New take on reducing the deficit
It's not what you do, it's the way that you do it. That is the message of a recent contribution to the debate on how and when to cut UK borrowing - from two city economists.
In essence, they say if you're worried about the economic impact of bringing down the deficit, you need to think hard about the balance between spending cuts and higher taxes.
"Not more guff from competing economists", I hear you cry. You have a point. The recent "war of letters" over the deficit - played out in the pages of the Sunday Times and the FT - didn't exactly enhance the profession's reputation for giving advice.
But there is grandstanding, and there is reasoned argument. This new paper from Ben Broadbent and Kevin Daly, from Goldman Sachs, falls into the second category, even though the Conservatives have inevitably claimed it for their camp.
The two economists have some good news for the government: they don't think the UK public finances are "as cataclysmic as some commentators suggest", they're fairly optimistic about the recovery - and they think growth will go some way to bring down borrowing.
Like me, they think the Treasury may well be overestimating the size of the structural deficit (though, with borrowing this high, nothing can be taken for granted).
Broadbent and Daly are also of the school that thinks a falling exchange rate will help support growth even in the face of tough budget cuts (see Monday's blog post). Even though most in the city seem to think the pound would be stronger, on balance, under the hawkish Conservatives than under Labour.
However, they do think Britain needs to get serious about the deficit - surprise surprise. And, "if past experience is anything to go by the manner in which this is done will have implications for the economy."
Specifically, "There is a significant body of cross-country evidence suggesting that during the transition, the economy fares better in corrections driven by reductions in current spending - better, even, than when no correction is made - than in those driven by cuts in investment or higher taxes."
This is not a new argument. Research by Alberto Alesina, Roberto Perotti and others has tended to show that efforts to cut borrowing which emphasise spending cuts tend to do better than ones centred on tax rises.
But in this paper the Goldman Sachs duo have updated and extended this analysis - using data for 24 OECD economies from 1975 onwards. They draw some striking conclusions.
One is that with large fiscal tightenings, centred around spending cuts, the government debt ratio starts at a higher level but then falls sharply. Whereas large, tax-centred deficit reduction programmes don't seem to cut the debt ratio at all, as their graph below shows.
Another is that tax-driven adjustments "have proved very damaging for growth" (see the graph below) - or at least, growth relative to other OECD countries. Whereas expenditure-driven budget cuts seem to actually boost relative performance, at least after the first year.
Interestingly, they don't find much difference in the behaviour of the exchange rate, raising a question about as to where the growth actually comes from.
At first glance, these results look like the "proof" that the Conservatives have been looking for. No wonder they've been firing off copies of the research to everyone they know.
The results do, at some level, make sense. Remember the sample relates to "large" fiscal adjustments, which only tend to occur when governments have got themselves into trouble. And when governments have got in a mess, the public may be more likely to worry about future fiscal pain, even when the pain has yet to start.
That is why some have said that when borrowing and debt are high, governments need to get tough adjustments over with quickly, so the private sector can stop worrying and start growing again.
Equally, we know - and if we didn't, the Conservatives are happy to remind us - that the financial markets can push up long-term interest rates (bond rates) if they're worried about the level of borrowing, meaning that governments can find they have no alternative but to cut borrowing, because the risk premium on borrowing would otherwise make it impossible to grow.
Arguably, that was Ireland's position last year. It is clearly Greece's situation now.
There are also possible explanations why it might be less costly for growth cut spending rather than raise taxes. For example, consumers might find it easier to "fill the gap" left by lower government borrowing, if they're not having to pay higher taxes at the same time.
In normal times, this would not be considered especially controversial among economists. Whether anyone else would sign up to them is another matter. Preferring spending cuts to tax rises is practically a mandatory condition for joining the economist club.
The key question is: what bearing does this have on the current debate in the UK? There, I'm afraid, there's still room for plenty of debate.
First, the government's own fiscal plans, over time, rely more on spending cuts than on tax rises to bring down borrowing. Though, perhaps worryingly, there seems to be more emphasis on tax rises in the first few years, and cuts in investment do play a significant role.
Second, looking at the experience of other countries, it's actually hard to distinguish discretionary spending cuts (ie "tough government action") from declines in spending that occurred due to economic growth ("safeguarding the recovery".). Some of the supposedly 'expenditure-driven' adjustments in this research may have simply been due to the fact that the economy grew faster than spending, not any great spending control.
This, of course, is at the crux of the Labour argument about the next year or two - and it is why they keep banging on about the billions in savings they have reaped from unemployment being lower than predicted.
Finally, and most importantly, we have not been here before. Since 1975 the advanced economies have not been in a situation remotely like this.
In the wake of a global financial crisis, the usual economic relationships may not apply. Monetary policy is less powerful than it was. Deficits are high nearly everywhere. And growth is expected to be sub-par across North America and Europe.
That makes the usual exit strategies seem more questionable. We can't all export our way out of growth. And we can't be sure that private sector demand will recover when consumers and the financial sector are each facing years of reducing their overhang of debt.
In other words, what happened when governments cut deficits before may not be an accurate guide to what will happen now.
So yes, this research has some very interesting lessons for the fiscal debates to come. But it won't resolve them.