Coalition: Too much, too fast

The tax increases and spending cuts that began in earnest in April will remove two percentage points of GDP in spending power—roughly equivalent to the total growth of GDP in 2010—from the economy in each of the next four years. This will be the biggest fiscal consolidation attempted in postwar Britain. The cumulative saving will be, according to the IMF, the most extreme belt-tightening attempted by any OECD country apart from Iceland and Ireland. Will the coalition succeed in this unprecedented experiment?

Economics and politics suggest very different answers. On economics, the debate has been about whether the reforms will improve business confidence, competitiveness and work incentives. But such “supply-side” concerns will become almost irrelevant if the squeeze on personal incomes causes a sharp fall in demand. Even if some of the controversial cuts—such as reductions in the disability living allowance—prove popular with voters, they will take money directly out of consumer’s pockets. Most beneficiaries of public spending have no substantial savings and will cut back immediately on consumption when their incomes fall.

Thus, the key financial question for the rest of the parliament will be how the money withdrawn from the economy by the government can be replaced by new private spending. Consumers and private businesses, the Office for Budget Responsibility somewhat hopefully assumes, will be so inspired by the government’s prudent behaviour that they will be emboldened to do the opposite: increase their borrowing and eat into savings. Sadly, there is no reason to expect such an upsurge of confidence among people who see their taxes rising, their real wages falling, their benefits and pensions cut and their public sector jobs disappearing. In fact, with the cuts approaching, consumer confidence has fallen back to the almost unprecedented depths plumbed at the worst point of the banking crisis, in the winter of 2008-09.

Apart from faith and prayer, the only factors likely to promote the bullish behaviour necessary in the private sector will be the continuation of very low interest rates and a very cheap pound. Big interest rate cuts and devaluations were the key to all Britain’s successful fiscal consolidations—in 1976-79, 1981-86 and 1993-97. This time, however, short-term interest rates are already near zero and the pound is already cheap.

Osborne has been relying on assurances from the Bank of England that it can provide whatever support might be required for demand. But with inflation well above the 2 per cent target, and a clamour for higher interest rates among the media and the ageing rentiers who make up a large proportion of mainstream Tory support, Mervyn King’s promises now ring hollow. Far from offsetting the loss of demand from public spending cuts, the Bank of England has been doing the opposite: hinting at higher interest rates and allowing the pound to rise.

If, instead of accelerating in the two years ahead, the economy sinks back into stagnation, the outlook will be disastrous. The fiscal targets will be missed and Osborne will be reduced to mumbling excuses about “difficult global conditions,” just as Gordon Brown was. Here, the politics of the coalition could take a surprising turn.

Suppose it becomes apparent that the treasury is missing its fiscal targets. The cabinet must then decide whether to cut public spending further, or instead abandon the plan to eliminate the deficit and return to a Keynesian policy of loosening the fiscal tourniquet. At this point, the coalition’s unity will be sorely tested. The Tories would almost certainly insist on another round of deeper cuts. Many of them genuinely believe public borrowing is evil. Most crucially, they see reduction of welfare and public spending as an end in itself.

For the Lib Dems, spending cuts could never be an end in themselves. They are only justified as a means to achieving deficit reduction. If the deficit fails to shrink as promised, the main justification for remaining in the coalition would be removed—especially with the question of voting reform settled by the referendum on AV.

How would this conflict play out? If the coalition stuck together, the Lib Dems would become so unpopular with their voters that their only hope would be an electoral pact in 2015, almost guaranteeing victory to a permanent Tory-Lib Dem coalition. An alternative scenario would be for the Lib Dems to split, with Clegg and other ministers joining the Tories while the rest of their party drifted off into opposition and electoral oblivion. Since the great majority of Lib Dem seats are in affluent suburbs and rural areas, the Tories would benefit far more than Labour from a Lib Dem meltdown. The upshot is that an economic debacle for the country could well guarantee the re-election of a Tory government. Osborne may be a political genius, even if he proves an economic dunce.