Monday, June 7, 2010

Economics of Suffering

Suffering Isn't Good.

No Pain, no gain.' As a competitive cyclist, I often hear this mantra. The worrying thing is that we hear it increasingly with regard to economic policy.

There is often a general feeling, that if you implement something painful, it must be doing something good. Like the necessary injection to protect you from a worse disease.

The question is does is suffering good in economics?

At the moment, the big issue is spending cuts. The new UK governments are almost gleefully talking about the necessity of 'painful cuts' and years of austerity. Perhaps this is political sense - make it sound really painful and then when its not quite as bad, electors will vote for you.

The problem with large spending cuts is that they have the capacity to push economy into recession. Unemployment in the UK is already at its highest level since 1994, more public sector job cuts and a fall in aggregate demand would further worsen the situation.

If drastic spending cuts (plus much negative talk of how bad the economy is in - thereby reducing consumer confidence) did lead to lower growth, it ironically makes it much more difficult to reduce deficit. A fall in growth would reduce tax revenues and lead to higher unemployment spending. There is a danger of cutting spending drastically, but, not reducing debt very much.

The first thing that springs to mind, is the great depression of 1931. Faced with mass unemployment and a collapse in GDP, conventional wisdom forced the government of the day (the national coalition led by Ramsay McDonald) to cut unemployment benefits to balance the budget (presumably bond markets were on the verge of revolting then too). Needless to say the cut in unemployment benefits and higher taxes only made the Great depression worse.

Another example is 1937. As the US was recovering from the Great Depression, the government prematurely tightened fiscal policy (reducing spending and raising taxes), combined with a small tightening of monetary policy, the economy fell back into a recession - which of course worsened the deficit.

When the Conservatives came to power in 1979, there was a similar feeling of 'we really need to suffer as much as possible' The government tightened fiscal, monetary policy and allowed the exchange rate to appreciate. Even when unemployment hit 3 million there was no let up, as that lady wasn't for turning.

The good news is that it is possible to cut spending, and cut a deficit without plunging the economy into recession. It is all a question of timing. If growth is robust, if jobs are being created in other sectors, then a certain degree of cuts can be absorbed. A small detail about the coalition is that the Lib Dems added a caveat to spending cuts - they said they should be made in consultation with the Bank of England.

In theory, this should mean that the Bank of England will be able to veto any over zealous fiscal tightening - if there isn't sufficient monetary stimulus. Though whether that would happen in practise is open to debate.

There is always room for thoughtful evaluation of government spending. Just because you've always spent £600bn, doesn't mean every billion is well spent. Government spending is only a means to end, not an end in itself. There will always be powerful pressure groups fighting for their corner, but, this is not a necessary justification.

It's behind the scope of this blog post, to evaluate where government spending cuts would fall. The main point is to say - Be careful of over-reacting. Be wary of shrill announcements from politicians, who say we are on verge of collapse. We often hear the bond market is on the verge of revolt. But, long term bond yields are as low as ever (10 year = 3.51%).

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