October 31, 2011

Plan B or not to B

Writing about web page http://clients.squareeye.net/uploads/compass/documents/Compass_Plan_B_web.pdf

Plan B was launched over the weekend to much fanfare. There was much excited analysis in The Guardian. In The Observer, one hundred economists told George Osborne that Plan A is failing.

I will focus on one small aspect, the Plan B critique of current fiscal policies. Behind Plan B is the idea that "current policies … may do the very opposite of their avowed intention, by actually increasing the deficit." The logic underlying this argument extends he Keynesian multiplier: public spending cuts put people out of jobs and reduce their incomes, so that they pay less in tax; if taxes fall by more than spending, the deficit will widen, ending in higher, not lower public debt. Turn this argument around and there would be scope, apparently, for Britain to spend its way out of debt.

Another idea behind Plan B is that "the UK national debt is not large by long-run historical standards." Judging from the historical record, it seems, Britain can easily afford a higher public debt. While debt reduction may sound virtuous, it is suggested, it is currently unecessary (and the policies designed to achieve it may be actively harmful).

The outcome of Plan A, according to Plan B, is economic "sado-masochism": We are enduring the pain of public spending cutbacks to no purpose (since the cutbacks will not reduce the deficit) when the purpose (to reduce the public debt) is not even necessary in the first place. Or is there pleasure for some in the pain of others?

This weekend, by coincidence, the Royal Economic Society Newsletter (no. 155, October 2011) published my short paper Surely You're Joking, Mr Keynes?This paper makes two points.

First, it's true that Britain has carried much larger debts relative to its GDP in the past, but this was almost entirely the result of wars; do we have a comparable excuse today? It's completely unhistorical, moreover, to compare Britain's credit today with that obtainable when Britain was the world's dominant economic and financial power. The world has changed; is that something we still need to get used to?

On this, I conclude:

Historically, having a debt twice the size of the national income has been a sign that something went terribly wrong: a run of major wars, for example. Faced with the worst recession in 80 years, the British government was right to let its budget go into deficit temporarily. At that moment an increase in Britain’s debt was inevitable. Now it looks essential to bring it back under control over a few years.

Second, there is no robust evidence in the historical data that deficit reduction is self-defeating. There is claimed to be evidence, but I show that it crumbles when you touch it. On average, in fact, deficit reduction has reduced the national debt -- as one would expect.

Here, I conclude:

It remains true that, once the public debt is set on a particular course, it is hard to change that course quickly. But this is only momentum that takes time to reverse; there is no evidence of destabilizing pushback from Keynesian multipliers.

To sum up: I have taken aim at two common beliefs about the British public finances. One is that we should borrow our way out of recession; the other is that we can spend our way of debt. These beliefs are based on intriguing stories. But, like many good stories, they are fictions. Our country cannot spend its way out debt. In today’s world, we can afford to borrow much less than in the past, and that may be just as well.

- 4 comments by 1 or more people Not publicly viewable

  1. Jorge

    My deepest compliments for supporting the view that government present policies are helping boosting the economy and to exit recession very quickly and effectively. The figures of GDP and unemployment however seems to contradict your theoretical statements.
    Greece adopted in 2010 a similar austerity packages and the drop in GDP is so large that self-defeat the stated goal. Facts are facts and when a theory is in contrast you prefer the theory.

    04 Nov 2011, 13:47

  2. Dr sunil

    Yes I dont agree in public spending cuts, but we need to be more efficient. We need to cut waste.

    07 Nov 2011, 22:44

  3. Joe Bloggs

    What is your opinion, are interest rates on UK gov debt low because of a credible fiscal plan or because of expected low growth into the future? Genuine question.

    25 Nov 2011, 12:26

  4. Mark Harrison

    Thanks for your question. Both factors are at work, but most western countries now expect low growth, so that is not uniquely British. Credibility is important, and relative credibility may be decisive. Britain’s fiscal consolidation plan looks more credible than that of others, and is not infected (as even Germany’s may now be to some extent) by joint responsibility for debts of the Eurozone periphery.

    25 Nov 2011, 14:46

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I am a professor in the Department of Economics at the University of Warwick. I am also a research associate of Warwick’s Centre on Competitive Advantage in the Global Economy, and of the Centre for Russian, European, and Eurasian Studies at the University of Birmingham. My research is on Russian and international economic history; I am interested in economic aspects of bureaucracy, dictatorship, defence, and warfare. My most recent book is One Day We Will Live Without Fear: Everyday Lives Under the Soviet Police State (Hoover Institution Press, 2016).

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