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.

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