Britain’s fiscal failure

By Felix Salmon
March 13, 2013

Never mind Sachs vs Krugman: by far the most interesting and important fiscal-policy debate right now is Cameron vs Wolf.

David Cameron, of course, is the prime minister of the UK, and last week he gave a rambling 4,000-word speech on the national economy which is almost impossible to read. For some reason the speech appears online in what you might call teleprompter format, with a single sentence sometimes spanning three separate paragraphs. It’s a clear indication that Cameron is more interested in rhetoric than he is in substance.

Meanwhile, Martin Wolf, who for many years has been the most respected and important economic commentator in Europe, has in recent weeks become much more accessible. Check out his column on bankers’ bonuses, for instance: it’s a smart and rollicking read, arguing persuasively that the UK government is being idiotic in its opposition to European bonus caps.

Wolf’s immediate response to Cameron was solid, but his second go-round is just devastating: we’re now officially in a world where the wonkiest columnist in the driest newspaper in Britain is stating his case far more simply and clearly than the populist PR man turned prime minister:

Mr Cameron argues that those who think the government can borrow more “think there’s some magic money tree. Well, let me tell you a plain truth: there isn’t.” This is quite wrong. First, there is a money tree, called the Bank of England, which has created £375bn to finance its asset purchases. Second, like other solvent institutions, governments can borrow.

Wolf’s main point is simple: in an economy which might already be in a triple-dip recession, deficits are caused by economic sluggishness. That’s what forces up government spending while reducing government revenues. Everything comes back to growth: the UK credit rating, the size of the deficit, and, most simply, nominal GDP, which is now 13.6% lower than the government officially forecast it would be back in 2008.

What’s more, government spending comprises a much larger share of GDP in the UK than it does in the US, which means that spending cuts can easily directly cause recessions. And deficits always go up, rather than down, in recessions:

The prime minister also stated: “[Labour] think that by borrowing more they would miraculously end up borrowing less … Yes, it really is as incredible as that.” What truly is incredible is that Mr Cameron cannot understand that, if an entity that spends close to half of gross domestic product retrenches as the private sector is also retrenching, the decline in overall output may be so large that its finances end up worse than when it started. Bradford DeLong of Berkeley and Larry Summers, the former US Treasury secretary, have shown that, in a depressed economy, what Mr Cameron deems incredible is likely to be true.

Cameron’s speech is basically the horrible personal-finance metaphor writ large: he’s trying to persuade people that solutions which make sense on a household-budgeting level can scale up to the national-accounts level. He’s obviously never heard of the paradox of thrift.

In fact, the speech is even more confused than that. At the beginning of the speech, Cameron attacks the policies of politicians who thought “that we had ended boom and bust”. Obviously, we haven’t. But then he makes no attempt at all to explain what government policy should be during boom years, and how that policy should differ during recessions. And finally he gets into the thicket of monetary policy, explaining that he essentially needs to abolish boom and bust himself, else none of his policies are going to work.

Cameron boasts in the speech that “it is now possible to buy a new home anywhere in the country with only a 5% deposit, and at very low interest rates,” and worries that “even just a 1 per cent rise in mortgage interest rates would cost the average family £1,000 in extra debt service payments”. He then says (the ellipses are his, not mine):

It is hard to overstate the fundamental importance of low interest rates for an economy as indebted as ours…

…and the unthinkable damage that a sharp rise in interest rates would do.

When you’ve got a mountain of private sector debt, built up during the boom…

…low interest rates mean indebted businesses and families don’t have to spend every spare pound just paying their interest bills.

In this way, low interest rates mean more money to spare to invest for the future.

A sharp rise in interest rates – as has happened in other countries which lost the world’s confidence – would put all this at risk…

…with more businesses going bust and more families losing their homes.

In other words, Cameron is placing all his chips on permanently low interest rates, which are the one thing he can’t control. And at the same time, he’s pursuing a contractionary fiscal policy, which is the main thing he can control. Here’s Wolf, explaining elegantly just how confused the prime minister’s thinking is:

As the prime minister himself notes, “we had over-indebted households borrowing from over-indebted banks”. So why does he expect monetary policy to achieve much? He evidently thinks people should borrow less…

Today, even more aggressive monetary policy is quite likely to be ineffective, even counterproductive, to the extent that it slows desirable deleveraging. It is likely that direct monetary financing of even larger fiscal deficits would be more effective and less damaging than using even looser monetary policy to prod the private sector into life.

This is the political mess that Mark Carney is inheriting as he takes over the Bank of England. The prime minister is betting everything on low interest rates and on loose monetary policy, while using fiscal policy to make Carney’s job as difficult as possible.

The UK is in a very tough economic spot right now, and it needs coordinated fiscal and monetary policy to get itself growing again. But the leader of the Conservatives seems to relish the idea of doing nothing at all on the fiscal side, while the leader of the Bank of England only took the job after deciding that he wouldn’t run for leader of the left-wing Liberal party in Canada. The chances of these two working effectively together seem slim indeed — and as a result, the future’s looking pretty bleak for Britain.

Update: Wolf’s colleague Chris Giles pushes back.

12 comments

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“even just a 1 per cent rise in mortgage interest rates would cost the average family £1,000 in extra debt service payments”?

Quite apart from anything, UK mortgages are not generally priced off bond yields. They’re priced off Bank of England base rate. That’s a really basic fact to know about the UK mortgage market. The only way not to know it is to have basically nobody in your social circle who’s got a mortgage.

Posted by dsquared | Report as abusive

You cannot always rely on growing your way out of your problems. At some point you need to tighten the belt. Yes it is better to do this counter=cyclically, but the electorate refuses to do that and there is only any public appetite for it synchro-cyclically.

Presumably you don’t thin the developed world can just keep increasing its GDP to debt ratios indefinitely? At some point borrowing costs will increase. So wen do you propose change? During the next boom? Do you know the odds of that happening?

Posted by QCIC | Report as abusive

QCIC — I seem to remember the GDP-to-debt ratio shrinking in the US counter-cyclically. But well, I guess you’re right that it must not apply because I’m so old and that was such a long, long time ago.

What was it? The 90s, I think they call it. I mean, that was, like, almost two decades ago. Life will never be like that again, surely. You have a good point – we should make people suffer now because you’re certain something that happened less than 20 years ago could never, ever happen again. I mean, the odds are clearly next-to-impossible.

[Of course, the ratio also shrunk for a sustained thirty year period after WWII, but clearly, that was a whole different century and has no bearing on what you definitively know to be case because of your infallible crystal ball]

Posted by AnonymousJones | Report as abusive

You’re missing the point QCIC. Belt tightening during recessions just further depresses growth. That leads to lower tax revenues and more debt because automatic stabilizers are kicking in as more and more people fall on hard times. So you can’t shrink your way to growth, unless you’re willing to cut off those stabilizers and let people starve. But of course a starving animal doesn’t just quietly wait to die, so you end up with social unrest and violence in that scenario.

Only when the private sector is growing can government shrink, and reduce it’s deficits. The UK v. US is proof of this. The UK is worse off than it was in 2009 and the US is better off.

Posted by Harpstein1 | Report as abusive

The Cameron government, as Krugman has made clear, is every bit as stupid as the government of the EU whatever it is or whoever, Merkel and associates. Indeed, it would appear that Cameron has been determined to throw away the UK’s great advantage over the EU in that it has its own currency. That could have saved the UK economy if not for the austerity hysteria that has overtaken Cameron.

Posted by Chris08 | Report as abusive

So please correct me if I’m wrong, but currently mainstream economists are advocating accruing more debt now so we don’t need more debt in the future? In the hope that it will kickstart growth?

I see the point, but isn’t this just kicking the proverbial can?

Is this not an excuse for exponential growth of debt? This hardly seems like a prudent policy one way or the other.

Posted by jststw | Report as abusive

Wolf used to write a lot of persuasive articles about the housing bubble etc. but although a journalist, he is also a politician and best friends with senior Labour figures such as Ed Balls. Growth definitely would close the deficit but it’s such a bad idea. A recession would kill off the parts of the economy that we need to. We’re ploughing all our efforts into things like low interest rates to prop up high asset prices. Expensive assets are never a good thing. They are great to get votes when mortgage buyers think they are all getting rich without producing real wealth with innovation and work.

Posted by WikiChris | Report as abusive

Sorry, but Cameron is right. As was Morning Joe against Krugman. There isn’t a money tree. Not the Bank of England, not the Federal Reserve, not the ECB. What these can do is increase certain numbers in certain accounts, and the engravers can follow behind increasing the number of notes, but that doesn’t increase wealth in any real sense — the wealth of nations consists of their ability to produce goods and services with the resources available, and that wealth is not enhanced but threatened by this notion that there is a money tree.

Posted by Christofurio | Report as abusive

Sorry, but Cameron is right. As was Morning Joe against Krugman. There isn’t a money tree. Not the Bank of England, not the Federal Reserve, not the ECB. What these can do is increase certain numbers in certain accounts, and the engravers can follow behind increasing the number of notes, but that doesn’t increase wealth in any real sense — the wealth of nations consists of their ability to produce goods and services with the resources available, and that wealth is not enhanced but threatened by this notion that there is a money tree.

Posted by Christofurio | Report as abusive

UK mortgages are generally priced off LIBOR. Vendors tell you this is the Banks’ base rate, and buyers generally hear the Bank’s (i.e. Bank of England) base rate.

The big mistake here is to see the Dave/Gideot argument as an economic one. They are making a political argument, that we cannot afford the welfare state, that Britain is in the grip of a dependency culture and that ‘strivers’ need to be rewarded and ‘shirkers’ punished.

Cameron and Odbourne are talking policy as a morality play, not an economic one.

Almost everyone agrees, because they all think they are the strivers and the shirkers are someone else.

But most benefits get paid to people in work, and of those not in work, the vast majority go on pensions.

Austerity will hit the working poort the hardest. They are the real ‘strivers’.

Posted by Urban_Guerilla | Report as abusive

AnonymousJones-

You think we are close to the 90s in terms of situation?

The end of a decades long cold war, discontinuous technological change (the internet), and bipartisan cooperation.

You think those things are coming back? Not to mention the fact that a lot of the “growth” in the 90s was illusory. You always go chasing “growth” instead of attending to fundamentals and you get the tech bubble, and the housing bubble, et cetera.

Posted by QCIC | Report as abusive

Good points, QCIC.

I think we are closer to the 30′s (perhaps 1937) than to the 90′s. Let’s hope the next decade works out better this time around…

And agree totally on “chasing growth”. If you pay people to dig holes and fill them in again, you’ve increased the GDP without any real increase in productivity. This is effectively what we were doing in both the tech bubble and mortgage bubble. We haven’t had a healthy domestic economy since the 1980s, and that shows when you look at middle-class paychecks.

Posted by TFF | Report as abusive