Published in Business Spectator (Melbourne), 28 October 2010

http://www.businessspectator.com.au/bs.nsf/Article/George-Osborne-UK-spending-cuts-GDP-deficit-debt-pd20101027-AM3VA?OpenDocument

The responses to the British government’s spending review were predictable. Chancellor George Osborne’s announcement to cut government spending by a £81 billion ($130 billion) over the next four years was bold only in one sense, Paul Krugman wrote in his column, because it “boldly goes in exactly the wrong direction”. Financial Times commentator Martin Wolf expressed his doubts that such drastic measures were actually required.

As usual, Joseph Stiglitz went even further than the rest of his Keynesian friends. Far from supporting the spending cuts, he seriously argued that what Britain really needed was more stimulus spending. Those who had always assumed that Stiglitz inhabited a world of his own may well take this as confirmation.

The kneejerk Keynesian reactions against the British government’s plans only demonstrate two things. Osborne’s critics have not fully understood the seriousness of the UK’s long-term fiscal position. And secondly, they overestimate the degree by which spending will actually be cut under Osborne’s plans.

The Comprehensive Spending Review was an emergency budget in all but name, and the fiscal situation in Britain is without doubt a disaster. It did not happen overnight, and so fixing it will also take some time.

Just a decade ago, Britain was thought to be in reasonably good shape. At the time, the UK budget was in surplus. Real public sector net debt had slightly fallen from its peak in the mid-1990s. Total managed expenditure had also fallen to a relatively healthy 37 per cent of GDP, which was about seven percentage points lower than at the end of the Thatcher years.

By and large, British public finances looked fine. The British certainly felt good about themselves. So good in fact that Chancellor Gordon Brown even claimed that he had personally abolished the business cycle. “No more boom and bust’, Brown promised.

In hindsight, this was the time the British made the biggest long-term mistakes about their finances. The position of relative fiscal strength was reversed within the short space of a decade, partly because for a long time the British ignored their actual exposure to debt. National debt may have looked small and manageable, but some areas had always been excluded from the official data.

In the fiscal year of 2000/2001, official debt stood at £381 billion. But taking into consideration unfunded public sector pensions of £434 billion and unfunded state pensions of £1.4 trillion, Britain’s real debt had already reached close to £2.3 trillion.

In other words, Britain’s debt did not stand at 31 per cent of GDP as the British government claimed at the time. It was a full two hundred points higher, namely 231 per cent of GDP.

Unfortunately, the official debt figures were taken as an invitation to spend more and more and more. After all, the public was not too concerned about public debt. And so the government under Tony Blair and Gordon Brown kept spending on their pet projects.

For example, under the Labour government, about 800,000 extra jobs were created in the public sector. The Conservative opposition under David Cameron were complicit in this policy as they did not dare to oppose these measures.

Apart from increasing spending, the British government did nothing to address the issues in its two pension systems. In both state pensions and public sector pensions, liabilities ballooned. In nominal terms, they nearly tripled in a decade.

When the financial crisis hit Britain, public finances were in a sorry state. Today, the British government officially estimates its national debt to be £890 billion – or 63 per cent of GDP. The actual figures are much higher, though.

Including pensions, both state and public sector, and further including public finance initiatives, Network Rail, and nuclear decommissioning liabilities, we are talking about a total of just under £5.3 trillion – or 376 per cent of GDP. Including the government’s exposure to the debt of RBS/Lloyds, the figure goes up to 560 per cent of GDP.

Once a country reaches total debt several times it annual economic output, there should not remain any question what needs to be done. When if not now should the British government cut back on public spending? To question Osborne’s assessment that Britain was just one step from the fiscal abyss you either need to be blind or the recipient of a Nobel Prize in Economics.

The critics of Osborne’s measures are also wrong in another sense. They seriously seem to believe that the UK government had just proclaimed a return to 19th century government sizes. At least that is what all their shrill talk about ‘austerity’ implies.

With all due respect, this is nonsense.

As Jeff Randall, editor-at-large of London’s Daily Telegraph, just pointed out the total amount of cuts presented in the Comprehensive Spending Review will only return government spending in real terms to where it had been in 2006/2007. This, of course, presumes that Osborne will actually be able to implement the review in its entirety, which is far from certain.

Even if Osborne managed to cut spending as planned, bringing public spending back to the level of three or four years ago hardly looks like the cure for Britain’s public finance black hole. The cuts are necessary, but in fact they are only a first step. Before too long, further measures will be required.

The problem with Keynesians like Krugman and Stiglitz is that they are theoretically committed to balanced budgets, but only in the long run. But as no other than Keynes taught us, in the long run we are all dead. In the meantime, his disciples will never tire to explain why the right time to cut spending is never.

In the British case, Osborne has fortunately ignored their advice. The moves of the British government towards fiscal consolidation do not come a day too early.