Now isn't the time to cut

by Ed Bowsher on 03 June 2010  |  4 comments
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The coalition government is set to announce more spending cuts in the upcoming emergency budget. That's a mistake. Spending cuts will make the economic situation worse, not better.

The UK government’s deficit for the last year was £156 billion. In other words, it spent £156 billion more than it received. That’s equivalent to around 13% of the UK’s economic output or GDP (gross domestic product.)  That’s a very high number.

Now if an individual approached me and said he was spending more than he earned, I’d say he should either cut his spending or increase his income. So it’s tempting to apply the same logic to governments. In other words, the UK government should either cut spending and/or increase taxes.

However, I’m pretty sure that this isn’t the right solution for our current economic predicament. Spending cuts or tax increases will actually make it harder for the government to reduce its deficit.

Balance sheet recession

That’s because we’re in a balance sheet recession. In a conventional recession, businesses and individuals are profit-maximisers. As interest rates fall, people borrow money and they use that money to buy things or invest in their businesses. As a result, the economy moves forward.

Trouble is, we’re not in a conventional recession. Property prices and share prices tumbled in 2008, and that meant that many individuals and businesses suddenly had big debts. Maximising profit was no longer a priority. Instead people focused on minimising debts and that’s still the case now. We’re in a  classic balance sheet recession.

I should stress that this isn’t my idea. I’m no way near clever enough to come up with a theory like this! It comes from a guy called Richard Koo, an economist who has worked in Japan for the last twenty five years. Check out this interview with him - it’s fascinating stuff.

Here’s the key passage:

“Take, for example, a household with $1000 of income that spends $900 and saves the remaining $100. The $900 that is spent becomes income for someone else and continues to circulate in the economy. The $100 of savings is deposited in a bank or other financial institution and eventually is lent to a business, which spends (invests) it. In this way, all of the original $1000 in income is passed onto others. The economy remains in motion; every $1000 income generates (at least) $1000 in spending.

“But what if there are not enough businesses eager to borrow all of the household’s $100 in savings? The banks’ first response would be to lower interest rates to attract hesitant borrowers to take out loans so that the initial household’s entire $1000 of income would be recirculated and the economy could keep firing on all cylinders.....

“But when everybody’s balance sheet is underwater, like Japan in the early 1990s, even if you bring rates down to zero, nobody is going to borrow. Instead companies were paying down debt at the rate of several tens of trillion yen a year. Under these conditions, to go back to our example, our hypothetical household’s $100 deposit in the bank will neither be borrowed nor spent – despite the bank’s best efforts. In which case, only $900 of the original $1000 in income is spent to become income for someone else. Then assume that this next household also spends 90% of its income and saves 10%. That means it spends $810, and saves $90.”

And on it goes. The only way out of this is for the government to run a sustained fiscal stimulus. That will take up the slack in the economy until the private sector has paid off its debts and restored its balance sheets. The beauty of this argument is that the government doesn’t have to borrow from abroad to fund its stimulus. It can borrow from the UK banks who are struggling to find anyone who will borrow from them.

I find this argument very persuasive and it chimes with my own thinking that now isn’t the time to cut government spending. But before I go I thought I’d look at some of the arguments put forward by supporters of spending cuts:

Mervyn King says spending cuts are essential

Well, the Bank of England has been wrong many times in the past. Most recently when it set interest rates at too low a level in the early to mid-noughties. Central bankers around the world thought that low interest rates were fine because consumer prices were rising slowly. Trouble was, asset prices such as property and shares were rising much more quickly. In hindsight, Mervyn and his mates should have focused more on those areas.

If we don’t cut spending, the UK’s credit rating will be downgraded

Yes, that’s possible. And if our credit rating was downgraded, the UK government might have to pay a higher interest rate on its borrowing. However, I stress the word ‘might.’ And anyway, Spain’s credit rating was downgraded by one of the agencies last week even though the government had recently announced an austerity package. Spending cuts don’t guarantee top-notch credit ratings.

What’s more, the Bank of England has had no problem selling enough gilts at recent ‘auctions.’ Investors are currently happy to buy UK government debt.

Don’t get me wrong

Don’t get me wrong. I can’t say with 100% certainty that I’m right on this. We live in extraordinary times and it’s impossible to be absolutely certain about any economic solutions.

However, I do think Richard Koo’s argument is strong. I think it’s likely that further spending cuts will trigger a double-dip recession. Another recession will reduce the government’s tax revenue and the government will find it even harder to cut the deficit. Cheerful stuff....