[Viewpoint] Britain’s path of denial

Visit London nowadays and you will notice something strange: The worse the British economy tanks, the more fervently Prime Minister David Cameron’s ministers and Tory economists insist that draconian spending cuts are good for economic growth.

Some observers see this as an act of faith (presumably in the virtues of the unfettered market). Others, such as the economist Paul Krugman, see it as an act of bad faith: The Tories just want smaller government, regardless of the consequences for growth.

The question remains whether there is a non-faith-based argument for cutting back spending to stimulate an economy. The answer is yes. In fact, there are two. Academic research has shown them at work in the past - for example, in Ireland and Denmark during the 1980s. Unfortunately for the Tories, neither case for stimulative spending cuts fits Britain’s predicament today.

One argument emphasizes the links between fiscal and monetary policy. In a country with large fiscal deficits, the central bank may have to keep interest rates high to control inflation. In this scenario, budget cuts create room for interest rates to fall. But little effort is needed to see that this is not the British story today. The Bank of England’s policy interest rate has remained just above zero for more than two and a half years.

The second case for expansionary fiscal contraction is subtler. In an economy in which public debt is growing quickly, the longer fiscal adjustment is put off, the larger and costlier it will have to be.

So, the argument goes, a courageous Tory government that cuts spending today spares citizens that future pain. Then, feeling richer and brimming with optimism, the private sector goes on a spending spree and the economy booms.

So far, so good - except that this story, too, does not apply to Britain.

In short, private demand in Britain is flatlining rather than surging. Add to the mix the collapse in public-sector demand that comes from deep budget cuts and you have all the ingredients necessary for prolonged stagnation. And stagnation, if not worse, is precisely what recent British economic reports are showing.

The longer this goes on, the more serious the problem will become. What is to be done in Britain? With the euro zone tumbling from crisis to crisis, salvation will not come from abroad. At home, all that is left is unconventional monetary policy. The Bank of England recently injected an additional 75 billion British pounds into the economy via so-called quantitative easing. Now, that is real cash, not just an act of faith.

*Copyright: Project Syndicate, 2011.
The writer, a former finance minister of Chile, is a visiting professor at Columbia University.

By Andres Velasco