Matthew Hancock is MP for West Suffolk and has contributed to the Social Market Foundation's new book, The Class of 2010, which is published today and includes contributions from a variety of new MPs.
The pundits and political soothsayers got it wrong. As the coalition was formed, almost all predicted the Coalition Government would be short and weak. Even now, most people think its strength is a surprise given the difficult times. Yet from my new seat in the Commons, I find that these difficult times do not weaken the coalition, but strengthen it.
These political dynamics are underpinned by a clear economic analysis: that it is only by following a credible plan to restore the nation’s finances to health that growth can sustainably be restored. Political opponents of the UK’s plan to deal with the deficit do not themselves have a plan to put in its place. Instead they raise questions about the cause of the fiscal hole we find ourselves in, the timing of action to deal with it, and where the growth will come from. These questions must be answered head-on.
Firstly, some deny the scale and cause of the problem. Too often, this includes a wilful attempt to confuse the deficit with the debt. The annual deficit, by which the debt rises each year, is the gap between what the nation spends and what it takes in taxes. At 11% of national income, the UK’s deficit was the highest in the G20 going into the crisis, rose fastest, and became the highest in our peacetime history.
Clearly before we can even touch the debt, the first act must be to tackle its growth: the deficit. After all, even while dealing with the deficit, the Government’s current plan will leave the debt rising every year of the current Parliament. Acting more slowly would leave the debt rising in the next Parliament too.
For those who accept the need to act, some then argue for delay. Taking longer to deal with the deficit would leave us with higher debt, so permanently higher interest costs, and greater cuts in other government spending. The indirect costs of delay are higher still, in terms of the loss of confidence and private sector growth.
Evidence is put forward about the likely number of job losses from dealing with the deficit. Yet even those who have estimated the likely cost in terms of jobs argue that inaction would be worse. A further argument is sometimes made that by reducing public sector employment, costs actually rise due to unemployment benefits and lost tax revenues. For anyone losing their job it is very difficult. But for this argument to be valid, the cost to the state of not employing someone must be higher than the cost of employing someone. Were this “redundancy fallacy” true, it would be a terrible indictment of the system. Thankfully it is not.
Sometimes they say that only deficit-funded growth will get the deficit down. So let’s go through the logical steps. They say increase the deficit to help growth, then the growth will help deal with the deficit. That collapses to saying we should increase the deficit to deal with the deficit. The argument so obviously defies logic it’s a surprise anyone serious uses it.
There is now extensive empirical evidence that as well as providing the basis for sustainable growth in the long term, fiscal consolidations can support growth in the short term. In the mid-1980s, Spain, Portugal, Denmark and Ireland all had to rein in large deficits and their economies grew as a result. Finland, Sweden and Italy had similar experiences in the 1990s.
When public finances are being brought under control, the extra jobs must be created by the private sector. This private sector growth requires the confidence that government's own finances are sustainable. This argument has support from an unexpected quarter. John Maynard Keynes said:
“The problem of recovery is, therefore, a problem of re-establishing the volume of investment. The solution to this problem has two sides to it: on the one hand, a fall in the long-term rate of interest so as to bring a new range of propositions (business investments) within the practical sphere; and, on the other hand, a return of confidence to the business world so as to incline them to borrow on the basis of normal expectations of the future”.
Quite so. Keynes believed in stimulating a weak economy. So does the Government: through low interest rates.
By giving confidence to investors that the Government will honour its debts, the interest premium on those debts will fall. All other interest rates in the economy are based off government interest rates. So the interest rates charged to businesses, on mortgages, and to households are all lower than they would be.
Since May, market interest rates have fallen. This contrasts sharply with countries with high deficits, like Spain and Portugal, where interest rates have risen. Since household debts are the highest in our history, low interest rates are welcome for families struggling under the burden of debt. In the UK a rise of 1%-2% in mortgage rates would add some £700-£1400 to the average annual mortgage bill.
Britain is less at risk of a catastrophic and disjointed loss of confidence that has befallen other European economies. Rating agencies Moodys and Standard and Poor’s have confirmed that our valued AAA rating is now stable once again. They cited Government action as a cause of the stability.
Getting to grips with the nation’s finances has a direct impact on business confidence. With a credible plan to live within our means in place, businesses can have more confidence to make long term investments, and international businesses can have more confidence in the UK as a destination for investment.
This confidence can come through a more stable macro-economy. But it also comes through the knowledge that emergency tax rises are less likely. For households and businesses, the fear that the hole in the nation’s finances will be transferred to them through higher taxes can lead to lower demand.
A credible fiscal consolidation which implies a permanent reduction in levels of government spending may lead households to expect lower levels of taxes in the future. This reasonable expectation can raise consumption, and boost output and demand even in the short term.
How to cut
The first lesson from the evidence is that cuts are most effective when a credible plan is clearly set out and adhered to. A study by the European Commission found that consolidations that were followed through to conclusion were most likely to lead to stronger growth.
It is easy to see why. Setting out a clear plan helps businesses to plan themselves, and helps signal to markets the period for which fiscal policy will be tight. Sticking to that plan helps bolster confidence that stability will be maintained, and future costs through higher taxes will be avoided.
The second factor that increases the likelihood of higher growth is the consolidation’s composition. Growth is most likely to be supported by more cuts rather than tax rises. Analysis by the OECD suggests the best balance for growth is 80% cuts and 20% tax rises. There are more risks associated with consolidations based on tax rises. If a government is living beyond its means, growth can only come from private businesses; tax rises that discourage enterprise would harm any prospect of boosting that private sector growth that we so badly need.
Finally, the evidence suggests that the bigger the deficit, the more likely the cuts will help growth. This finding from the evidence might seem counter-intuitive. But of course the bigger the deficit, the bigger the problems it causes in terms of confidence, crowding out, and high interest rates. This finding is fortunate for the UK, as the current deficit is of record proportions, historically, and internationally.
Confidence, consistency and credibility will be the lynchpins supporting an agenda focused on growth and underlined by fairness. It is this project, to deal with our debts, and to restore sustainable economic growth, that ties together the parties of government.