BERKELEY – At the end of 2008, as the financial crisis hit with full force, the countries of the world divided into two groups: those whose leaders decided to muddle through, and China. Only the Chinese took seriously Milton Friedman’s and John Maynard Keynes’s argument that, when faced with the possibility of a depression, the first thing to do is use the government to intervene strategically in product and financial markets to maintain the flow of aggregate demand.
Then, at the start of 2010, the countries that had been muddling through divided into two groups: those where government credit was unimpaired continued to muddle through, while countries like Greece and Ireland, where government credit was impaired, had no choice but to pursue austerity and try to restore fiscal confidence.
Today, another split is occurring, this time between those countries that are continuing to muddle through and Great Britain. Even though the British government’s credit is still solid gold, Prime Minister David Cameron’s administration is about to embark on what may be the largest sustained fiscal contraction ever: a plan to shrink the government budget deficit by 9% of GDP over the next four years.
So far, China is doing the best in dealing with the financial crisis. The mudding-through countries lag behind. And those where confidence in the government’s liabilities has cracked, forcing the government into austerity, are doing worst.
Now the question is: will Britain – where confidence in the government has not cracked and where austerity is not forced but chosen – join the others at the bottom and serve as a horrible warning?
Cameron’s government used to claim that its policies would produce a boom by bringing a visit from the Confidence Fairy that would greatly reduce long-term interest rates and cause a huge surge of private investment spending. Now it appears to have abandoned that claim in favor of the message that failure to cut will produce disaster. As Chancellor of the Exchequer George Osborne put it:
“The emergency Budget in June was the moment when fiscal credibility was restored. Our market interest rates fell to near-record lows. Our country’s credit rating was affirmed. And the IMF went from issuing warnings to calling our Budget ‘essential’ Now we must implement some of the key decisions required by that Budget. To back down now and abandon our plans would be the road to economic ruin.”
But if you ask the government’s supporters why there is no alternative to mammoth cuts in government spending and increases in taxes, they sound confused and incoherent. Or perhaps they are merely parroting talking points backed by little thought.
What is so bad about continuing to run large budget deficits until the economic recovery is well established? Yes, the debt will be higher and interest on that debt will have to be paid, but the British government can borrow now at extraordinarily favorable terms. When interest rates are low and you can borrow on favorable terms, the market is telling you to pull government spending forward into the present and push taxes back into the future.
Advocates of austerity counter that confidence in the government’s credit might collapse, and the government might have to roll over its debt on unfavorable terms. Worse, the government might be unable to refinance its debt at all, and then would have to cut spending and raise taxes sharply.
But that is what the British government is doing now. How is the possibility that a government might be forced into radical fiscal consolidation an argument for taking that step immediately, under no duress and before the recovery is well established?
To be sure, back in the 1970’s, confidence in the credit of the British government collapsed, forcing it to borrow from the IMF so that spending could be cut and taxes raised gradually rather than abruptly. But that is why Keynes and Harry Dexter White established the IMF in the first place. An IMF program restores confidence in the fiscal soundness of governments that markets distrust. The lending allows the necessary medium- and long-term spending cuts and tax increases to be undertaken at a more appropriate time.
Borrowing from the IMF may be humiliating for government officials. But businesses establish lines of credit for future contingencies all the time, and they don’t think there is anything humiliating about resorting to them when those contingencies come to pass. And what, really, is so humiliating about borrowing from your own citizens?
Britons, as Osborne knows, are willing to lend to their government on an enormous scale – and on terms that are more generous than those on offer from the IMF. And, if one is worried that the British people might change their minds, well, the princes of Wall Street or the barons of Canary Wharf or US Treasury Secretary Tim Geithner would certainly be willing to sell derivatives contracts to protect Britain against exchange-rate risk for the next several years.
To borrow from your own people is especially non-humiliating when your economy is in depression, when the interest rates at which you can borrow are at near-record lows, and when every economic argument cries out for spending now and taxing later.
What is humiliating is to have a government that cuts a half-million public-sector jobs and causes the loss of another half-million jobs in the private sector. In an economy of 30 million jobs, that translates into an increase in the unemployment rate of 3.5 percentage points – at a time when no sources of expanding private-sector demand exist to pick up the slack. Britain’s finest hour this is not.
J. Bradford DeLong, a former US Assistant Secretary of the Treasury, is Professor of Economics at the University of California at Berkeley and a Research Associate at the National Bureau for Economic Research.
Copyright: Project Syndicate, 2010.