The 79 argue that George Osborne’s proposals to legislate for a budget surplus when the economy is growing could: “risk a liquidity crisis that could also trigger banking problems, a fall in GDP, a crash, or all three”. That would be quite an achievement for a policy that might (for example) require a budget surplus of as little as 0.1 per cent of national income if GDP growth were above zero. So, let’s have a look at the propositions that underlie the arguments of the 79.
Firstly, they argue that Osborne’s plans “have no basis in economics”. More on this below, but this statement is demonstrably not true. There is plenty of economic theory that suggests that a government tying its own hands increases credibility and thereby lowers borrowing costs. The 79 might not agree, but they cannot wish contrary views out of existence – they need to engage with them. Furthermore, there is certainly a case in economics for a government running a surplus when it is building up future pension liabilities in order to prevent inter-generational injustices. Also, the theory of the “fiscal commons” suggests that voters will want governments to borrow more than they should because the costs will be borne by future generations who cannot yet vote: fiscal rules can inhibit this process. It is strange indeed that the 79 seem unaware of these basic ideas.
They then argue: “Economies rely on the principle of sectoral balancing […] In other words, if one sector of the economy lends to another, it must be in debt by the same amount as the borrower is in credit […] if it [the government] chooses to try to inflexibly run surpluses […] Households, consumers and businesses may have to borrow more overall, and the risk of a personal debt crisis to rival 2008 could be very real indeed.”
This might be true under one very strict assumption – that the foreign sector is irrelevant to this process. Given that the foreign sector holds 33 per cent of UK government debt, this is a really rather implausible assumption. A government surplus could – indeed, probably would – lead directly to reduced capital inflows which are necessary to finance borrowing, in turn this would precipitate a fall in the exchange rate and possibly a consequent improvement in the balance of payments.
This might not happen, all sorts of other things could happen too, but, even if we assume away the 6,940m people who do not live in the UK, the chain of events that the 79 propose is highly unlikely to happen. What might be the result of a budget surplus in the absence of any foreign capital flows? The most likely scenario is that the government would begin to redeem its bonds or issue fewer bonds to fund redemptions. Around 60 per cent of government bonds not held by overseas lenders are owned by UK life and pension funds. Most of the rest are held by non-bank financial institutions. So, the government will redeem bonds and UK life and pension funds, for example, will invest in other financial instruments.
This may lead to various consequences, such as increases borrowing and equity issuance by corporations. This may represent an increase in net investment or a reduction in net saving by the UK non-government sector as the 79 suggest but the intellectual somersaults you need to jump through to turn this into a banking crisis are extraordinary. If this group of economists believe that the next banking crisis will be caused by the government running a small surplus, then they can no longer see the wood for the trees.
Finally, the 79 argue: “These plans tie the government’s hands, meaning it won’t be able to respond appropriately to constantly evolving economic circumstances […] The plan actually takes away one of the central purposes of modern government: to deliver a stable economy in which all can prosper.”
This takes us back to the debates of the 1970s about whether fiscal policy can be used to fine-tune the economy. This is not the same debate that we had in 2009 about whether in extremis fiscal policy should be used to prevent economic collapse (though I would not agree with the 79 on that issue either). Fiscal fine tuning assumes a degree of economic foresight that governments simply do not possess. And it also assumes that any attempt to fine tune is not undermined by changes in interest rates or exchange rates which stimulate economic activity and compensate for the fiscal tightening.
In essence, this was the crux of the debate between the 364 economists, who wrote to The Times, and their few opponents back in 1981. Of course, that letter was catastrophically badly timed. Almost the very week the words “present policies will deepen the depression” were written, the economy turned. But perhaps the most interesting similarity between the 79 and the 364 is that the 364 wrote: “There is no basis in economic theory or supporting evidence [for the government’s policies]”. In other words, the 364, like the 79, were not even aware that there might be a contrary view to that of their own.
The 79 who wrote to the Guardian are teaching the best and brightest of our undergraduates. Following the financial crisis, many have recognised that students should be taught a wider variety of paradigms, ideas and theories. The IEA has been a strong supporter of their perspective and has participated in the events of the Manchester University Post-Crash Economics Society. Of course, the IEA has also been responsible for popularising public choice economics, Austrian economics and institutional economics in Britain. Students deserve to be taught by economists who are passionate about their ideas. However, they also need to be taught by economists who understand that there are alternative ideas.
Prof Philip Booth is the IEA’s Editorial and Programme Director and Professor of Insurance and Risk Management at Cass Business School.