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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.

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.