Forget the dull, repetitive bleatings of the Left. The essential elements of George Osborne's economic strategy are just about right. As time goes on, economic events are strengthening the argument for what the Coalition is doing – not, as Ed Balls and others desperately (and somewhat comically) urge, demonstrating its "errors". The key critique of his strategy is that he should be doing more of it, quicker – and there is every chance that in due course he will. If the Coalition keeps this up, this government will have achieved much that we, its supporters, can be proud of. And the more so, because doing the Right Thing has every chance of losing us the next General Election.
The key problem that the Coalition faced, when it entered office, was one that it never openly stated and that I don't believe it ever truly comprehended. The key problem for the UK economy was that households had taken on huge debts (especially on their mortgages), gambling on their salaries rising faster than in the past, but Gordon Brown's economic policies had significantly damaged the sustainable growth rate of the economy, so in fact salaries were likely to rise slower. If salaries did/do, in fact, rise more slowly than in the past, then households would/will be unable to service their debts, and will default. If UK households default on their debts, then the banks that lent them the money will, in turn, go bust. Because the British government stupidly backed the British banks in 2008, indeed nationalising around half of them, the banks going bust would mean the British government going bust.
In 2008, Britain, Ireland, and Spain were in very similar positions. In each case the government's own debts were relatively modest, deficits were large (all headed for around 10% of GDP), whilst their banking sectors were 400%+ of GDP. The Irish government was bankrupted by the backing it provided for its banking sector. That Britain has not – so far – gone the same way as Ireland comes down, really to two things. First, having our own currency and hence the ability to print money. So whilst in Ireland in mid-2009, deflation reached six and a half percent, in Britain deflation reached only around two percent. That relatively small difference in deflation was the difference between total ruin and scraping through, for now. And the other difference was sheer luck. In truth, there was no way of our knowing, in 2008, that the stupid, ridiculous, unnecessary, suicidal, misconceived, immoral decisions taken in both Britain and Ireland to bail out the banks would, in the one case, lead to rapid total collapse, and in the other to drawn-out pain. It just turned out that it was them that were quickly ruined and not us.
Spain lasted a little longer – and indeed is still, just about, muddling through. The key to the survival of Spain's sovereign without bankruptcy seems likely to come down to its willingness, in the end, to do what it should have done in 2008 – namely to impose losses on lenders. Those that made bad loans should be the ones to lose out when those loans go bad. (Doesn't seem like rocket science, does it? And yet this principle is one that has been entirely beyond the comprehension of policymakers in Europe and the US since early 2008.)
There is every chance, yet, that George Osborne will eventually be forced into the same decision. Indeed, that could come as soon as the next few weeks if matters in financial markets continue to deteriorate. The cost of insuring debts to nationalised bank RBS have recently exceeded those at the height of the crisis in 2008. In other words, despite notional government backing, lenders believe that RBS is more likely now to default than was the case in 2008. Share valuations in RBS and Lloyds have fallen to their pre-nationalisation lows. Across the Eurozone, we may be gearing up for the Great Reckoning, when the policy (and ethical) errors of 2008 finally come home to roost. Double dip in the US would leave underwater US mortgages at increased risk of default – and British banks continue to have large exposure to the US mortgage market. Even China may now be starting to slow.
Many people forget that although Osborne misguidedly supported the bailouts of late 2008, he opposed those of early 2009 (which were actually larger than the 2008 bailouts, on some measures). He also opposed the bailouts of Greece and Portugal and the second Greek bailouts. Even in the case of Ireland, Osborne argued (in combination with the IMF technical staff) that the Irish banks should default. Osborne has further shown willingness to see even depositors make losses, asserting the principle that deposit insurance only applies up to statutory limits and there is no "implicit" insurance of deposits beyond that – in the case of the Southsea Mortgage and Investment bank, which went bust in June this year, around five percent of the depositors were above the statutory limit and had to take their chances along with other creditors.
If it comes to it – as it might – there seems every chance that Osborne will, this time, do the Right Thing. He will not take the lazy, immoral option of taxing poor people to spare rich people the consequences of their mistakes. Apart from anything else, can you imagine Osborne going on television and saying to the British public "Well, what with all the benefits and services we've been cutting, and the taxes we've been raising, we had a bit of money put by, so we've found a good use for it – we're going to give it to the banks!!"?
No. Osborne's stated policy positions, the signals he has given, the brute political realities of the British political scene, and the financial strictures faced by the British public sector all militate against there being any bailouts this time, if it comes to it. That is one reason RBS debt default insurance is high – the safety blanket is gone.
In the meantime, Britain's best chance through is twofold. First, we must give our own economy every chance we can to grow fast enough for our households to service their debts. There are three parts to this. First, the Bank of England must keep monetary policy loose enough for nominal wages to keep growing. If we can get real growth (of which more in a second), all the better. If we can't get real growth, then inflation will have to do the work.
There have been two key weaknesses to government policy in this area. First, the government has not changed the inflation target. Setting a 2% target when everyone knows that the government doesn't want inflation to be 2% is simply ridiculous. Literally – the UK's inflation target is now an object of ridicule. Letting inflation be higher, if necessary, is the right strategy. But it should be an explicit strategy. The inflation target should be set at a level (or have a zone of tolerance around the target) that the government actually desires.
Second, for reasons that I have no sympathy with (specifically, being put off by one good number for the 2010 Q3 GDP growth figures), the MPC decided not to proceed with QE2 in late 2010. It should have enacted QE2 in June 2010. That it did not do so looks more extraordinary all the time.
The second part of the government's growth strategy has been to reduce public spending. Ignore the nonsense spouted by those on the Left. There is a mountain of evidence that economies that spend less grow faster. (It does not follow that spending should only be 25% or whatever the growth "bliss point" is – after all, we get something good out of the spending; the only policy objective isn't growth.) Osborne plans to get spending down from the nigh-on 50% of GDP of 2009/10 to below 40% by the end of the Parliament. That could raise the medium-term growth rate of the economy by anything up to 1% – a huge difference, that if actually delivered could well be the difference between scraping through and catastophe.
The second element to our scraping through is winning the international "ugly contest" – being less broke than everyone else, and hence achieving a sort of relative "safe haven" status, allowing us in fact to borrow at much lower rates than our fundamentals warrant. Many commentators write as if the ugly contest were one we should not want to win! Of course we want to win it! Of course, if everyone else goes bust, we want to be the least bust! Remember the following parable? Two men were walking in the woods when they heard the distant roarings of a hungry bear they had been trying to avoid for days. One man started to flee, whilst the other stopped to change his walking boots for a pair of soft trainers. The fleeing man yelled back: "Why are you doing that? Even with those on, you won't be able to outrun the bear!" His associated replied "I don't need to outrun the bear – I only need to outrun you." If the US and France and perhaps even Germany and China are damaged by forthcoming events, but we are damaged less, then we will rise relative to them. Geopolitically, that could be huge beyond anything anyone currently says out loud.
Osborne's strategy on spending reduction is just about right for now. The correct criticisms are twofold. First, he is unlikely to achieve his GDP growth forecasts, so spending will not decline, relative to GDP, by as much as he projects. Growth is already tepid. There could well be further outright recession. If that happens, spending will need to be cut more. The media needs to catch up with this point – it is still trapped in a 2008-9 wonderland in which the government increasing spending by 10% of GDP over a three-year timescale increases the growth rate of the economy, and running a 10% of GDP deficit – contrary to all academic theory or evidence – makes economies grow faster, not slower! I'll say it one more time: if the economy turns down, there will need to be more and faster spending cuts, not less and slower. This is obvious, obvious, obvious.
The third part of the growth strategy should be reform of the growth-generation of public spending itself – i.e. public service reform. If the productivity of the public sector grew only at the same rate as that of the private sector over the next decade (a modest goal, given that it fell about one third behind during the decade 1997-2007), the economy would grow about 0.5% per year faster.
For now, Osborne is getting most things right. He has placed himself in a position in which, if it comes to it, he should be able to avoid bailing out the banks further. He is cutting spending a little slower than will ultimately be necessary, but having set out the plans and won the initial debate is enough for now. Monetary policy has some weaknesses – which Osborne may live to regret – but there is so little widespread comprehension of what those weaknesses really are that I shall forgive him that for now (many people think the real problem is that inflation should have been kept to 2%! As if!). The public services output reform agenda is crippled by political unwillingness to take on producer lobbies in the health sector, and a quasi-religious attachment to mantras of the 1940s, but Osborne is hardly the first chancellor to face that issue.
Overall, I think he's doing a great job. His problem, however, is likely to be that during this Parliament I believe we will face at least one major recession – if not over the next six months (e.g. if the euro falls apart) then in 2013 (when the inflation starts being squeezed out). I fear that the British public will not be forgiving. If the Conservatives were to win the next General Election despite having whacked up taxes, cut benefits, and presided over rising inflation, falling house prices, rising unemployment, and a nasty recession (not to mention riots etc. – of which, I suspect, more anon) that would be a real slap in the face for the opposition.
The problem here is going to be being hated for doing the Right Thing. Just like Thatcher… or indeed Blair.