Barmy arguments from Philip Hammond on spending

February 05, 2008 12:23 PM

From today's FT:

Mr Hammond argued on Monday night it made no economic sense to advocate cutting public spending when the economic cycle was in a downturn. “At any time, the proposal that we should cut back the growth in public spending more harshly than Margaret Thatcher did is pretty odd.” He said that if the idea was “an extraordinary one last summer, it’s quite a barmy one now ... It’s not a sensible approach at this point in the cycle”.

Mr Hammond's assertions are wrong on so many counts that it's hard to know where to start!


1. It's not clear that in a small open economy with high capital mobility (like the UK), fiscal policy has much impact on demand. Monetary policy is far more effective. Note that the US, which is currently preparing a fiscal stimulus package, is a less open economy than the UK, and that therefore fiscal policy will have more impact across the Atlantic. That said, if you believe in Ricardian Equivalence, then borrowing to stimulate the economy will fail - in this scenario the best thing is to restrain spending and enact supply-side tax cuts (in the long run surely the right thing to do).


2. If you do accept that fiscal policy can play a role in supporting an economic recovery in the UK, at least in the short-term, which Mr Hammond's statement imples, then the relevant question is the fiscal stance as a whole. Assuming the economy grows at 2 per cent, then freezing public spending and cutting taxes by 2 per cent would create the same fiscal position as growing spending at 2 per cent and leaving taxes at their current level. It would therefore be entirely plausible to cut public spending in a downturn, provided that taxes were also reduced.


3. In terms of their effects on the economy, public spending and taxes are very different. The public sector is far less productive than the private sector, so a pound spent in the public sector will have less economic benefit than a pound of tax cuts - a very simple rule to remember and backed up by mountains of evidence showing that higher public spending and higher taxes have a negative impact on economic growth. While far from perfect, the US fiscal plan does at least stimulate the economy by providing tax rebate cheques rather than extra spending on government programmes. The lesson is therefore that if you want to pursue counter-cyclical fiscal policy, then cut taxes rather than increase spending. In the long run, that will benefit the economy far more, and given the dynamic effects of tax reductions, you won't be borrowing quite as much as you thought anyway.


4. Even under Mr Hammond's own logic - that we can't cut spending growth faster than Mrs Thatcher because we're in a downturn - his case against cutting spending growth is weak. Mrs Thatcher came in during a downturn much more severe than the one at the moment, and therefore even under Mr Hammond's logic, had less room to cut spending than today.


The great danger for the future is that if the Conservatives stick to their plans to increase spending by 2 per cent per annum, and if the economy grows more slowly (as looks likely), taxes or borrowing will have to increase. Raising taxes in a downturn is the worst possible thing to do, while accepting increased borrowing makes the pain of fiscal adjustment worse in the future. In addition, the state would be consuming a higher proportion of GDP - another negative consequence of failing to restrain spending.


If the Tories are serious about forming the next government, they have to offer voters an alternative to the failed high spending, high tax consensus of the Labour years. Criticising calls for spending restraint as "barmy" implies that Tory policy will be no different to Labour policy, and that tax reductions will not be forthcoming. It also reveals a massive contradiction in the Tory stance. The Shadow Treasury team has rightly criticised rising taxes under Gordon Brown and rightly pointed out their economic costs. So will the Tories cut taxes then?! It seems as though the answer is "no".

From today's FT:

Mr Hammond argued on Monday night it made no economic sense to advocate cutting public spending when the economic cycle was in a downturn. “At any time, the proposal that we should cut back the growth in public spending more harshly than Margaret Thatcher did is pretty odd.” He said that if the idea was “an extraordinary one last summer, it’s quite a barmy one now ... It’s not a sensible approach at this point in the cycle”.

Mr Hammond's assertions are wrong on so many counts that it's hard to know where to start!


1. It's not clear that in a small open economy with high capital mobility (like the UK), fiscal policy has much impact on demand. Monetary policy is far more effective. Note that the US, which is currently preparing a fiscal stimulus package, is a less open economy than the UK, and that therefore fiscal policy will have more impact across the Atlantic. That said, if you believe in Ricardian Equivalence, then borrowing to stimulate the economy will fail - in this scenario the best thing is to restrain spending and enact supply-side tax cuts (in the long run surely the right thing to do).


2. If you do accept that fiscal policy can play a role in supporting an economic recovery in the UK, at least in the short-term, which Mr Hammond's statement imples, then the relevant question is the fiscal stance as a whole. Assuming the economy grows at 2 per cent, then freezing public spending and cutting taxes by 2 per cent would create the same fiscal position as growing spending at 2 per cent and leaving taxes at their current level. It would therefore be entirely plausible to cut public spending in a downturn, provided that taxes were also reduced.


3. In terms of their effects on the economy, public spending and taxes are very different. The public sector is far less productive than the private sector, so a pound spent in the public sector will have less economic benefit than a pound of tax cuts - a very simple rule to remember and backed up by mountains of evidence showing that higher public spending and higher taxes have a negative impact on economic growth. While far from perfect, the US fiscal plan does at least stimulate the economy by providing tax rebate cheques rather than extra spending on government programmes. The lesson is therefore that if you want to pursue counter-cyclical fiscal policy, then cut taxes rather than increase spending. In the long run, that will benefit the economy far more, and given the dynamic effects of tax reductions, you won't be borrowing quite as much as you thought anyway.


4. Even under Mr Hammond's own logic - that we can't cut spending growth faster than Mrs Thatcher because we're in a downturn - his case against cutting spending growth is weak. Mrs Thatcher came in during a downturn much more severe than the one at the moment, and therefore even under Mr Hammond's logic, had less room to cut spending than today.


The great danger for the future is that if the Conservatives stick to their plans to increase spending by 2 per cent per annum, and if the economy grows more slowly (as looks likely), taxes or borrowing will have to increase. Raising taxes in a downturn is the worst possible thing to do, while accepting increased borrowing makes the pain of fiscal adjustment worse in the future. In addition, the state would be consuming a higher proportion of GDP - another negative consequence of failing to restrain spending.


If the Tories are serious about forming the next government, they have to offer voters an alternative to the failed high spending, high tax consensus of the Labour years. Criticising calls for spending restraint as "barmy" implies that Tory policy will be no different to Labour policy, and that tax reductions will not be forthcoming. It also reveals a massive contradiction in the Tory stance. The Shadow Treasury team has rightly criticised rising taxes under Gordon Brown and rightly pointed out their economic costs. So will the Tories cut taxes then?! It seems as though the answer is "no".

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