Comment: Bitter pill with long-term benefits

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The financial markets were unimpressed by the news of the public spending plans. That is a perfectly understandable reaction, for it is difficult not to be cynical about the speed at which the pre-election fiscal stance is being reversed. If the Government had expected a vote of confidence from the gilt market for its rediscovered fiscal virtue it will be disappointed. But two years from now the change may well come to be seen as setting an important example to the rest of the industrial world.

Most of the present debate about public sector deficits is over their impact on economic demand in the short and medium term: do large fiscal deficits increase or decrease demand? More of that in a moment. First, consider their impact on intergenerational equity.

Excessive government deficits are a global problem. Among the Group of Seven countries, only Japan is running a fiscal surplus. The rest range from France's acceptable deficit of a little over 2 per cent of gross domestic product to Italy's unacceptable 11 per cent. The result has been the sharpest build-up of public debt globally that has ever taken place in peace time: in all the G7 countries, public debt has only soared in this way in times of war. The debt/GDP ratio in the US is now 54 per cent, up from 44 per cent as recently as 1989; in the UK, France and Germany it is between 40 and 50 per cent; it is more than 100 per cent in Italy (and, among the smaller countries, Ireland and Belgium).

These levels are still relatively low compared with that which Britain had at the end of both the first and the second world wars. In 1918 debt was equivalent to 110 per cent of national income; in 1945 it was 230 per cent. But it was possible after the Second World War both to whittle away the debt burden by reducing its real value through inflation, and to contain its cost by holding long-term interest rates down. Now long-term interest rates are set by global financial markets: any attempt to inflate would be met by a rise in such rates.


So the debt burden of the G7 countries will be much more akin to the impact of government debt in much of Europe in the 1920s after the First World War (or, for students of economic history, in Britain from 1815 after the Napoleonic wars, to about 1845). It will be a serious constraint on economic policy.

The parallel with the 1920s is reinforced by the fact that both then and now the debt burden bears on an ageing population. In the 1920s the working population had been depleted by the slaughter of the first world war; from now onwards it will decline relative to the number of dependents as a result of more general demographic changes. (In the 1950s and 1960s, by contrast, the working population was rising.)

The result will be that a smaller number of working people will have to pay back the debt currently being incurred to boost the living standards of the present generation. Governments throughout the industrial world are thus caught in a double bind: not only are they are piling up debt at a time of high real interest rates, but they are doing so at precisely the wrong point in the demographic cycle. They ought in fact to be running surpluses now to help finance the pensions of the present generation of workers.

The reform of the public finances, then, is a global problem. The political pressures on all democratic governments are such that it is very difficult for them to run the appropriate fiscal policy. Only Japan's government seems able to do so, and it has the advantage of operating without the constraint of an effective opposition. Does this new British initiative provide a solution to the global problem? Might the Government even find it imitated elsewhere in rather the same way that the policy of privatisation has swept the world?

This really depends on whether it works. There is nothing new in governments setting cash limits for themselves; the problem is keeping to them. The device of setting these cash limits on all discretionary spending three years in advance is nothing more than that: a device. All it is doing is applying a framework for self-discipline, in much the same way as a balanced budget constitutional amendment would do in the United States, or indeed the Gramm-Rudman legislation was supposed to do.

If, in two or three years' time, it proves to be a useful way of controlling public spending, it may well find imitators in other EC countries. That would be one measure of its success. If, on the other hand, the system of cash limits becomes like the medium-term financial strategy of the middle 1980s - an intellectual framework designed to make public policy look more rational that it really is - then it will be quickly forgotten.


Meanwhile the markets have a more immediate problem to consider: what will the public spending profile do to demand in the economy?

It would be comforting to be able to compare this round of public spending cuts with those of 1981 and argue that they will set the framework for a sustained recovery. Alas, there is no close parallel. The main forces pulling Britain out of the 1981 recession were low real interest rates and a fall in sterling (admittedly from a very overvalued level). Neither of these conditions is in immediate prospect. It is reasonable to expect some fall in interest rates next year, and when the dollar turns the trade-weighted value of the pound will come down without there being any exchange rate mechanism realignment.

But the first of these conditions is unlikely to be in place until 1994. It is possible that cheaper money will coincide with the planned clamp on public spending in 1994/5, but if it does it will be more by luck than judgement.

Perhaps the most sensible way of looking at these new spending plans is to acknowledge that the previous plans had no credibility, and that something had to be done if the Government's deficit was to be financed at a reasonable cost. Since there were going to be cuts in spending anyway, it may well be that the best way to use these to rebuild credibility was to create some kind of fiscal straitjacket. If the existence of the straitjacket helps rebuild confidence, and so lead to lower long-term interest rates, then it may turn out to increase demand in the economy. But the answer to that lies in the gilt market in the months ahead.