Friday, May 8, 2009

Debt reduction is better done by cuts in spending than raising taxes

TO BE NOTED: From the Telegraph:

Debt reduction is better done by cuts in spending than raising taxes
There is something odd about the idea that the huge levels of government debt revealed in last week's Budget must imply penury for ever more.

This is not a natural disaster, like an earthquake or tsunami which destroys buildings and productive assets.

And it is not like an epidemic which may kill millions of people. Nor is it like a war, which may do both. For all the red ink, the real productive capacity of the economy may be exactly what it was before. So where does the impoverishment come from?

This is another example of how dangerous it can be to compare the position of a whole economy with that of an individual. If any of us had equivalently huge debts, we'd be bust, plain and simple.

But this does not apply to the economy as a whole because we owe the Government's debts to ourselves. The common approach to this issue is to imagine that the huge interest payments from the Government will be poured into a black hole. In fact, though, they will be received by all those who hold the extra gilts, namely pension funds, insurance companies and banks, aka all of us at one remove.

Now you may immediately point out that a good part of the extra gilts will be bought by foreigners so the debt and the interest payments will be due not to ourselves, but to "them". This is true. But although we are running a current account deficit and hence having to borrow from foreigners, compared to the fiscal deficit, this deficit is quite small – about 2pc or 3pc of GDP.

More importantly, the problem of huge fiscal deficits is international. Thinking globally, it is undoubtedly global citizens who receive the interest payments. Who else could they go to? The man on the moon?

So what's the problem? There are two ways in which real disaster could occur as a result of this purely financial problem – the first arises from doing nothing, but the second arises from doing too much.

Suppose that the debt continues to mount and the UK government takes no further steps to reduce the deficit. The interest bill would rise and the debt would increase even faster. As the markets saw this, the rate of interest at which they were prepared to lend to the Government would rise – so the interest bill would rise still more, and so on. The debt would begin to explode.

This is known as the "debt trap". When governments find themselves in this position then, short of draconian and probably impossible rises in taxes or cuts in spending, there are only two ways out – default or inflation. Either of these would have serious real consequences – and not only economic ones. So it is worth trying hard to avoid getting to this point.

But let's look at the opposite extreme. Suppose the Government jacked up taxes sufficiently to clear the deficit this year. With lower disposable income, people would spend less and that would depress the economy – which would reduce tax receipts still more. A tax rise of that sort would cause a drop in GDP which would make the last year look like a tea party.

So what to do, other than hope and pray for an early and strong recovery? First, the Government needs to set in train measures now which would ensure that as the recovery comes there will be a net fiscal tightening to reduce the deficit more rapidly. The aim should be to head off the debt trap and to persuade markets that it has been headed off.

But not more than that. The bulk of the job of getting over the fiscal problem will be done by economic growth, combined with expenditure restraint. Subject to putting off the debt trap, the Government should do nothing to inhibit that growth. This argues for accepting that the debt will be large for ages and that debt interest payments will be huge.

We have been here before, as our chart shows. Following the Napoleonic Wars, net debt peaked at 261pc of GDP in 1819. It took until 1861 to fall below 100pc. Government debt again exceeded 250pc of GDP after the Second World War, but by 1951 it was down to 140pc of GDP. It took until 1964 to get under 100pc of GDP.

Cynics will say that this was only achieved through inflation. But this isn't fair. Until 1970 inflation, although continuous, was quite modest. It was sustained, strong economic growth which made the difference. And over the 19th century overall there was no inflation at all.

Second, whatever the Government has to do to reduce the deficit it should do in such a way as to try to boost the confidence of spenders so as to encourage the recovery to come sooner and to be stronger. That is why I favour concentrating the pain on public spending cuts rather than tax rises. Freezing nominal spending would create striking savings. It would save £20bn or so in the first year. By 2015-16 it would have saved around £340bn cumulatively.

Mind you, it isn't as though public spending cuts are a free option because lower spending will directly reduce aggregate demand as much as, or more than, higher taxes. But there are some key differences. Higher taxes affect the incentive to work.

Moreover, the possible losers from lower future government spending cannot so easily identify themselves and so will not suffer the same blow to confidence and hence reduce current spending as existing taxpayers.

Furthermore, there is widespread recognition that there is huge waste in the public sector. Reducing this would increase the productive potential of the economy, and knowledge of this would help to boost confidence.

Really tight spending control would even allow taxes to be cut consistent with reducing the deficit. But the Government should do all it can to avoid raising taxes. If taxes have to rise, I have a modest suggestion which could help. Rather than doing this in the usual way, instead make people contribute to government funding. In return for increased "taxes", give them a certificate, a gilt if you like, which entitles them to a stream of interest payments, which could be used to reduce their tax bills in future.

As long as default and inflation can be held at bay, and the economy can be kept fully employed, which requires monetary policy to be kept supportive for a very long time, then there need be no future real pain as a result of past financial mistakes. Admittedly, achieving this result will require some immediate announcement of tough public expenditure control.

But substantial fiscal tightening must be delayed until the economy can stand it and supportive monetary policy can provide a powerful offset.

Roger Bootle is managing director of Capital Economics and economic adviser to Deloitte."

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