Andrew Haldenby: Fiscal stimulus will prolong the recession

Andrew Haldenby is director of the think-tank Reform, which today publishes a report, The hole we are in and how to get out of it, presenting new evidence that a fiscal stimulus – whether tax reductions or spending increases – will prolong the recession. This, he says, is worrying since the Government is expected to announce just such a package in the Pre-Budget Report next week.

The Chancellor wants to introduce a stimulus to give the electorate the confidence to increase consumption.  But the overwhelming academic evidence is that what actually restores confidence is a sense that governments have regained control of their finances.  This is why many economies – including the UK in the early 1980s – had the paradoxical experience of a return to growth after tax increases.

This is also why fiscal stimuli in the form of crisis tax cuts don’t work.  Either the electorate will discount them because they know the money has to be paid back in higher taxes.  Or – this is the view of the academic authority, Stephen Ceccheti – governments will avoid the higher taxes and the public finances will get even further out of balance.

Reform’s Consultant Director, Nick Bosanquet, points out that the Government has misread Keynes.  Keynes actually focused on confidence; a true Keynesian position would be about measures to raise confidence and demand in the private sector.  Instead we have what he calls “Toxic Keynesianism” – the view that what we need is big government spending programmes which will beat unemployment and further increase the role of the state.

Our report is also about honesty.  The Prime Minister and the Chancellor have said that the public finances can withstand a burst of extra borrowing.  In fact the UK has the fourth highest structural budget deficit in the OECD.  Including the Government’s long term spending commitments on pensions and education, the deficit stands at 6.6 per cent of GDP.  Without changes in spending, that means eventual tax rises of £100 billion, or £4,000 per household, which would wipe out over a quarter of families’ disposable income.

Please don’t believe the Treasury’s estimates on borrowing in Monday’s report.  In the last five years, it has underestimated the true level of borrowing by a total of £121 billion.

And it’s about culture.  In retrospect the UK has endured a long period of living beyond its means, supported by interest rates held far too low.  We have become used to unsustainable levels of debt and consumption (we use the graphic image of the “obese economy”).  We now need to find a new path based amongst other things on saving (remember that?).  A fiscal stimulus would be the last hurrah of the debt-binge era.  It’s time to move on.

Instead the Chancellor should get a grip of public spending.  That does not mean crisis cuts in public spending, which would increase inefficiency and – by creating a perception of under-funding – lead to demands for higher spending later on.  This, by the way, was the story of the 1990s.  Crisis (Conservative) spending cuts led to a popular demand for (Labour) spending increases.  The UK public sector needs to leave behind this cycle of boom and bust.

Instead it means the programme of public service reform that the Government should have introduced years ago.  The recession should give the Government the courage to tackle the root causes of inefficiency. Above all that means the workforce agreements with public sector workers and the political direction from Whitehall.

Much of the programme will save money immediately.  We can’t underestimate how much of the inefficiency of public spending is due to the targetry and tinkering to which most Ministers and senior officials remain addicted.  A typical finding of our research is that the leaders of public services have the tools to change the way their services are run but are continually distracted by political priorities, from hospital cleanliness to changes to school curricula to ever-changing rules on use of police resources. The only cost of putting targets on a bonfire would be a certain amount of Ministerial embarrassment.  The gains would be immediate and large - even if for example the NHS became only 5 per cent more efficient (and it would be much more), that would save over £25 billion during a Parliament.

The Chancellor can also set out a productivity agenda for the private sector and individuals.  We suggest greater competition between businesses – the Lloyds / HBOS merger is ill-omened – and deregulation.  We should also enable individuals to make better use of their own money.  Public sector reform should open up the room for sustainable reductions in marginal tax rates, improving productivity.

In the short term, the automatic stabilisers have to be allowed to work and overall public spending will rise due to higher benefit payments. At the same time, the Government must reform the rest of public spending.  We suggest that the Chancellor should revise his Comprehensive Spending Review and republish it with the March Budget. When the Chancellor drew up his last spending forecast, he expected growth of 2.75 per cent in 2009.  It will actually be less than minus 1 per cent.  His proposals for spending (excepting the automatic stabilisers) need to be revised downwards.

The Conservative Party’s new policy on public spending therefore looks well-judged and well supported by the evidence.  The danger of excessive borrowing is real.

The remaining challenge is over public service reform.  We read that the Conservative Party is looking for “waste” to justify reductions in public spending (rather like the James Review in the last Parliament). That isn’t good enough – the problem isn’t “waste” but the structures that lead to the waste.  There is no avoiding the need to tackle head-on factors like the terms and conditions of public sector workers.  There is also no avoiding the NHS – it’s the biggest budget (£100 billion) and can’t just be appeased.

The Conservatives faced down union opposition in the early 1980s recession, to the great benefit of the economy.  Will they find the courage to repeat their achievement in today’s recession, in the public sector?

Next year the recession will bite hard.  Policy makers will be confronted with unemployment and public finance figures that keep on getting worse and worse.  Further damage to the public finances will be recognised to be highly irresponsible.  I hope Alistair Darling will reconsider.