Gavin McCrone: Have cuts gone too deep?

AN independent Scotland might adopt a different approach to the UK on keeping the economy flowing, but it would still have to balance the books, writes Gavin McCrone

Ever-increasing austerity seems to be having an ever-more damaging effect, not only in the European Union as a whole, but also in individual member states. The UK government is bearing down heavily on policies that are highly valued and, therefore, it is only right, as Joyce McMillan argued in this paper recently, that one should question whether it is really necessary and whether in the end it will prove to be a mistaken policy. Surely there must be a better way?

There can be no dispute about the need for countries to be able to raise enough revenue to cover what they decide to spend on public services. Failure to do so may be covered for a time with increased borrowing, so long as markets are prepared to provide the necessary funds at reasonable cost. But the cost of this is then carried forward to future generations.

With the exception of Greece, which was the extreme case, government borrowing did not cause the crisis. Spain and Ireland were both actually in surplus and, while in Britain there was more government borrowing than was sensible when the economy was in boom, the problem here, as in the other two countries arose from weak financial regulation enabling the accumulation of excessive private and corporate debt.

Sooner or later, this had to stop and when it did so, spending dropped, the economy went into recession and unemployment rose; inevitably spending on welfare then increased and tax revenue fell. In Britain, the financial sector had provided very substantial tax revenue during the boom and this was one of the main casualties of the recession. This was the process that resulted in the government’s budget deficit rising to nearly 11 per cent in 2009-10.

Obviously, this cannot go on. Thankfully, the British net national debt before the crisis – at less that 40 per cent of GDP – was low both by historical standards and in comparison with other countries, but budget deficits of this order are causing it to rise quickly. In 2010-11 net debt was 60.1 per cent of GDP and is forecast to reach 85 per cent by 2015-16. This is still comparable to the level in many other countries, but it would be irresponsible in the extreme not to take action to stop its rise, even if the markets are still willing to provide the funds at low cost.

So, it has to be dealt with, but how best to do this is far from a simple matter. For an economy, there is a circularity between expenditure and revenue that does not apply to an individual. A person spending more than income has to cut it back to what he or she can afford. But in an economy, the process of cutting expenditure or raising taxes depresses the economy’s growth, thereby causing an increase in welfare expenditure and a fall in tax revenue. It is, therefore, necessary to estimate how far any benefit from the initial cut in public expenditure or increased tax rates is offset by the negative effects on the economy’s growth.

The relationship between the initial budgetary action and economic growth is what economists call the fiscal multiplier and recent work from the International Monetary Fund (IMF) suggests that it is much higher and, therefore, its adverse effect on growth much greater than governments, including the UK government, have been assuming. This may well explain why Chancellor George Osborne has been missing his deficit and debt reduction targets, why he cannot eliminate the deficit in this parliament as he said he would and why the national debt continues to rise. The assumption has been that the multiplier had a value of about 0.5, which would mean that a 1 per cent cut in public expenditure would result in a 0.5 per cent reduction in the economy’s growth.

As Gavyn Davies has recently pointed out in the Financial Times, this would in turn reduce tax revenue or increase public expenditure by about 0.2 per cent of GDP, and enable the budget deficit to improve by 0.8 per cent.

But the IMF is now arguing that the multiplier is in the range of 0.9 to 1.7. If that is so, the second round adverse effects of a 1 per cent cut in public expenditure on growth will be much larger, putting the economy more deeply into recession and thereby raising public expenditure and reducing tax revenue to such an extent that the gain to the budget of the initial public expenditure cut is quite modest. In the extreme case, if the multiplier was even higher – and in the 1960s it used to be estimated at 2 – the initial action to improve the budget could even end up making the deficit worse. It could be that this is what is happening in Greece.

So what is to be done? It is argued that the fiscal multiplier is higher at present than it would be in more normal times because of the paralysis in bank lending caused by the crisis and the inability of monetary policy, with interest rates already at their lowest level ever, to do anything to counteract the tightening of fiscal policy. It would appear that this has not been adequately allowed for by the Chancellor in framing his budget.

It is also important to recognise that the multiplier will vary depending on how public expenditure is cut or which taxes are raised. Cutting public investment on infrastructure, for example, is likely to be particularly damaging to economic growth and taxing the better off, who spend a lower proportion of their income, will be less damaging than cutting benefits for the poor, who will spend virtually all of it.

There will be many who will say, as some government ministers have done, that more borrowing is not the solution when borrowing is already too high. But it will be much easier to bring the deficit down when economic growth is buoyant and, therefore, the priority should have been to try to build on the growth that started modestly in 2010, after a sharp fall in the two previous years, rather than strangle it by trying to move too quickly to cut expenditure. It is not even clear that borrowing would have been higher and, even if it was, sustaining growth would have made it much easier to reduce it in the end.

So, government policy has tried to do too much too fast and that has been counterproductive; it should have been more selective, avoiding cuts to those parts of public expenditure where the multiplier is likely to be high and trying to use taxation to raise money from sources where the multiplier would be low.

Some Scottish politicians have argued that an independent Scotland could free itself from this austerity and from unpopular measures imposed by the government in London. It is true that the government of an independent Scotland could have different priorities and, therefore, might tackle the problem differently. But the problem would still be there. An independent Scotland would face the same need to balance its budget and would have to take measures that would be unpopular with many in the electorate.

First Minister Alex Salmond has argued that an independent Scotland would have a proportionately smaller deficit than the UK has at present, based on the most recent figures in Government Expenditure and Revenue Scotland (GERS). But it is still an unsustainable deficit at 7.4 per cent of GDP, compared with the UK’s 9.2, and that depends on Scotland receiving 90 per cent of the revenue from North Sea oil (its assumed geographical share), on what Scotland’s share of the national debt would be and on what interest might have to be paid in the markets on Scottish bonds.

All of those matters would have to be negotiated and decided. At this stage, no-one can predict how this would turn out, but an independent Scotland, like other countries, would have to get its accounts into balance and that could be a bumpy ride.

l Professor Gavin McCrone is a former chief economic adviser to the Scottish Office