Britain’s Path of Denial

SANTIAGO – Visit London nowadays and you will notice something strange going on: the worse the British economy tanks, the more fervently Prime Minister David Cameron’s ministers and Tory economists insist that draconian spending cuts are good for economic growth.

Some observers see this as an act of faith (presumably in the virtues of the unfettered market). Others, such as the economist Paul Krugman, see it as an act of bad faith: the Tories just want smaller government, regardless of the consequences for growth.

Support Project Syndicate’s mission

Project Syndicate needs your help to provide readers everywhere equal access to the ideas and debates shaping their lives.

Learn more

The question remains whether there is a non-faith-based argument for cutting back spending to stimulate an economy. The answer is yes. In fact, there are two. Academic research has shown them at work in the past – for example, in Ireland and Denmark during the 1980’s. Unfortunately for the Tories, neither case for stimulative spending cuts fits Britain’s predicament today.

One argument emphasizes the links between fiscal and monetary policy. In a country with large fiscal deficits, the central bank may have to keep interest rates high to control inflation. In this scenario, budget cuts create room for interest rates to fall. If the country has a floating exchange-rate regime, the currency depreciates, too.

Both of these changes are good for demand and growth. If their combined impact more than outweighs the initial contractionary effect of expenditure cuts, then the economy may well pick up after a round of fiscal tightening.

But little effort is needed to see that this not the British story today. The Bank of England’s policy interest rate has remained just above zero for more than two and a half years. Regardless of the government’s fiscal-policy stance, this interest rate cannot move below zero.

The second case for expansionary fiscal contraction is subtler. In an economy in which public debt is growing quickly, the longer fiscal adjustment is put off, the larger and costlier it will have to be. Households and companies understand this and cease to consume or invest in anticipation of the painful spending cuts and tax hikes to come. So, the argument goes, a courageous Tory government that cuts spending today spares citizens that future pain. Then, feeling richer and brimming with optimism, the private sector goes on a spending spree and the economy booms.

Put differently: without the budget cuts, Britain would have been Spain – or perhaps even Portugal or Greece. With the budget cuts in place and the markets reassured, Britain no longer risks resembling an unruly Mediterranean country. Thus, Britons will soon start spending again and economic growth will ensue.

So far, so good – except that this story, too, does not apply to Britain. There is no sign of a crisis narrowly averted. Ten-year yields on British government bonds were at historic lows long before Cameron took office. If a crisis was imminent, the markets clearly took no notice. And if the coalition government’s budget cuts had improved expectations about future output, that greater confidence would have shown up in higher equity prices – but there is no evidence of this, either.

In short, private demand in Britain is flatlining rather than surging. Add to the mix the collapse in public-sector demand that comes from deep budget cuts, and you have all the ingredients necessary for prolonged stagnation. And stagnation, if not worse, is precisely what recent British economic reports are showing.

The longer this goes on, the more serious the problem will become. The long-term unemployed will drop out of the labor market. Firms that invest little will become uncompetitive. In the jargon of economists, low demand will engender low supply, making a non-inflationary recovery even more difficult to achieve.

What is to be done in Britain? With the eurozone tumbling from crisis to crisis, salvation will not come from abroad. At home, all that is left is unconventional monetary policy. The Bank of England recently injected an additional £75 billion into the economy via so-called quantitative easing. Now, that is real cash, not just an act of faith.