George Osborne's critics urge him to change course but it would be foolish to renege on deficit reduction now.
The central economic and political battle over the coming year will be whether or not to stick with Plan A in fiscal policy. With the economy weakening in the wake of the euro crisis, the political cry will go out to slow deficit reduction. And the appeal will be supported by legions of economists. Moreover, the case for an activist fiscal policy is simple to make and really connects with the electorate – public spending is part of GDP, less public spending means less GDP, and more spending means more GDP. What could be simpler?
For those with long memories the situation closely parallels the 1981 budget, when the then chancellor, Sir Geoffrey Howe, tightened fiscal policy at the bottom of the recession. In response, 364 economists wrote a letter to the Times warning that "present policies will deepen the depression… and threaten social and political stability". With exquisite timing the economic recovery began almost before the ink was dry on the letter. The economists were wrong then and I believe the same arguments are misplaced now.
The concentrated media focus on fiscal policy misses one key issue, the nature of deficit financing. Any easing in budget deficit reduction, if it is financed by gilt sales to the non-bank private sector, will not expand the money supply.
The euro crisis shows that this is the worst imaginable time to be reneging on deficit reduction, given that the headline deficit numbers are already heading further south because of the weakening economy. In the current febrile financial market environment there would almost certainly be an upward spike in gilt yields if the government were seen to be backsliding on reducing the budget deficit.
The risk posed to gilt yields is a widely held view. Financial Times economics editor Chris Giles has written: "Do not panic Mr Osborne, Plan B is in cloud cuckoo land… The chancellor is right to reject the arguments of the Plan B brigade because the risk that investors would lose confidence in the deficit reduction plan far outweighs the likely small economic gains."
The case against a traditional Keynesian stimulus is very strong and this article touches only on the key issues. Those who wish to investigate this further should read the IoD's Pulse Economic Outlook from November, which set out 10 reasons to stick with Plan A.
Graeme Leach is the IoD's chief economist and director of policy
