By Andrew Lilico, Policy Exchange's Chief Economist.
The past few days have seen many articles in the UK press suggesting that Ireland’s current travails illustrate the dangers of excessive austerity, and constitute a warning to Britain’s Coalition Government that it should tone down its plans. These critics imagine that the argument goes something along the lines of:
- Ireland had a large deficit because it had a recession
- It tried to cuts its deficit because it felt its large deficit risked undermining investor confidence
- The deficit cutting programme led to the economy shrinking further
- Because the economy had shrunk, tax revenues shrunk further and the deficit got not better but the existing debts became larger relative to GDP
- Therefore, the attempt to cut the deficit has made Ireland’s problems worse, not better
This argument completely misunderstands why Ireland needs to cut its deficit and why it currently faces concerns over its sovereign credit-worthiness.
Ireland’s creditworthiness problems are not, in the first instance, anything particularly to do with the level of the deficit. They arise because on September 29th 2008 the Irish Government chose (rightly or wrongly) to guarantee all the debts of Ireland’s banking system — all the deposits, all the bonds, all the other debts. Ireland’s banking sector was huge relative to the size of its economy — getting on for 400% of GDP (only a little less than the UK’s). Furthermore Ireland’s banking sector was epically bust, and matters got worse, fast. In 2009 alone, Irish households lost wealth of around €150bn, larger, relative to GDP even than the fall in US wealth from 2006 to 2009. House prices have fallen over 35% from peak.
The Irish state’s fundamental problem is that it cannot afford to save its banks. That is why it must reduce its deficit — since the Government has already rendered itself bust by its banking sector guarantee, running a large deficit only makes it even more bust; borrowing even more from international lenders to pay off other debts is a short road to sovereignty oblivion. Barring extreme measures such as leaving the euro, defaulting on its debts, and printing money to fund a deficit; or less extreme measures such as reneging on its guarantee of the banking sector, the Irish have had no option but fiscal cut-backs and smiling sweetly every time one saw a German.
Alas, they just haven’t been able to cut back by enough to keep pace with the accelerating disasters in their banking sector.
There are lessons for us here in the UK. Our banking sector is even bigger, relative to GDP, than that of the Irish. Now we have not made explicit formal guarantees to our banks’ creditors in the way that the Irish have, so it would be easier in theory for us to let bank bondholders take some pain if push came to shove. But (at least in respect of the state-owned banks) in practice the British Government’s commitments to the banking sector are so deep that banking sector default would be little distinguishable from sovereign default. That was the key reason the UK needed to cut spending: we needed to get enough growth that our households’ salaries would rise fast enough that they would be able to repay their debts rather than defaulting and imposing losses on the banking sector that would drag down the UK sovereign in the same way the Irish sovereign has suffered.
We have a number of advantages over the Irish. Because we controlled our own currency, although there were some interest rate-setting errors in the UK in the 2000s, they were very minor compared with the consistent large gap between the ideal level of Irish interest rates for Irish needs and the much lower rates set by the European Central Bank for the interests of the Eurozone as a whole. That meant that Ireland’s housing and construction boom were even worse than Britain’s, and the poor lending decisions more damaging. Then, once the bust came, whilst in Britain we could allow the pound to depreciate and print extra money (QE) to prevent deflation, as members of the euro Ireland had no domestic monetary policy. So it was trying to cut back the deficit without the opportunity to offset the effects with monetary loosening. The money supply contracted, as one would have expected, and prices fell 6.6% in the year to Autumn 2009, meaning that debts that are fixed in nominal terms became a larger component of the economy and that loans had huge real interest rates (even at a nominal interest rate of zero, the real interest rate would have been 6.6%).
In our own consolidation in the UK, we must be very careful that the money supply is not allowed to contract. We must also focus on what is the true purpose: we must cut spending to raise the medium-term growth rate of the economy so that households can repay their mortgages so that the UK’s banks do not suffer large losses so that the Government’s guarantees of the banking sector are not called upon. It is thus not the deficit per se that should be the core motivation for cutting spending. That is important, but it is not sufficient. We should not, for example, believe that it is important that we raise taxes to cut the deficit. The point of the tax rises is purely political — it is because it would be politically very challenging (close to implausible) to cut spending by £80bn without at the same time raising taxes so that we are seen to be “all in it together”. If that should change — if the tax rises were to be independently unpopular or seen to imperil growth — then it is the tax rises, not any part of the spending cuts, that must be the focus of any “plan B”. As the IMF pointed out in its report on the UK last week, there is nothing improper with the government stating its readiness to adjust taxes to economic conditions. But any backtracking on spending cuts could be disastrous.
If the Eurozone crisis should drive a significant downturn or double dip, the Government must not listen to the siren voices on slowing down the spending cuts. Stay lashed to the mast, and stick to the plan. Meantime, the Bank of England will probably have to think again on QE. It should have secured permission to recommence in November. It certainly ought to recommence by January.