Political game of blind man’s buff

Political game of blind man’s buff

By Martin Wolf

In tough times, politicians squabble. Out of this heat, light should emerge. Alas, it is not doing so, at least in the UK. The utterances of leading Labour and Conservative politicians do not explain how the UK economy is to emerge from its current quagmire.

The UK has proved horrifyingly vulnerable to a financial crisis that has cut off funding from abroad. But why is it so vulnerable? The answer from David Cameron, the leader of the opposition, is simple: “We’re in this mess because of too much debt – too much government debt; too much corporate debt; too much personal debt; and it becomes clearer all the time that the scale of Britain’s debts puts us in a much weaker position than other countries.”

The right answer, Mr Cameron suggests, is “an economy where government and its citizens live within their means, save for a rainy day, waste not and want not. It’s an economy where everyone has the chance to own their own home with space to live and breathe – and where we work to live, not live to work.”* So, in response to the biggest economic crisis since the 1930s, he has decided to take a pre-Keynesian view of the management of public finances.

Mr Cameron argues that the government should save for a rainy day. But he fails to note both that it did – public sector net debt was 36 per cent of gross domestic product at the end of 2007-08, down from 43 per cent in 1996-97 – and that no day could be much rainier than today.

Mr Cameron argues, again, that everyone should own their own home. Yet it was this silly idea – coupled with controls on house building supported by his party and the liberalisation of finance it promoted – that formed the housing bubble and explosion of household debt.

Mr Cameron argues for improving the tax treatment of savings. But an excessive private desire to save is now a huge danger. He also fails to note the already favourable treatment of home owners, savers for pensions and investors in “individual savings accounts”. He is pandering to current complaints about low returns. But low returns are an alternative to debt deflation and mass bankruptcy, which would wipe out many financial assets.

Mr Cameron continues to argue against the government’s decision to cut value-added-tax. But discretionary measures are forecast to cost only 1.1 per cent of GDP this financial year against the forecast of overall public sector net borrowing at 8 per cent of GDP. The question he ducks is whether the government should have tried to cut the fiscal deficit in the midst of a deep recession and, if so, by how much. Compared with this, the VAT cut was a mere bagatelle.

Yet Mr Cameron is also right to argue that “any action that must be taken in the short term must be consistent with the long-term economic change that Britain needs”.

This does not mean the government is wrong to act as borrower of last resort. But the weakness in the government’s position is indeed strategic. From what Alistair Darling, chancellor of the exchequer, said in his interview with the Financial Times this week, it is not clear that its strategy consists of more than trying to get back to normal as soon as possible. If by “normal” one means the pre-2007 economy, that goal is both unobtainable and undesirable. The post-crisis economy must be utterly different from before. Mr Cameron at least understands this.

What does this mean? It means a return to growth, despite lower levels of private borrowing, higher savings rates and a move to fiscal balance. If the government knows how to achieve this combination, it has not said so.

So what are the required elements?

First, the economy will have to grow out of its over-indebtedness during many years. It is important to sustain the financial system, but crazy to expect a return to buoyant lending.

Second, the current account will have to go into surplus, to generate activity without extra borrowing.

Third, higher savings will also be needed. That is partly because output of tradeable goods is more capital intensive than that of services.

Fourth, it makes sense to use a substantial portion of today’s massive government borrowing for investment, particularly in infrastructure. Such investment must make sense when the government can borrow cheaply.

Fifth, the transition to an economy with higher exports is going to take years. The fall of sterling should help. But the economy will depend on large net inflows of capital for some years.

Finally, the government must indeed maintain fiscal and monetary credibility. If a return to inflation is widely feared, the game will be up for the UK. The danger is not only deflation, but also a sterling collapse, a jump in inflation expectations and a spike in long-term government bond rates. The Bank of England was right to cut interest rates modestly this time.

What is needed now is a plan of escape into what should be a different economy. The opposition does have some notion of the need for such a strategic shift, but has a foolish response to the immediate crisis. The government now has a broadly sensible response to the crisis, but no strategic view. Each condemns the other for its failings. Meanwhile, the hapless UK economy flounders.