No backtracking

Andrew Lilico is Policy Exchange’s Chief Economist.

There has been much excitement in the press over the weekend about a supposed softening in the Conservative line on spending cuts, focusing particularly on Cameron’s comments that cuts needed to begin early but that the early cuts didn’t need to be “particularly extensive” and that there would not be “swingeing cuts” in the first year.

Many commentators have connected these statements to the very poor GDP figures and the growing expectation of a double dip, with the suggestion being that the recovery may not be sufficiently robust for the economy to tolerate significant spending cuts.  But does the prospect of a double dip stymie the case for early action to correct the deficit?

It is certainly true that, for much of late 2009, the Conservative Party emphasized that if there were recovery in 2010, there would be no need for additional fiscal stimulus and that with a recovery in growth, a normalisation in fiscal policy could begin.  But this was not the case for fiscal consolidation we at Policy Exchange offered.  In our view, the case for early action to address the deficit is even stronger if there is a double dip.

A mild double dip may well commence before the General Election, perhaps as early as the first three months of 2010 or more probably in the April to June period.  This was, for example, the experience in 1992, when, after growth from October 1991 to March 1992, the economy slipped back into contraction from April to June.  This will come before any action to cut spending or raise taxes – indeed, spending will still be rising rapidly over this period.  Double dip will make it all the more urgent to cut spending.  Why?  Well, suppose that we left spending at about 50% of GDP and left the structural deficit (that bit of the budget deficit that won’t go away once the economy is growing well again) at about £125bn.  The result would be that financial markets would become very concerned that the British political classes lacked the will (and the economy lacked the growth) to address the deficit when times were tough and that unless everything went smoothly thereafter, Britain would be at risk of inflation or even defaulting.

We have seen in the case of Greece – a country with a much lower structural deficit than the UK, though arguably higher government debt (excluding off-balance-sheet items) – how rapidly financial markets can punish delinquent fiscal policy once the political will to address it is not there.  Greece now has interest rates on its medium-term debt some 4% higher than those in Germany.  This, for the UK, would have the consequence of households paying an average interest rate of something in excess of 9%, on average, over the lifetime of their mortgages – an economic catastrophe for an economy already so over-indebted.

The issue is thus not whether early spending cuts would bring about a double dip: there will probably be a double dip now, with or without early spending cuts.  The issue is how much worse the double dip would be if spending is not cut.  And the answer is: disastrously worse.

So has Cameron got it wrong?  Probably not.  For the practical reality is that a new government coming into power in May or June is already part-way through the financial year.  There should be scope not to engage in all of Labour’s planned £30-odd billion further spending rises.   But given that the Conservatives have not already pre-committed to reversing Labour’s huge spending rises of 2009/10 and 2010/11, cuts in the first year are only likely to be some £5 billion - £10 billion.  The “heavy lifting” of the spending cuts programme must come in years two to four – probably £20 billion in the first year, £30 billion in the second, and £20 billion in the third.

Cameron and Osborne are also quite right to emphasize the coordination of fiscal and monetary policy.  It is likely that there will need to be additional quantitative easing combined with the fiscal tightening.  Early action to cut spending to keep interest rates low and allow further money printing: that will be the correct response to double dip, not a cause of it.