Clegg's cuts confusion

Nick Clegg’s argument here seems desperately weak - and his discomfort suggests he knows it. When asked by Andrew Marr why he now supports Osborne’s spending cuts when he opposed them before the election, he says:

I don’t think anybody could have anticipated quite how sharply economic conditions in the euro zone would have deteriorated and that the need to show that we are getting to grips with this [deficit] suddenly became much greater.

He goes on to say that the “black hole” is “in many ways much worse than we could have anticipated.”
There are three things wrong with this.
1. One of the main effects of the euro area crisis is that it jeopardizes our exports - because fiscal tightening in the PIGS will depress demand, and (to a much lesser extent) because it has weakened the euro. One could argue that this adverse demand shock increases the argument against a fiscal tightening.
2. Gilt yields have fallen during the euro crisis, as part of the flight to quality that’s depressed bund and Treasury  yields. This has actually diminished one concern I had beforehand - that gilts would be undermined by a contagion effect arising from a debt crisis elsewhere. With confidence in  gilts  surprisingly high, the case for cuts is smaller.
3. The fiscal position is not worse than thought. Latest figures show borrowing is actually less than Darling forecast.
The truth is that the case for spending cuts hasn’t strengthened at all. I suspect Clegg’s position has changed simply because he had to concede something to get a coalition. His reluctance to say as much suggests he’s still in “old politics” mode.
 Whilst I’m on the subject, a new paper here is grist to the mill of those who are worried about the macroeconomic impact of these cuts. The authors estimate that shocks to government spending have powerful short-run multiplier effects. Their data comes from the US, but the question arises: why should the UK be different now?

Comments

[Luis Enrique]

Chris, other than

1. the risk the government's cost of borrowing may rise (prob leading to inflation)
2. question of whether benefits of running deficit now justify imposition upon future generations

are there any other objections to/ problems with the "do nothing" approach to the deficit?

[chris]

It depends how you regard the deficit. If you see it merely as the counterpart to a credit crunch-induced private sector surplus, then you've exhausted the objections.
However, one could argue - without swallowing all the Tory guff about the "overspend" - that a deficit is in part a sign of excessively big government and that spending cuts would increase allocational efficiency. Is it really healthy that two-fifths of economic activity occurs in areas where price signals are weak or absent?

[Alex]

Good post.

On you third point, I think you missed something. What if the deficit actually had been worse than was thought? Would that have made Clegg's argument better?

No. Because if the deficit is higher, then that means that demand is lower than expected. Which would justify further public spending to increase demand, not less. Politicians can't just point to the deficit (or even the debt) and say "That's a big number, we must protect confidence by cutting". They are just individual people, making their judgement. Instead, if they want to know about the confidence of the market, then they should take a look at the market, by looking to gilt yields as you to above.

*****

Slightly off topic, but did you hear what David Laws said about the Child Trust Fund:

"At present the Child Trust Fund is based on the claim that young people will build up an asset which they can use later in life. But since Government payments into this scheme are being funded by public borrowing, the Government is also storing up debts which will have to be re-paid by these same young people. It is therefore a deception to claim that young people are being made richer by the Child Trust Fund. For every pound paid into this scheme there is an extra pound of public debt."

That statement, in my mind, manages to make two horrific mistakes:

1. It seems to imply there is no such thing as multipliers.

2. Just because the government is borrowing money now much of which will have to be paid back later, doesn't mean it shouldn't be done. That is how banking works for goodness sake (something Laws should know having worked for JP Morgan)!

[Econoclast]

There are a couple of issues. First, the UK's fiscal position is close to the limits of what we can credibly run. Our deficit is extremely large as a share of GDP and debt is rising rapidly. Second, markets might currently be using the UK as a safe haven, but what if that suddenly reverses? If the economy were still in freefall, I admit the case for fiscal tightening would be weak. But right now, prudent policymaking dictates you put in place a credible plan to reduce the deficit and stabilize the debt ratio. It's also prudent to make sure that households and companies recognize there is an inevitable hit to living standards. This can happen through government policy or a market-induced currency crisis. The former is preferable.

[Luis Enrique]

Everybody (retrospectively) castigates the banks for having "taken on too much risk".

How do we get a handle on the risk the government would be taking by continuing to run a big deficit?

What are the chances that if the ConDems didn't attack the deficit, we'd be sitting here in a few years time, after some new major economic mishap, talking about how stupid and complacent everybody was?

Of course we could also be sitting here talking about how silly it was to try and cut the deficit.

most of the economic research I know (like the paper linked to above) gives some insight into some component of the story, but I don't know of anything that would really help us weigh up all the options in front of us against each other. This sort of thing does make me feel macroeconomics is fairly useless.

How Chris might your idea that the deficit is merely the counterpart of private sector saving, and not something the government ought to try to actively manage, resemble the idea that, say, financial markets can be left to look after themselves. i.e. a theory that didn't work out too well in practice?

also, is there anything at all to "Treasury View" type arguments that government borrowing is somehow "taking money out of the economy" even with interests rates at zero no "crowding out". I tentatively think those arguments are garbage, but I'm never quite sure I understand, if you compare a "cut deficit" to a "don't cut deficit" scenario, what happens to the money the government isn't borrowing in the "cut deficit" scenario, and whether/how that matters.

[Fred Kapoor]

Great post, worth reading!
After analyzing it and reading the comments above I came to agree with @Alex comment. I believe that comment makes a valuable point with a very objective and realistic insight.
Thanks for sharing.

[Alex]

"Second, markets might currently be using the UK as a safe haven, but what if that suddenly reverses?"

That is an argument for never having a deficit ever. Because you could say that any time someone advocated deficit spending. There is nothing that could falsify this argument of yours.

[Econoclast]

@Alex

I don't think that is my argument. The current market and economic context is important, surely. The UK is more exposed now because: 1. we have a large structural budget deficit; 2. we have a rapidly rising debt ratio; 3. we have a current-account deficit (ie we are reliant on external capital inflows to finance ourselves). It is the size and persistence of these variables that could potentially lead to a problem. Given current market nervousness, it's not inconceivable that capital flows could dry up if foreign investors lose confidence in the UK policy framework. It's also possible that domestic savers lose confidence in the policy framework and shift their money overseas. The effect is the same. As we are seeing in Europe, in a world of constrained capital, markets are becoming much more discerning about who they lend to. It's not as if that hasn't happened before in the UK (1967, 1974, 1976, 1992). Let's face it: there are only two real safe havens - Japan and the US. We shouldn't kid ourselves we are like them, because we're not.

[Alex]

Econoclast, your first point was:

"First, the UK's fiscal position is close to the limits of what we can credibly run. Our deficit is extremely large as a share of GDP and debt is rising rapidly."

The you made a second:

"Second, markets might currently be using the UK as a safe haven, but what if that suddenly reverses?"

When I argued against that second point, you have now replied that:

"The current market and economic context is important, surely. The UK is more exposed now because: 1. we have a large structural budget deficit; 2. we have a rapidly rising debt ratio; 3. we have a current-account deficit (ie we are reliant on external capital inflows to finance ourselves)."

which is using your first point to justify your second. You can't make the same argument twice.

[Econoclast]

Alex

No, you didn't argue against my second point. You inferred that I was suggesting a government should never run a deficit. I did not that argument, nor did I make the same argument twice. I was clarifying my argument because you appear not to understand it. So here goes again: I argued that 1) given the current state of the economy and public finances that 2) there was a greater likelihood of markets suddenly losing confidence in the policy framework. Put aside your apparent issue with the logic, and consider the substance of the argument. If the budget deficit was smaller and the debt ratio was lower, there would be less risk of markets losing confidence in UK. Why do you find that controversial?

[Alex]

I don't find it controversial. Let me quote back to you exactly what you said:

There are a couple of issues. First, the UK's fiscal position is close to the limits of what we can credibly run. Our deficit is extremely large as a share of GDP and debt is rising rapidly. Second, markets might currently be using the UK as a safe haven, but what if that suddenly reverses?

You give a "couple of issues". You say "First" then say "Second". Quite clearly, you are making two points in that paragraph.

Take the first point. You say:

First, the UK's fiscal position is close to the limits of what we can credibly run. Our deficit is extremely large as a share of GDP and debt is rising rapidly.

Your first point is about how bad the debt, deficit and so on are for the UK.

For your second point you said:

Second, markets might currently be using the UK as a safe haven, but what if that suddenly reverses?

Now, what I was saying, was that using this logic, if the market was viewing us as doing bad, we should tighten, and if the market was viewing us as ok, it might suddenly change its mind, so we should tighten.

Now it's true that the market could suddenly change its mind. My problem was not with that. My problem was with the "so... tighten" bit. If no matter what the market is doing your logic means we should tighten, then it is unfalsifiable.

You then replied:

The current market and economic context is important, surely. The UK is more exposed now because: 1. we have a large structural budget deficit; 2. we have a rapidly rising debt ratio; 3. we have a current-account deficit (ie we are reliant on external capital inflows to finance ourselves). It is the size and persistence of these variables that could potentially lead to a problem. Given current market nervousness, it's not inconceivable that capital flows could dry up if foreign investors lose confidence in the UK policy framework.

This was to defend what you had been saying in your second point after I had argued against it. Read back what I just quoted. It essentially means the market's confidence might reverse because "1. we have a large structural budget deficit; 2. we have a rapidly rising debt ratio; 3. we have a current-account deficit".

So you have basically said, the market could lose confidence because of the debt. deficit and so on. But let me remind you what your first point was:

First, the UK's fiscal position is close to the limits of what we can credibly run. Our deficit is extremely large as a share of GDP and debt is rising rapidly.

Your first point was about the debt, deficit and so on.

Your second point was a separate one:

Second, markets might currently be using the UK as a safe haven, but what if that suddenly reverses?

As such, your two points about the UK's situation become:

1. The UK's debt, deficit and so on are incredible. This is bad.

2. Markets could suddenly lose confidence in the UK because the UK's debt, deficit and so on are incredible. This is bad.

So both your two points are exactly the same. They both say that the UK's situation is bad because of our debt, deficit and so on.

[Alex]

There was meant to be some blockquotes in that, but they disappeared. I hope its clear in that who's saying what.

[Econoclast]

Alex

I appreciate your attempt to tell me what I'm arguing but it's really not complicated. Points (1) and (2) aren't saying exactly the same thing. Point (1) is a statement about the UK's budget position. Point (2) is a statement about market sentiment and how it might react to (1).