The deficit threat

I have been loath to enter the debate about whether cuts in public spending will harm economic growth, as this has become a merely tribal issue. However, I fear that they will do so. I say so not because I'm a Keynesian - Keynes was perhaps the most over-rated economist of all time - but simply because I don't see what parts of aggregate demand will take up the slack created by weaker public spending. Let's run through the possibilities.

1. Consumer spending. Government debt is just future taxes (or monetary creation - but leave this aside). In principle, the prospect of lower debt than would otherwise be the case could cause people to spend more in anticipation of lower future taxes. This is Ricardian equivalence.

However, for this to happen, people must be able to borrow freely - to build up debt now in the expectation that they'll pay it off with higher future disposable incomes.

But this is not the case. Personal borrowing has almost ground to a halt. In this context, parallels with Geoffrey Howe's 1981 Budget - which tightened fiscal policy and yet led to economic recovery to the consternation of many economists - are mistaken. Back in 1981, the government removed restrictions on bank lending, so consumers - who then had low debt-income ratios - stepped up their borrowing, thus offsetting lower public borrowing.

There's little chance of a repeat of this. Quite the opposite. Public spending cuts could reduce consumer spending, as sacked government workers spend less. Useless pen-pushers are consumers too.

2. Net exports. To offset a one per cent fall in government consumption, exports must rise by around a percentage point faster than imports. This doesn't sound too demanding. But it is. For one thing, the globalization of the supply chain means that any rise in exports requires a rise in imports, of materials and parts. And for another, our export markets are likely to grow slowly: last year, the UK exported almost three times as much to Ireland as to China (£15.9bn against £5.4bn). And thirdly, we can't rely on a fall in sterling to help us out. Yes, in theory, a tighter fiscal policy can lead to a lower exchange rate. But sterling didn't fall significantly in response to Mr Osborne's June Budget, so we shouldn't rely upon it doing so soon. And even if it does, it might not help much, given the long lags between exchange rates and net exports.

3. Capital spending. In theory, deficit reductions can "crowd in" private investment, because lower gilt yields help reduce companies' borrowing costs. But this is not happening yet. In July and August (taken together), non-financial firms actually repaid capital market borrowing. And they've been repaying bank debt for some time.

An alternative possibility is that public spending cuts increase corporate profit expectations by reducing labour demand and hence wage growth: Silvia Ardagna of Wellesley College in the US has shown that this has stimulated economies in the past. But can it really happen here? For one thing, it can only do so to a great degree if firms can borrow freely, against higher expected future profits. But this is doubtful. And for another, it is unlikely that high labour costs have been a major factor behind low investment recently.

So, I don't see what will offset spending cuts.

You might object here that I would say this, being a tribal lefty. I'm not sure. There are circumstances in which I would be more sympathetic to cuts: if gilt yields were high; if our export markets looked like doing well; if the banking system were healthy; if government spending really was crowding out the private sector, say by creating labour shortages. But these conditions do not exist.

Now, we must distinguish between two claims here. One says that spending cuts will lead to a "double dip" recession. The other says that the cuts will reduce GDP relative to what it would otherwise be.

The latter is more plausible. It is possible that the recession has created a backlog of investment demand, so we could see a boom in capital spending, or perhaps the lagged effects of sterling's fall in 2008 will eventually help our net exports. If so, deficit cuts might be accompanied by healthy growth, even if they don't cause it, and actually retard growth.

Against all this is the argument that deficit cuts are necessary to retain the confidence of bond markets. Or maybe they are a price worth paying for a smaller public sector.

Such claims, however, merely mean cuts are the lesser of two evils. They do not mean the cuts do not carry considerable dangers.

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