The Centre for Policy Studies exposes Five Fiscal Fallacies

Ryan Bourne is the Economic and Statistical Researcher at the Centre for Policy Studies. Here he summaries Five Fiscal Fallacies by Tim Morgan, which is published today by the Centre for Policy Studies.

Recent evidence suggests support for the Coalition’s spending programme is waning as the cuts begin to take grip. This is gravely concerning (particularly given cuts have hardly begun), but in truth the government have not done enough to combat the portrayal of spending restraint as an obliteration of public services. Luckily for the Coalition, Tim Morgan has this week produced a hard-hitting critique of ‘deficit denial’. In his Centre for Policy Studies Pointmaker, he offers a comprehensive defence of the austerity programme, concluding that anything other than fiscal consolidation would have devastating consequences for the UK economy.

Dr Morgan, the Global Head of Research at Tullett Prebon, reminds us of the context in which the cuts are being made. The global recession was merely the catalyst which exposed the weak foundations of the UK economy – ‘a toxic legacy’ had left us more exposed than most OECD countries. The bungled tri-partite regulatory system had disastrously weakened oversight, whilst forcing the Bank of England to target retail inflation meant the whole concept of asset price inflation had been completely ignored. The Labour government appeared to subscribe to a ‘debt doesn’t matter’ philosophy, assuming the economy could ride indefinitely on the debt wave – a philosophy which subsequently transferred itself to consumers reassured by inflated housing equity.

But growth was largely illusory and resulted in government spending increasing up to and beyond the phantom boom. The banking crisis meant that all of a sudden the high deficit mattered a great deal, and cut backs were required to plug the gaping hole in the public finances. Ed Balls and Ed Miliband now argue that elimination of this deficit over the five year Parliament goes ‘too far, too fast’, but their standard objections are shown by Morgan to be based upon five fallacious assumptions:

Fallacy #1 is that the profligacy of the previous Labour government is in any way sustainable. The exponential debt threat highlighted by the Bank for International Settlements shows continuation of a budget deficit at anywhere near 11% of GDP would leave national debt at 300% of GDP by 2025 and well over 500% by 2040. Debt at these levels could simply not be serviced.

Fallacy#2 is that there is an economic soft option. The huge fiscal and monetary stimulus and slashing of the base interest rate has meant that so far the recession has, for many homeowners, been relatively pain free.  But in reality, recessions are painful, and the public finances have yet to adjust. Whilst cuts might adversely affect short-term growth prospects, there is no reason to assume that long-term growth would be secured through massive government overspend.

To see this, we need only look at the fact that enormous stimulus spending of near-on 40% of GDP has merely resulted in sluggish growth of 1-2%. This, Morgan argues, is because the recession was not an ordinary destocking recession, but rather a deleveraging one. Businesses and individuals are using the government stimulus to reduce their debts rather than boost consumption – rendering further Keynesian-style stimulus absolutely futile.

Fallacy#3 is that the cuts are massive. By 2014/15, real government spending will be just 3% below spending levels in 2009/10 and 48% higher than in 1999/00. These modest cuts will hurt because of blooming interest payments, and the decision to ring-fence the large health budget – the result of which is average real spending reductions of 10% for unprotected departments. Profit –making businesses, whilst recognising this level of cut backs are challenging, would in no way describe them as ‘massive’.

Fallacy#4 is that increased spending results in directly proportionate improvements in services. To show how untrue this is, Morgan rigorously examines healthcare productivity figures produced by the Office for National Statistics. The original results of the ONS work showed that between 1997 and 2007 there had been an overall DECLINE in productivity of 3.4%. But this analysis did not use expenditure as the input measure, and the 3.4% figure was largely made respectable by the massive increase in prescriptions as a health output. Focusing solely on Hospital, Community and Family health services, and using real expenditures as inputs, Morgan shows that productivity in these areas of healthcare had in fact deteriorated by as much as 34% between 1995 and 2008!

The significance of this is clear: if NHS productivity had remained constant during the Labour Government's huge spending increases, the health care provided in 2008 should have been provided at a real terms cost 34% lower than the sum spent that year (£102 billion). There therefore appears to be no automatic equivalency between state spending and the quality and quantity of output. It surely follows, he argues, that reductions in spending need not degrade the quality and quantity of services.

Fallacy#5 is that there is equivalency between £1 spent by the state and £1 left in the hands of businesses. Shifting resources from a high productivity private sector to a low productivity public sector is clearly not going to be growth inducing. But this is precisely what Labour did as it increased public spending from 36% of GDP to 48% of GDP over ten years. Had more resources been devoted to the productive private sector, greater productive growth would have been enjoyed. Indeed, evidence from the Global Competitiveness Report suggests much government activity actively harms growth prospects – the UK ranks 72nd out of 139 countries on the wastefulness of government and 89th on the ‘burden of government regulation’.

Morgan rightly concludes that the government spending cuts will lower growth prospects in the short-term. But it would be wrong to treat this as an ordinary recession risk. The significant threat to Britain is not sluggish growth, but an increase in interest rates which would make national debt unserviceable and reduce mortgage-paying homeowners to penury. The cuts agenda is still the right path, but deregulatory supply-side policies are welcome in making the transition to a private sector led recovery easier. The GCR highlights the UK as a country with good innovative and technological characteristics, but one which is hamstrung by waste, overregulation and interference.