King's "fiscal warning"

Headline writers are paid to grab readers' attention, not to tell the whole truth. In this sense, they've done a good job on Bank Governor Mervyn King's comments about fiscal policy to the Treasury Select Committee yesterday. "Mervyn King warns that spending cuts and tax rises are needed," says the Telegraph. "Investors could shun Britain over its rising debts," says the Mail. "King steps up demand to curtail UK budget deficit," says Bloomberg. "King hits at Treasury policy," says the FT.

In fact, in economic terms, what he actually said is a tad blander than this would imply. His key phrases are these:

"If the economy were to recover along the path assumed in the Budget projections of GDP then I think the time over which deficits need to be reduced is likely to have to be faster than was implied by that projection...There will certainly need to be a plan for the lifetime of the next parliament, contingent on the state of the economy, to show how those deficits will be brought down."

The words I've emphasised are doing a lot of work here. The Budget projections (chapter C here) assume that real GDP will grow by 3.25 per cent after 2011. Despite this, it sees net borrowing of 5.5 per cent of GDP in 2013-14. Most economists would agree that such a deficit would be too high after two to three years of significantly above-trend growth. Because such fast economic growth would raise gilt yields, there would, as Mr King says, be "challenges" in easily financing such a deficit.

However, as Mr King's "if" signifies, it's far from clear that the economy will grow as fast as 3.25 per cent. The Bank's own median forecast is for growth of less than 2.5 per cent in 2011-12. And there are many obstacles to such growth: the poorly state of banks; weak overseas economies; the fact that abundant spare capacity will limit companies' investment even for those that can raise cash; and the possibility that consumers might yet cut spending in response to weak balance sheets.

Tightening fiscal policy soon - before the recovery is under way - risks adding to these obstacles. And as my highlighted phrases show, this is not what Mr King is calling for. He doesn't want a fiscal tightening now - just one when the economy has returned to growth.

And even this might not be necessary. If the economy does return to 3 per cent-plus growth, it's possible that the budget deficit will shrink faster than the government has assumed.

To see why, imagine the world in which such growth is happening - this might be something of a stretch! It would be one in which the banking system is healed and companies and households are borrowing again. But one sector's borrowing is - by definition - another's lending. Simple national accounts identities - plus historical experience - show us that if the private sector is borrowing, the public sector is not.

Just as the government has to borrow hugely now because the private sector is running a big financial surplus - it's saving more than it's investing - so the decline of that surplus will improve the public finances.

Now, the government could not have forecast this in the Budget. This is because a forecast for a sharp reduction in government borrowing is, by definition, a forecast of either spending cuts or a bigger tax take. And it is politically awkward to do either. Gordon Brown has got into trouble for denying even the small cuts in spending projected in the Red Book (and rightly so - he lied). So imagine how much more awkward it would be if the Red Book forecast bigger falls in borrowing.

So let's be clear. Mr King is not calling for a fiscal tightening now. Instead, what he's doing is highlighting an inconsistency in the Treasury's forecasts, between optimistic growth and pessimistic borrowing projections.

But this inconsistency arises from the fact that Treasury forecasts are often motivated by politics, not macroeconomics.

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