Terra Firma

The causes of our present economic difficulties are many and various. But amongst them lies excess consumption, supported by excess borrowing. We have been living beyond our means. The corollary is that we have not been saving and investing enough. The result is a yawning gap between the sustainable consumption path and the path we have been on.

Keynesians would have us believe that what we have experienced is a sudden withdrawal of demand, and that the right way to fix this is for government to step in and make up the spending, financed by yet more borrowing. For Keynesians, this sort of shock is temporary, to be solved by using the tools of macro policy to manage the business cycle. Some – notably Mr. Brown – had assumed that these tools were so good that the business cycle itself had been abolished.

The problems for the Keynesians are twofold. First, they must assume that people are at best ill-informed, and at worst ignorant. For the fact is that the borrowing has to be paid back and that means higher taxes. And since the public sector is typically a lot less productive than the private, the extra future taxes will be higher than the value of the spending. Keynesians are quick to add a multiplier to their spending, but not a divider to the taxes. So if people are smart, they see all of Mr. Obama’s and Mr Brown’s spending and start saving for the very rainy days to come.

The second problem is the accumulation of the debt to pay for the spending. This has been piling up for some time, and especially since the crash in 2000. Running historically unprecedented low interest rates since then, coupled with the opening of the gates of public spending, has built up a legacy of liabilities in the UK and the US which would have taken years to pay off even before the credit crunch in 2007 and the economic crisis since then. The UK was already running a structural deficit of around £70 billion per annum before we got to 2007. The interest bill is set to become one of the major items of public expenditure – alongside defence, health, education and social security.

RISING COSTS OF DEBT

Spending our way out of recession might not work, but it has not stopped the UK and the US trying to do so on an unprecedented scale. This is not just about economics: it politically appeals to the centre left. All that spending translates into projects politicians support. It is like a giant “pork barrel”. After years of treasuries trying to hold back the floodgates of public expenditure against lobbies and political constituencies, suddenly they could have almost unlimited monies. It was like a political Christmas.

But now we have the debt – and on a scale only experienced after world wars. Keynes famously remarked that we should not worry about the long run – that “in the long run we are all dead”. The power of compound interest – and growth – would make the economic prospects of our grandchildren very bright, but in the long run will not go away, and then the power of compound interest will increase the debt burden.

This will haunt governments to come – as will the environmental legacy of the excess consumption. As investors become increasingly sceptical about the ability of governments to pay them back, the costs will rise, and interest payments will add to the burden on public finances. This is already happening with private investors, and surplus country governments too are becoming more sceptical. China cannot relish pumping more money into US bonds, and sterling has retreated sharply.

THREE ROUTES TO ESCAPING THE DEBT BURDEN

These investors are right to be sceptical: the debt levels built up in the UK are probably unsustainable, and may even be so in the US. Investors know that there are just three options to get out of the mess to make radical cuts in public expenditure and raise taxes; to default; or to inflate, thereby debasing the currency.

Option one, cutting public expenditure and raising taxes is, in effect, a policy of lowering standards of living so that we get back onto the sustainable consumption path. The scale in the UK of the required cuts and tax increases is enormous. Roughly it requires that the private savings rate is around 7 per cent of GDP, the consumption level is about 20 per cent lower, and government not only balances its budget, but starts debt repayment in earnest. Even this may not be enough the sheer scale of the Keynesian borrowing may mean even more consumption cuts are required, and for every day that it goes on and the economy fails to respond, the scale of the adjustment required just gets bigger and bigger.

Put into context, for the UK it means winding back and repaying all the structural deficits since 2000, and reveals that economic growth since then has been illusory merely the mirror of the borrowing. It may even be that the standards of living in 2000 are actually above the sustainable consumption level now. A clear implication is that the pension liability simply cannot be paid – and that is one reason why the retirement age will probably have to be put back to around 70. Pensions are just promises: there has to be the production to produce the surplus to pay them.

The problem with option one is that the voters might not wear it: there may simply be no democratic mandate to take the medicine and lower living standards enough. In the run up to the next election in the UK, the electorate s stomach for this sort of retrenchment will be tested. Brown may just keep on promising more spending, unfunded and unfinanced and the voters may even fall for it.

THE RISKS OF THE INFLATIONARY ROUTE

But not doing option one opens up remedies which in the long run would prove much worse. Option two, straight default, is extremely unlikely, which leaves the 1970s solution and option three inflation. By getting inflation going, the creditors are wiped out, cleaning up the national balance sheet. It is default by another name. The 1970s witnessed high inflation, a public expenditure crisis, and the IMF was needed too.

Getting inflation going is much easier than many Keynesians now assume. Being caught in the headlights of Japan s deflationary experiences, they readily – and erroneously – read across to the UK and the US. They ignore the particular circumstances the conservative population, its high historical savings rates, the export orientation of the economy, and so on. Japan in the mid 1990s is not the same as the US and UK at the end of this decade.

The transmission mechanisms to the inflation option are various. An obvious one for the UK is a collapse in sterling, pushing up import prices. Then there is printing money to support the unfinanced deficits. It can even be done by granting big wage settlements in the public sector, now so dominant in the economy as a whole. And once inflation got going it would be very hard to stop. We might have the tools – interest rates – to stop it, but the political economy of the sorts of interest rates that we had at the end of the 1970s and at the end of the 1980s might be tough to weather.

Longer term, the inflationary route would do great damage to credibility. Interest rates would stay higher for longer as a UK (and US) risk factor was added on, and the shock to the economy of the interest rates necessary to reduce inflation would be all the greater for having been postponed. Sterling would take a long time to recover and faith in savings would be eroded. At the limit, high inflation undermines social cohesion and with it political stability too.

REAL STANDARDS OF LIVING WILL HAVE TO FALL

The net result is that the first option taxes and cuts – is likely to be cheaper in the medium term than the inflation option. There is really no way out. If we have been living beyond our means, then there comes a point when standards of living have to fall. What is unsustainable cannot be sustained. Already some of that has happened sterling has fallen sharply. Private pensions are not worth what they were. Postponing the pain will simply make it worse, and trying to postpone it indefinitely risks investors simply pulling the plug. If governments want to borrow, someone has to be willing to lend. Lending, however, is a voluntary activity.

Tax is compulsory, but only for those who stay and choose work over leisure. The 1970s taught us that high taxes were not the route to higher prosperity. They also taught us the real costs of inflation. It took a decade and North Sea oil and gas to get out of the resulting mess inherited from the 1970s. This time it looks even worse and to get out of the debt burden in a decade would be a real achievement. Public expenditure has to fall to a level that can be sustained by the productive economy. Fortunately, much can be saved by addressing chronic public sector inefficiencies, but there will have to be real cuts too.

Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe.

© Dieter Helm