Business

Austerity: a double-edged sword?

UK Chancellor of the Exchequer, George Osborne
Image caption There is little doubt which side of the debate George Osborne favours

Is the government right to cut back on deficits the way it does?

The austerity debate is about different timings and extents of budget cuts. Not only politicians but also economists are divided.

BBC News has asked two top economists to give their views about pros and cons of cut backs.

Broadly speaking, Jeffrey Sachs, director, Earth Institute, Columbia University, New York, is in favour, while Robert MacCulloch, professor of economics, Imperial College, London is opposed.

At the heart of the debate is a question of confidence: should the government worry more about markets gaining confidence in the public finances, or consumers losing confidence in their own finances?

Jeffrey Sachs, director, Earth Institute, Columbia University, New York

IN FAVOUR OF AUSTERITY:

I think bringing the deficit back under control is important, and it is equally important to start now.

Budget cuts and tax increases are politically painful, and it neither credible nor politically possible to promise to take such painful actions in the future without taking some of the first steps now.

This is especially true with a new government. It must use its five-year mandate to set out a five-year path of budget consolidation.

Cutting public deficits is indeed important for market confidence. Markets have already shown signs of lower confidence in the debt of some European countries and those warnings should be taken seriously. Fortunately, the UK recognizes this reality.

I have consistently supported the Cameron-Osborne budget approach, and I continue to think they are on the right track, even if one can debate some of the particulars.

Current mess

I also emphasise that both budget cuts and tax increases are needed because you can't tackle such a large deficit with only one of the two tools.

Nevertheless I can't stress enough the fact that there is a vast difference between simple "austerity" and an overall public-sector long-term strategy that includes forward-looking investments in education, science and technology, and 21st-century sustainable infrastructure.

We got ourselves into the current mess by emphasizing personal consumption over social investment.

Now that private consumption has finally declined in line with economic realities, we need to substitute that decline in private consumption with an offsetting increase in investment, often through public-private partnerships, or in some cases, through public investment alone.

Austerity without a boost to long-term investment is not what we want.

As needed budget cuts are made, we should take care to protect the incentives for long-term investments in key areas, such as a low-carbon economy, a high-quality national access to broadband, more university completion and excellence in science and technology around problems of critical need - such as energy, the environment, and public health.

Bold and brave

In the US, we are still operating on a populist philosophy. We've not yet recognized that more "stimulus" of private consumption is bound to fail.

We've not yet recognised that recovery will require a long-term public investment strategy. We've not yet recognised that we need to raise taxes and cut the spending on the useless war in Afghanistan.

Only recently, President Obama has acknowledged that "shovel-ready" public investments don't really exist, despite championing them last year.

We need now to turn our attention to budget stabilisation and public investment over a period of several years, starting with tax increases and cuts in military spending today, especially by ending the war in Afghanistan.

Image caption Professor Sachs says markets are already losing confidence in the debts of some European countries

In contrast, the UK spending review appears as a bold and brave step. I'm concerned however about cuts in fields related to human skills such as education, science and technology. Knowledge is the cornerstone of the 21st century economy.

University fees should remain within working-class means, and the government should support advances in science and technology, both for their direct contribution to wellbeing and as a bulwark to competitiveness.

Precise perspective

I do not see much evidence that the last year's fiscal stimulus has boosted employment, or that it had a positive effect on the economy, and I believe this is because the deficit has an offsetting effect.

Households know that any tax cuts today are going to be temporary, and should be saved rather than spent.

Moreover, consumers and companies are increasingly worried about a fiscal crisis in the future.

Of course I do think that a double-dip is a real risk for the US and European economies, but I don't think spending more on stimulus packages would be a reliable way to escape this scenario.

I would rather opt for sound, medium-term policies that give a clear and precise perspective, and for the promotion of long-term investment over consumption.

Robert MacCulloch, professor of economics, Imperial College, London

AGAINST AUSTERITY:

Governments aiming to reduce the budget deficit quickly are running a big risk, because severe cuts could throw the economy back into recession.

In the UK, the government is pushing the line that there is no other choice, but I think this is misleading and the public needs to know that there is evidence over the world of countries making different choices and not doing such severe cuts.

For instance, Germany and France have public debt of a similar size to the UK's, but are pursuing very different policies.

There is no consensus among economists on what should be done because the question has not been clearly answered by economic theory.

Long-term versus short-term

The argument is mostly about the pace of the needed deficit reduction.

The 'pro-immediate big cuts' side argues that without improvement in state finances, business will start to worry about higher taxes and higher interest rates in the future, invest less and the country may lose competitiveness.

This is more of a long-term view. In the shorter-run, there is a risk of the economy being thrown back into recession, and this is why I support the view that cuts should be more gradual than what is being proposed in the UK.

The government hopes that a reduction in its expenses will increase confidence in the economy, leading consumers and companies to spend more and fill in the gap left by budget cuts.

There are several possibly successful examples of this kind of policy: Ireland in 1983 and Denmark in 1986.

Those countries were heavily taxed and regulated, and spending cuts were clearly perceived by the public as a signal that the role of the state was going to diminish and a more business-friendly environment would follow.

Consumers and investors increased their spending and the policy appeared to work.

Worries and uncertainty

Image caption Professor MacCulloch worries about the short-term impact of austerity on the recovery

However in the current UK context, I think that this policy is a big gamble.

The economy is still weak and consumer confidence is very fragile. Some measures presently under discussion may hurt, not boost, consumer confidence.

For instance, worries about the future size of the welfare state could mean that middle-class families will start saving more because they perceive that they will receive less help from the government in the future.

For businesses and investors, there is also a great deal of uncertainty.

Contrary to the US, where clear steps have been taken since the beginning of the crisis to modify financial regulation, consecutive UK governments in the past several years have done practically nothing on that front.

How could investors know for sure that the UK is going to be a business-friendly place, especially in terms of the banking and finance sector, when much of the political rhetoric has been hostile to that sector?

What they really need is an unambiguous message about future policies.