug and a few platitudes. So I think we’re asking a heck of a lot of our putative creditors to envisage a healthy economy when even our politicians can’t tell us, and to invest here on the basis of a highly speculative imaginative exercise!

        Kudos to your scrambled eggs technique – butter is indeed the trick, plus fresh parsley. Anything less is skimping. (Ask Ian Fleming.)

        Regards

  3. […] proved wrong Posted at 2:46 pm on 16 Sep 09 by Adam Lent Thanks to Duncan for pointing out in a typically learned post that today’s fall in gilt yields proves my point  that bonds behave in complex ways.  This […]

  4. dannyboy said, on September 16, 2009 at 3:09 pm

    duncan, is it not the case that both the US and the UK national debt looks quite reasonable relatively speaking until you add in the money the government owes to itself – for example the penion liabilities the government is carrying for public sector workers – for example, Sir Fred Godwins pension.

    Now perhaps something can be done to scale back these liabilities but until that happens we ought to be adding these to discussions of the national debt, at least the ones coming due in the next 5 years or so.

    To this we need to add likely future benefit commitments including increased unemployment benefit and social security for the very many people nearing retirement without adequate savings.

    I remain opposed to cutting spending in the short term or even medium term, however I still think there needs to be more discussion of the final deficit reduction/exit strategy. Likewise I agree that the funding situation for the deficit in terms of rates and demand for gilts is likely to improve rather than worsen.

  5. duncanseconomicblog said, on September 16, 2009 at 3:50 pm

    Dividing Lines – I like to keep things civil…

    We actually agree on quite lot here. The boom was overdependent on consumption, asset prices (especially property) and debt.

    The economy needs to be massively rebalanced.

    The disagreement come on the response and method.

  6. duncanseconomicblog said, on September 16, 2009 at 3:51 pm

    Dannyboy,

    Agreed there is the issue of future liabilities.

    I do though find it strange that there is always a focus on state liabilities but rarely on state assets, where else do we only look at one side of the balance sheet?

  7. dannyboy said, on September 16, 2009 at 3:56 pm

    State assets – excellent point.

    What are they, apart from various banking operations? What was the asset side like prior to lehman’s collapse?

    • duncanseconomicblog said, on September 16, 2009 at 4:01 pm

      A lot of buildings, a lot of land, a lot of equipment, a lot of military equipement, network rail, met office, etc, etc.

      I have no idea how much it’s all worth. I do find it strange its rarely considered.

      And yes – point taken on Lehman’s balance sheet. Or indeed Northern Rock’s. A balance sheet is only reliable if assets are valued properly

      • dannyboy said, on September 16, 2009 at 5:24 pm

        “I have no idea how much it’s all worth. I do find it strange its rarely considered.”

        That is a very good point. I wonder where one finds the answers to these questions? How does one value an aircraft carrier or a section of track. I guess one has to ask what the market for the assets is in terms of price and liquidity.

        And it does raise the interesting issue that if massive cutting sends us into a tailspin, these national assets will be seriously impaired as a result.

        Further, it also makes me think that if we’re going to continue to expand the national debt, we’d better do it in such a way that we’re adding to the asset side at the same time. That makes some kinds of spending more justifiable than others. A power station would be justified, but increased benefit payments for example maybe not.

  8. Cuts are Stupid « OutofRange.net said, on September 17, 2009 at 9:45 am

    […] Hat Tip: Duncan’s Economic Blog. […]


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