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How to cut the deficit

Created:

15 March 2010

Written by:

Chris Dillow

Everyone agrees that Chancellor Alistair Darling must come up with a credible plan to cut government borrowing in next week's Budget, even if they disagree upon when the cuts should start or how deep they should be. This, though, runs into a problem - government borrowing depends not just upon the Chancellor's plans, but upon upon monetary policy too.

One fact hints at this. This is that there have been huge errors in Budget forecasts for government borrowing. Between 1999 and 2007, the average error in forecasts for borrowing one year ahead was £8.3bn (around 0.7 per cent of GDP), and for two years ahead it was £11bn, or one per cent of GDP. And this is not to mention the fact that the 2008 Budget under-predicted deficits in the following two years by probably more than £180bn.

Such errors tell us that Budget decisions about public spending and tax rates do not fully determine government borrowing. If they did, deficits would be entirely predictable.

Instead, what also matters is monetary policy. There's a simple reason for this. Government borrowing is the counterpart of private sector net lending - the gap between savings and investments. And this gap, insofar as it is responsive to policy at all, is influenced by monetary policy.

I don't just mean that interest rates influence how much we save and invest. They also influence "animal spirits" - low interest rates can engender optimism about the future and hence contribute to investment booms. And monetary policy, more than fiscal policy, holds the key to restoring banks' capital bases and thus their willingness to lend.

A Chancellor who was desperate to cut borrowing would therefore use his Budget to instruct the Bank to keep interest rates super-low for a long time. But the chances are, he won't do this - and his shadow, George Osborne, doesn't want him to.

Instead, his job is to tell a story - which might or might not please the markets - whilst the "real world" is in large part beyond his control. But then, that's politics.