To cut or not to cut?
The Government’s deficit reduction programme has been touted as the only path to pull the UK economy kicking and screaming back to fighting fitness. But is it? Over to our economists...
Richard Ramsey, Chief economist, Ulster Bank
‘To those waiting with bated breath for that favourite media catchphrase, the U-turn, I have only one thing to say: You turn if you want to. The lady’s not for turning.” Not only was this Margaret Thatcher’s most memorable line (October 1980), it was a defining policy stance for her premiership. She divides opinion, but Thatcher’s determination to stand firm against opposition to her liberalisation of the economy radically re-shaped the UK.
Today, the deficit is bigger than in 1980 — it’s the largest ever in peace time — but in many respects, George Osborne finds himself in a not dissimilar position to Thatcher, with clear economic and fiscal parallels.
Like economies elsewhere, and as in 1981, the UK economic recovery has been much weaker than anticipated. As a result, the Chancellor’s tax revenues will be lower and borrowing higher than originally envisaged. Against this backdrop, the view that the public expenditure cuts are too deep and too fast has led to a clamour for a fiscal U-turn or Plan B.
From the outset, however, it is worth noting that the UK’s fiscal plans are much less draconian than those being implemented in other parts of the eurozone periphery — notably the Republic of Ireland. In addition, it is important to note that Plan A also includes raising taxes and clamping down on tax avoidance. The recent UK-Swiss tax deal, potentially netting £5bn initially, is evidence of progress on this front.
Speaking just a few weeks ago, the Chancellor stated that “the events of the past month are a vindication of the Coalition’s decision to get ahead of the curve, and they demonstrate the reckless folly of the alternative route The alternative of more spending and yet more borrowing is now frankly ludicrous and places those who advocate it on the outer fringes of the international debate.”
This suggests Osborne will not change course in a hurry. Indeed, looking at the financial market chaos in the eurozone, the US and, more recently, Japan (whose credit rating, like that of the US, has been downgraded due to political inaction on the deficit front), the UK, by comparison, has been a sea of tranquillity. Sterling has strengthened on the back of this new found ‘safe-haven’ status.
Clearly, there are compelling economic and financial reasons why Osborne should stick to his guns. At the time of the general election last year, the cost of issuing 10-Year government debt was around 4%. Now, it is 2.5%, a significant reduction. Conversely, over the same period, the cost of government borrowing within the eurozone (excluding Germany) has increased dramatically, increasing debt interest payments and reducing the money available for the delivery of vital public services. For comparison, the cost of raising equivalent debt in other countries is Greece 18%, Portugal 11%, RoI 9%, Spain and Italy both 5%.
It has been suggested that VAT should be reduced to act as a stimulus. However, VAT is one of the largest revenue generators, and cutting VAT is simply not affordable and would lead to a loss of market confidence in the sustainability of the public finances.
The same would hold true if the public expenditure cuts were softened.
Arguably, such a scenario would trigger greater difficulties. The likely chain of events would be: the UK losing its ‘Triple A’ credit rating; debt interest payments rising significantly; sterling weakening; imported inflation increasing (notably food and energy); the MPC raising interest rates; the cost of mortgages rising and disposable incomes falling.
Clearly, given NI’s higher incidence of fuel poverty, lower household incomes and the property debt hangover, keeping interest rates low for longer is crucial.
In fiscal terms, while the UK does not need a fiscal Plan B at this stage, Northern Ireland does. As with Greece, populist policy measures need to be swiftly reversed. Economically speaking, they are unaffordable, inefficient and ineffective.
The Stormont Executive’s budget faces a cut of almost £1.5bn, in real terms, by 2014/ 15, relative to 2010/11. This has been presented as a cumulative reduction of £4bn in the block grant if expenditure had remained unchanged at 2010/11 levels in each of the four years.
On their own, these are manageable; but NI has its own devolved fiscal austerity to administer. The cost of devolved policies such as free prescriptions, free public transport for over 60s, lower tuition fees and no water charges all, in effect, have to be funded through public expenditure cuts to balance the books. Not implementing water charges alone costs, say experts, as much as £600m per year — or cumulatively £6bn of cuts in public services elsewhere. There is an alternative.
Without any increases in revenue, the Executive has to live with around £10bn less public expenditure (cumulatively) during the next four years. It remains to be seen where these reductions will be made, but households on lower incomes, who use public services predominantly more, will suffer the most. In this respect, retaining no water charges and free prescriptions for everyone, including the better off, is simply a waste of money.
Northern Ireland’s public finances and its economy need an about-face on these issues, and they need it quickly. As John Maynard Keynes said in response to an accusation of inconsistency: “When the facts change, I change my mind.”
Philip McDonagh, Chief economist, PricewaterhouseCoopers
‘There is no Plan B.” I always worry when I hear politicians saying this. Usually they are trying to demonstrate their leadership and confidence in the strategy that they have designed and to which they have committed themselves. Often a Plan B is, in fact, being prepared but it would be a sign of weakness to admit this.
In the case of George Osborne and the fiscal austerity package introduced in this year’s UK Budget, the refusal to consider any alternative is of increasing concern. With disappointingly low growth and depressingly high inflation, the UK economy desperately needs some alternatives.
It is, of course, understandable that the Chancellor should want to reassure the financial markets that his strategy is on course and the IMF amongst others has endorsed the UK approach. This contrasts sharply with the eurozone countries, where, no sooner has one crisis been averted than another one emerges.
The UK has the huge advantage of having control over its own monetary and fiscal policy, rather than being hamstrung by being part of the collective that is the eurozone.
But while it is one thing demonstrating your fiscal rectitude to the rest of the world — and in Osborne’s case, actually suggesting that the rest of the world could learn from it — it is quite another thing demonstrating some flexibility and imagination in responding to the very difficult economic circumstances that the UK economy faces at the present time.
At the time of the Budget, no one expected the global economic recovery to be as faltering as it has turned out to be. Six months ago, most forecasters were projecting above-average global growth in 2011, but since then the outlook has worsened considerably.
Growth in the UK economy in the second quarter of 2011 was recorded at less than 0.2%, although the statisticians took the unusual step of noting the special factors, including the Royal Wedding and the Japanese earthquake, that had kept growth down.
Earlier this month, the Bank of England downgraded its forecast for the UK economy in 2011 to 1.5% and independent forecasters are even more pessimistic.
Meanwhile, inflation remains stubbornly high, despite the extended period of low interest rates.
Ironically, lower growth actually makes the delivery of the austerity package even more difficult, because it tends to reduce tax revenues, thus throwing the projections of government income off course.
The Chancellor may be faced with the dilemma later in the year of whether he should actually introduce further tax rises or spending cuts to stay on track for his objective of eliminating the deficit by 2014/15.
In these circumstances, it is surely essential to re-examine the strategy to see what can be done to stimulate the economy and get the strategy back on course.
There are four essential components of GDP which drive economic growth — consumer spending, investment, government spending and net exports.
Consumer spending, which was the driving force of growth up until the recession, is now depressed as households struggle to manage debt and rising inflation.
Investment is also restrained despite the low cost of borrowing and government spending is, of course, actually being cut.
So that leaves net exports as the only potential source of growth for the UK economy.
Earlier in the year, there were signs that manufacturing exporters in particular were lifting the UK economy out of recession, but recent data suggests that this has petered out as global recovery stalls.
What is needed now is an economic stimulus from government to get the economy moving again.
This does not mean an abandonment of the fiscal strategy of deficit reduction over the medium term, but rather a short-term initiative to boost confidence and investment in key areas of the economy.
In Northern Ireland, levels of public spending still drive the economy and will continue to do so until we make some progress towards re-balancing the economy towards the private sector.
The Executive does not have much room for a Plan B on spending cuts because our budget allocation is determined in Whitehall. In fact, we could have done a lot worse in the last Spending Review, which saw us get a standstill budget for the next four years.
However, ministers do have flexibility in how they deliver their tighter budgets in smart ways that will maximise the economic benefits for everyone.
The decision to freeze student fees is a good example of this. Consideration might also be given to shifting more funding into capital budgets on infrastructure projects that are a good long-term investment, as well as providing a short-term benefit.
We await with interest the new Programme for Government and its associated economic strategy to see if the Executive still places the economy at the centre of the political agenda, and how this can be translated into a meaningful set of plans to rebuild and rebalance the economy.