The budget: wrong diagnosis, wrong cure

Budget-watchers who are old enough will remember a time when the most important element of a budget was the "budget judgement": how much money the chancellor was putting into or taking out of the economy. On this basis, today’s budget was a non-event. In 2013/14, the chancellor is adding £1.3bn to the economy, before taking £1.6bn out in 2014/15. In a £1.5 trillion economy, these are no more than rounding errors.

The prime minister and the chancellor claim they could do nothing else because Britain faces a "debt crisis." But the coalition has persistently misdiagnosed Britain’s economic problem. To the extent that we have a debt crisis, it is due to extraordinarily high levels of household and financial sector debt, not government debt. This is evident from the fact that the government is still paying less than 2 per cent to borrow for 10 years, despite the fact that public debt is now expected to peak at 86 per cent of GDP in 2016/17, compared to a peak projected at the time of the June 2010 budget of 70 per cent in 2013/14.

In the short-term Britain has a growth crisis, not a debt crisis. Real GDP has increased by just 0.7 per cent since the third quarter of 2010 and remains 3 per cent below its previous peak. The Office for Budget Responsibility has again revised down its growth forecast for this year to just 0.6 per cent.

The reason for the growth crisis is simple enough: no part of the economy is both willing and able to increase its spending. Households’ spending power is squeezed by prices increasing more rapidly than wages, and at the margin they prefer to save a little more, rather than take on more debt. Overseas demand for UK output is being hit by the recession in the eurozone, still our main export market. Meanwhile, some businesses have resources to spend but are put off by the weak outlook for demand for their goods and services; and other businesses that might want to expand are unable to get the funds they need from banks.

The government’s response has been to cut its own spending, thus making the situation worse, while hoping that an easy monetary policy and schemes such as Funding for Lending would change the behaviour of households and businesses. But, with the official bank rate having been 0.5 per cent for the last four years, £375 bn having been injected into the economy though quantitative easing and lending to small and medium-sized businesses still falling, it is clear that monetary policy and other wheezes like Funding for Lending are now having very little impact. The change in the Monetary Policy Committee’s remit proposed by the chancellor won’t make a difference.

The chancellor is, therefore, reduced to announcing a string of measures in the budget so as to appear to be supporting growth, while in fact being in the position of simply hoping that something turns up to lift the economy. Thus, we get more cuts to current spending by departments to provide funds for capital projects and a further cut in corporation tax, even though there is little evidence that past cuts have had any effect on growth.

A correct diagnosis of Britain’s problem as a growth crisis, together with an acceptance that the policies tried so far have had little effect, leads to the obvious cure: the government should be prepared to spend more. The best way to do so would be to increase spending on the country’s infrastructure. It gives a bigger boost, pound for pound, to output; better infrastructure will encourage private sector investment in the future; and it can be directed to regions of the economy that are lagging.

The government should have announced an additional £15bn spending on infrastructure for 2013/14 and a further £15 bn for 2014/15, to be funded by extra borrowing. This would not have created a debt crisis. After allowing for the extra growth this spending would generate, it would have meant a peak in the debt ratio at 87 per cent, rather than 86 per cent—an increase that pales into insignificance compared to the revision that has already taken place since June 2010.

Unfortunately, the prime minister and the chancellor have invested too much political capital in the idea of a debt crisis and in the argument that there is no alternative to the path they are pursuing. They cannot contemplate a change of policy without admitting that they have been wrong for the last three years and they are not prepared to do this. The economy is therefore likely to remain stuck in its current low to no growth rut for some time to come.