We’ve now reached the point where government sources say things like: <blockquote>“We are determined to tackle the record budget deficit in order to keep interest rates lower for longer, protect jobs and maintain the quality of essential public services. These planning assumptions are not final settlements, and do not commit the Treasury or departments to final settlements.”</blockquote>
This in the context of some government departments being warned off for cuts of 40% of their budgets, and the policy interest rate sitting at 0.5%. We’re now staring the zero lower bound straight in the face. This is evidently incoherent; to understand how, we need to think about the history and economics.
Back in the early 1980s, Geoffrey Howe’s famous or infamous 1981 budget took place in a framework of economic policy based on monetarism - the doctrine that the primary economic policy variable was the control of the money supply, that the economy faced a steep short-run supply curve, and therefore that there was no point in reflating it, as it would simply create inflation. The aim was to determine the Non-Accelerating Inflation Unemployment Rate and stick there, the means were to set numerical targets for growth in broad money.
So much for monetary policy. What about fiscal? Well, the early Thatcher fiscal environment was determined by two concepts. One was the broad ideological one of reducing the size of the state. The other was the notion of crowding-out - if the government is borrowing, all things being equal, it takes up so much of the pool of loanable funds available that the interest rate rises and chokes off investment in the private sector.
There’s been a lot of water under the bridge since then; monetarism failed, as it turned out to be impossible to control the broad money supply (as you can see from the chart, it just kept going up), the goal of cutting public spending in general failed, as welfare payments went through the roof, and the crowding out doctrine also failed, as interest rates remained high (and very unstable as the government struggled to control M4) throughout the 80s.
But here we are…the Thatcher Zombie is baack. In the light of all these developments, the incoherence is necessary; you couldn’t support the government’s current policy without being incoherent. The mechanism of crowding out is meant to be the rate of interest, but the rate of interest is 0.5%. Further, the entire business sector except for the well-named FIRE (Finance, Insurance, and Real Estate) markets is currently a net saver - rather than channelling capital into profitable opportunities in business, finance is channelling capital out of business and into its own tier one ratios.
This was the original Keynesian insight - like a fat man trying to budge in a tube train, you can only get out of the way so much. It’s impossible to have a negative interest rate, so when things get ugly, the whole point of avoiding crowding out is simply irrelevant. (Also, the idea of crowding out is itself problematic because the availability of credit isn’t fixed and isn’t equal to total saving - nothing is easier than for a bank to create more credit.)
The especially worrying thing here is that the Coalition is relying completely on the existence of massive crowding out for their policy to work. As Chris Dillow says, the OBR forecasts are dependent on very rapid job creation in the private sector. Even forgetting the reduction in aggregate demand, it’s going to be very challenging just absorbing the cut to public sector jobs. In fact, they don’t actually believe their own forecasts on this.
What about the second Tory cuts wave? In the early 90s, the budget deficit (which had remained high through the 80s and briefly flirted with balance at the peak of the housing bubble) blew out dramatically with the second recession - in fact, it set an all-time record as a percentage of GDP which lasted until the cataclysmic year of 2008-2009.
Kenneth Clarke, as Chancellor, was commissioned to cut the deficit; it was rough, but it’s worth remembering that there were a number of key elements in his plan that we don’t have now. First, he split the fiscal tightening 50-50 between spending cuts and taxation. This is important; cuts to public services are highly regressive, and this lot will amount to 20% of some households’ incomes.
Second, there was a credible strategy for growth - the sharp devaluation of the pound in 1992, plus loose-to-accommodating monetary policy. George Osborne has talked about “monetary activism” and export-led growth, but Clarke’s plan worked in the context of a fast-growing world economy (rather as Canada’s of the same period worked in the context of a fast growing US economy). The German finance minister, Wolfgang Schäuble, has been talking about expansionary fiscal consolidation, but the problem here is surely retrocausality - we’ve seen examples of countries reducing their budget deficits while enjoying growth, but quite clearly, the causality is the other way round. In fact, who would expect anything else?
Writing in the Torygraph, Roger Bootle of Capital Economics makes the excellent point that without addressing the global imbalances and getting the surplus states to spend more, austerity is pointless. But the coalition’s trip to the G20 was an embarrassing failure.
So why are we where we are? The disturbing conclusion is that it’s a matter of iconography and myth. If you’re a rightwing Tory of a certain generation, the 1981 Budget is your heroic founding myth. Never mind that if, in fact, it laid the foundations for growth, nobody can say what those foundations actually were - what matters is doing the same thing again.
The comparison with a cargo cult is tempting, but not in the obvious way. Everyone remembers Richard Feynman’s use of the image of the man in the fake control tower with his toy headphones to mock pseudo-science. But cargo cults existed for a reason. They served a purpose, in legitimising their leaders. If you want the Conservative Party to believe you’re a real Tory chancellor and a potential prime minister, “make like Geoffrey Howe” is a valid strategy.