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Why the coalition needs a Plan B

The Independent, August 23rd 2010

If tax takes fall, we could end up with spending cuts, a spiral back into recession and a deficit just as big as it was before – the worst outcome for the country and the Coalition

Economics should never be called a science, dismal or otherwise. It is closer to psychology than physics. Most of its inputs are unreliable, their effects on each other are even more so and, when you stir them up together, you have to add to the mix the unknowable ingredient of how people are going to behave.

So the future of the country hinges not just on how much the Government cuts public spending or raises taxes but on how we – as shoppers, employers or investors – react to what it does. Ministers can take an axe to the public sector, but if we respond by earning less, spending less or investing less, they may also end up turning the rest of the economy into kindling. Given that the deficit is the difference between what the Government pays out in spending and what it earns in tax, if tax revenues fall, we could end up with large spending cuts, a spiral back into recession and a deficit just as big as it was before. That would be the worst possible outcome both for the country and for the Coalition.

If growth disappears, so do tax revenues. Yet the Treasury’s forecasts of a shrinking deficit in the next few years assume decent rates of growth. If we decide we’re too worried about losing our jobs to spend money, or businesses decide that fewer people will buy their goods, then that growth won’t materialise. In that case, what’s the Plan B? The scariest aspect of the Government’s economic gamble is that there’s no obvious escape if it all goes wrong.

The UK bond markets are already sensing the possibility of a double-dip recession. Bond investors are cussed creatures: they prefer low inflation and the prospect of falling interest rates to economic growth. That’s why bond prices tend to rise on what normal people see as bad news, such as higher unemployment. And guess what? British bond markets are the strongest they have been for years. Last week, the ratings agency Moody’s said the UK was “clearly one of the weaker countries in the AAA peer group” and that the country was moving closer to being downgraded. The first challenge, said the agency, was to revive growth, a task that had been made harder by the lack of tools at our disposal. Because of the need to tackle the deficit, the Government can’t use the normal expansionary measures of cutting taxes or increasing spending.

George Osborne has made it harder for himself – and all of us – by promising to eradicate the whole deficit in just one Parliament. At the time, he claimed this was necessary to mollify the bond markets, which were already spooked by large deficits in Greece, Ireland and Spain. But they would surely have settled for less. Labour was offering to halve the deficit; Osborne could have said he would cut it by three-quarters, to 3 per cent of national income, a perfectly respectable level.

Instead, because he went even further, he is now risking both economic growth and the public services. Spending cuts and tax rises will take money out of the economy while it is still fragile, increasing the chances of tipping it back into recession. And the scale of the cuts will involve hacking out not just fat but muscle too from the public sector. Frontline services are bound to suffer.

These cuts will be all the more galling if it turns out that they haven’t even managed to reduce the deficit because of falling growth. So how can the Government encourage growth? It can’t do much with monetary policy. Interest rates have to remain low, but with a base rate at 0.5 per cent, they can hardly be cut further. More quantitative easing risks fuelling inflation. On fiscal policy, there isn’t much the Government can do either. If growth were to slow and Mr Osborne announced he was abandoning his deficit-cutting plans, the financial markets would punish him by selling UK gilts and the cost of his borrowing would rise – increasing the deficit still further. Privately, ministers say that if a double-dip loomed, they would have to bring forward tax cuts, but that wouldn’t go down well with the markets.

So all the Government can really hope to do is introduce supply-side measures that boost the private sector without costing the Government money. These will be the core of a growth paper, to be published in the autumn. It will include proposals for deregulation, liberalising trade, skills training and science.

Ministers are also desperate to get banks lending more to small businesses. In previous recoveries, small businesses and start-ups have led the way out of recession. That is proving harder this time, because of the difficulty of borrowing money on reasonable terms. “There’s a massive frustration in Government with the behaviour of the banks,” admits one Cabinet minister. “Once the economy does recover, it will become a crippling problem.”

The Government cannot relax the capital requirements that banks have to set against their small business lending without breaking international rules. It may have to draw up lending agreements with them or threaten an extra tax on their profits unless they step up their lending. Either way, we can expect quite a bust-up.

Meanwhile, lifting planning restrictions would help boost housebuilding, but all politicians know how inflammatory this can be. Allowing greater immigration of skilled workers would help businesses, but that runs counter to the Conservative policy of a cap on numbers. As one minister puts it: “It’s not easy to get all the ducks in a row. We’re really discovering that, being in Government and getting beyond slogans, it’s all a lot more complicated.”

One boost to growth could come from the new Green Deal, launched rather quietly last week. The plan is that all householders will be encouraged to have an energy-saving survey done of their home and any work they have done as a result can be paid off over the years in the form of lower energy bills. The utility companies will have to finance the upfront costs by issuing bonds. People moving home will be given a tax incentive to take up the Green Deal and give their new place an energy-efficient makeover before they move in. And private landlords may be forced to do it before they can let out their properties.

This plan will create jobs all over the country, soaking up some of the unskilled and skilled unemployed from the construction industry. And, critically, it will be financed by private not public borrowing.

But how much of an impact can schemes like this make against the headwinds coming the other way? There isn’t going to be much, if any, increase in consumer spending next year as our real incomes fall and VAT goes up. Yes, there have been encouraging economic statistics in the past week on tax revenues, manufacturing and retail sales, but these are all a leftover from the Labour economic stimulus. The new Government’s spending cuts and tax rises have barely begun to kick in. From now on, the cost of living is going to rise, but our earnings won’t. And many people, particularly in the public sector, will be worried about losing their jobs altogether.

It would be great if Britain could export its way out of recession. That won’t be easy, though, while other countries are launching their own austerity drives. And business investment is unlikely to pull us through while the economic outlook is so uncertain.

The Government’s Plan A is to eliminate the deficit and sit back while a newly energised private sector creates hundreds of thousands of jobs. The public sector becomes clean and lean, and the UK’s financial credibility is restored. But what if it doesn’t work? What if the private sector doesn’t respond, we tip back into recession, and we are left with savage cuts and a widening deficit? What’s the Plan B? Is there even one?

2 Responses to “Why the coalition needs a Plan B”

  1. Great website. Thank you! be back here soon.

  2. hurley says:

    Thank you for the great info, i’m going to write on this too!

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