Clarke vs the Tory right on budgetary policy

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One of the important sub-texts of the Conservative Party conference was the disagreement between Kenneth Clarke and the right of the party on budgetary strategy. In its most obvious manifestation, this was not a sub-text at all, but an open argument about whether to cut public spending further in order to avoid the need for tax increases in the Budget.

The right believes that the Treasury has gone soft on spending. The Chancellor's riposte is that the 1993 spending round is the toughest since the Conservatives came to office, and that it would be unreasonable to expect anything more draconian.

This column argued a few weeks ago that the Chancellor's claim to be 'tougher on spending than Mrs Thatcher' is rather dubious, since the intended clamp-down next year follows several years of real spending growth running at well above 3 per cent per annum.

Furthermore, the planned growth in spending in the rest of this parliament - ie before likely overruns - is already faster than the rate actually achieved by Margaret Thatcher at a similar stage of the last economic cycle. Clearly, the present spending round feels extremely painful to all those concerned, but that is because such large areas of spending have been declared politically 'off limits'.

This much is now all out in the open, but there is an interesting sub-text to the debate. The further to the right one moves in the Conservative Party, the less likely one is to find support not just for tax increases, but for any fiscal tightening at all.

The Tory right, which 12 years ago was absolutely determined to control 'fiscal profligacy' even at the expense of huge tax increases in 1981, is nowadays prone to argue that the budget deficit (though much larger now than it was then) is perfectly manageable. Meanwhile, the centre/left of the party, which opposed Mrs Thatcher's tax increases in 1981, now vociferously supports budgetary tightening.

Why has this game of intellectual musical chairs taken place? To a large extent it has mirrored a similar shift in thinking in the economics profession, where the classical economists are now the least persuaded of the need for tightening, while the low church Keynesians tend to be more hawkish.

It is not especially difficult to explain why the Keynesians have become more cautious about budgetary risks since 1981. In the past 15 years, three European countries - Italy, Belgium and Ireland - have moved quite quickly from manageable debt situations into outright financial crises in which governments have been forced into large emergency tax increases and draconian cuts in public services. Sweden, which had a perfectly acceptable public sector debt ratio four years ago, is going the same way. And although the level of the UK debt ratio is not yet especially troubling, it is rising (according to Dr Bill Robinson, Norman Lamont's former special adviser) at a faster rate than ever before in peace time.

This tendency for developed economies suddenly to encounter crises of government debt was a new phenomenon of the 1980s, and it is quite easy to explain why it happened. Until the decline in global inflation really took hold a decade ago, it was usual for the rate of interest to be considerably below the growth rate of nominal gross domestic product in most countries. This had a crucial bearing on the government's finances, since it meant that debt tended to accumulate more slowly than GDP increased.

In the past 15 years, the decline in inflation, and the rise in real interest rates, has meant that governments must run a generally much tighter ship to ensure that the debt ratio remains under control.

This can be illustrated by a simple example. In 1991, if the Treasury had then been performing 'debt sustainability' calculations (which it was not), it would have been reasonable to suppose that the real rate of interest might stabilise at around 1 per cent, and that an ambitious inflation target would be about 8 per cent per annum. Based on these figures, the Government could stabilise its debt ratio at 50 per cent of GDP by running a permanent budget deficit of 5.0 per cent of GDP each year. In other words, because inflation was eating into the value of debt so rapidly, it was not difficult even for profligate governments to ensure that the real value of outstanding debt was kept under control.

Nowadays, the same calculation is much less reassuring. Real interest rates are close to 4 per cent, and the centre of the Government's inflation target is only 2.5 per cent. This means that the Exchequer can run a public sector borrowing requirement of only 2.5 per cent of GDP - half as large as in the previous example - if it wishes to stabilise the debt ratio at 50 per cent of GDP.

The fact is that, once we have allowed for the reduction in inflation, the Government is now running a much more dangerous budget deficit than it was in 1981, or even in 1976 for that matter. The graph shows that from 1976-81, inflation eroded the real value of government debt by an amount equal to 7 per cent of national income each year - a phenomenal total. In the last few years, the equivalent figure has been under 2 per cent of GDP. Making allowance for the shrinkage of this 'inflation tax', the 'real' budget deficit is vastly higher now than it has been at any time since the Second World War. The conclusion is that governments in developed democracies are no longer able to finance themselves by duping the bondholder with persistent bursts of inflation.

None of these points is in any way news to classical economists in Britain. In fact, Professor Patrick Minford was one of the first to import this type of 'debt sustainability' arithmetic into the UK debate. Why, then, do he and others on the right have a tendency to regard today's budgetary problems as somehow less serious than those of 1981?

The only logical answer is that the right must believe that the budget deficit will automatically correct itself to a much greater extent than they believed last time. In other words, they argue that although the appropriate budget target is much tighter in today's low-inflation environment, there is a much better chance of hitting it automatically as the economy recovers. To some extent, they are placing their faith in their own economic reforms of the 1980s, which they continue to believe will show through with a large and sustained drop in unemployment in the 1990s. If this happens, then government debt will not be a problem, even though the present situation looks so serious.

Other economists - and I would include myself in this group - are much less persuaded that the Thatcher economic reforms will suddenly start to work in this fashion. To these sceptics, it would seem sensible for the Government to take nothing for granted until there is positive proof of a much enhanced economic performance - after all, the last five years have pointed rather firmly in the opposite direction.

When Mrs Thatcher was Prime Minister, she was the first to argue for public sector financial rectitude, even for 'housewife economics' at the Treasury. In 1981, this meant that she accepted the need for a massive tax increase, which her supporters have trumpeted ever since as the turning point for the post-war economy. Are she and they sure they really should be arguing the opposite today?

(Graph omitted)