Business

Budget 2013: Should the government plough ahead with cuts?

Construction of the Crossrail station at Farringdon
Image caption Could more infrastructure spending life the economy out of the hole it is in?

"It's like one of those horror movies - you think the recession's dead, and then it pops up again."

John Van Reenen is feeling frustrated.

The head of the LSE's Centre for Economic Performance believes his voice is just one of a growing chorus among economists calling on the government to slow down.

"The speed of spending cuts is too fast, and it has contributed to the economy's pathetic rate of recovery," says the left-leaning economist.

Lasting damage

"Pathetic" may be putting it mildly. The economy appears to have stopped growing altogether since the autumn of 2010.

The UK's output is about 15% smaller than it would have been by now, if the economy had kept growing at its pre-crisis rate, says Mr Van Reenen.

How much of that underperformance is due to government austerity is a moot point.

A recent paper by the IMF chief economist Olivier Blanchard noted that since the 2008 financial crisis governments throughout the world have been discovering that spending cuts have had a far more drastic impact on economic performance than anticipated.

Some economists say that austerity is also self-defeating, as the harm it does to the economy may actually worsen our debt position, at least in the medium-term.

For example, when the US ratings agency Moody's decided to strip the UK of its coveted elite AAA credit rating last month, one of its reasons for doing so was the impact of spending cuts - both by the government and the private sector - on our growth rate.

Another member of Mr Van Reenan's growing consensus, Jonathan Portes of the think tank the National Institute of Economic and Social Research, warns of lasting damage.

"If fiscal policy is too tight for too long, you can actually end up increasing the structural deficit in the long-run," he warns.

By that he means that when the economy is in a prolonged slump, businesses stop investing in increasing their production, and may even scrap existing capacity, while the out-of-work lose skills and motivation, becoming less employable.

That damages the long-term potential of the economy, meaning the government can rely even less on an eventual recovery to fix the hole in its finances.

Both men say the scale of cuts needed to balance the books is in fact somewhat less than what the Treasury and its watchdog, the Office for Budget Responsibility (OBR), believe it to be.

And both think the cuts should be strung out over a longer time frame to give the economy a break, particularly at a time when the Bank of England has seemingly run up against the limits of its ability to lessen the pain.

'Gargantuan deficits'

Yet this is not the view of all economists, and certainly not of Messrs Osborne and Cameron.

Perhaps because not everyone fits into this cosy consensus. Quite the contrary in fact.

"We've pretty much proved that running these gargantuan deficits has not worked, so we should withdraw them," says economist and Conservative supporter Andrew Lilico.

"We should have been trying to eliminate the deficit over the life of a single parliament, if not sooner."

In sharp contrast with his more left-leaning peers, Mr Lilico thinks the reason the economy has performed so badly is simply because the OBR and others greatly overestimated its potential.

"The most material reasons are the level of household debt, the high level of public spending, and the inefficiency of the public sector," he claims.

Under this view therefore, if a tepid recovery is the best we can hope for, then by implication the scale of spending cuts needed to get the Treasury back into the black is even greater than the OBR suggests.

Political calculus

All three economists do however agree on one point, though for very different reasons.

Government spending comes in two main types: current and capital. In the case of education, for example, a teachers' wages would come under current expenditure, while building a new school - a physical asset which will last a long time - would be classed as capital.

They all say it was a big mistake for the coalition government to slash capital spending shortly after they came to power.

The Lib Dem Business Secretary Vince Cable pretty much said the same in a recent opinion piece in the New Statesman.

For Mr Lilico, it is a question of the wrong strategy. "You want to cut current expenditure quickly because it is more difficult to get political assent."

Crisis jargon buster
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AAA-rating
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But instead of doing that, he says the government wasted the opportunity by going for the politically easier combination of raising taxes and suspending new construction projects.

He is particularly unimpressed by the decision to ring-fence the NHS: "The best place to cut spending is where it went up most [under Labour]. What the ring-fence taught other departments was that if you kick up enough political fuss, they won't cut you."

For similar reasons, Mr Lilico says it would now be a political mistake to increase capital spending.

Cheap and cheerful

But the other two beg to differ. They view ramping up investment in new infrastructure as the best way of giving the economy a much-needed jolt.

The arguments for more investment spending are fairly well rehearsed.

The Treasury can currently borrow for 30 years at an interest rate fixed at less than the rate of inflation - which suggests there are no noticeable qualms in the market about the government's creditworthiness, and sets an unprecedentedly low bar for the return that any new railway line or energy plant needs to earn in order to repay the debt.

And the government can certainly hire construction firms on the cheap too, if recent data on the sector's performance and expectations are anything to go by.

Sensible investments create valuable assets on the government's balance sheet, and should increase the long-term growth of the economy - both of which mean that government should be well positioned to repay any additional debt taken on to finance it.

On top of all that, infrastructure spending is widely perceived to have the biggest "multipliers", meaning it will perk the economy up in the short-run.

That is because the money ends up in the pockets of workers and companies who are themselves more inclined to re-spend it, and because the government's largesse gives private businesses the confidence to go out and start investing themselves.

But what exactly should the government splurge on?

"My first priority would be housing," says Jonathan Portes. "We do have a housing shortage in this country, particularly of social housing. And in the short-term, house-building is pretty shovel-ready.

"There are many small-to-medium-sized road projects ready to be started. There is also a need for more schools, and building schools is really not rocket science."

Think small

That "shovel-readiness" is an important consideration.

The long lead-times involved in major infrastructure projects - think of the consultation, planning, design, and engineering delays for Crossrail - mean they are no quick-fix.

Questions may also be raised about the government's capacity to cope with a big surge in projects, given the fiasco of the West Coast Main Line franchise award.

But Jonathan Portes is more sanguine: "In 2008-09 there was a really sharp run-up in public sector investment, which goes to show that when the political will is there, it can happen."

He points to a recent article in the Economist magazine that lists a string of small-scale local projects that could be resurrected, and suggests the scale of public-sector investment could easily be doubled.

Large-scale projects - such as a new airport for the South East - are important too, but because they are needed for the economy to function in the long-term, not because they will help resuscitate spending in the short-term.

However, Mr Lilico worries over the utility of whatever the government might seek to build.

"We should not underplay the risk of Japanese-style bridges to nowhere," he warns, referring to Tokyo's oft-cited propensity in the 1990s to build white elephants to keep construction workers employed and local patriarchs happy.

However, Mr Van Reenan of the LSE has a rejoinder.

He and fellow academics of the LSE's Growth Commission authored a report in January that called for the creation of various new bodies to co-ordinate and take a long-term view of infrastructure investment.

He also thinks it would give private sector firms the confidence to open their own purse-strings, by avoiding situations like the current stand-off with EDF over the construction of a new nuclear power station at Hinkley Point.

"It's an extremely low-cost thing to do," he says. "A lot of infrastructure is built by the private sector - energy, transport. But the big problem is uncertainty, due to changes in government, back-tracking and prevarication."