Since You Asked

In the long run, there’s logic to Liam Fox

‘The pressing case to cut both taxes and spending’

Title of Liam Fox’s article in the Financial Times this week

I see Liam Fox, the former defence secretary, has emerged from his bolt-hole.

What’s the story? Syria? Iran?

No, he’s published an op-ed setting out an economic strategy for the country.

Excellent, he’s branching out. What’s he saying?

He’s saying that George Osborne should change course. If I understand him correctly, he wants the chancellor to adjust both taxes and spending so the size of the state changes, while the path of deficit reduction is unchanged.

Well, that’s wonderful – thank goodness somebody in the government has finally . . .

He’s not in the government any more. Remember Adam Werritty?

 . . . thank goodness somebody with influence on the largest political party has finally discovered the balanced budget multiplier.

The balanced budget multiplier? What’s that?

At the moment we’re locked in a fairly sterile debate. Mr Osborne’s critics say he has raised taxes too quickly and plans to cut spending too deeply, and is thus damaging the economy. Shadow chancellor Ed Balls, in contrast, wants to cut VAT and take the whole deficit-reduction thing more slowly, but the deficit is already so large that this might jeopardise our ability to borrow money cheaply.

And?

The balanced budget multiplier says there’s another way: you can stimulate the economy by raising taxes and spending the proceeds.

Why would that stimulate the economy?

A temporary tax hike makes people poorer, which will reduce their consumption and weaken the economy. However, they will probably also reduce their saving, or borrow a bit more, rather than take the hit all in one go. In contrast every penny of tax revenue will be spent immediately by the government building high-speed railway lines or schools or some such thing. So government spending will rise by more than private spending falls, stimulating the economy even as the deficit itself is unaffected. Hence, balanced budget multiplier. It’s so good to see Mr Fox proposing this.

But he’s not proposing to raise taxes and spending simultaneously; he wants to see them both cut.

Oh.

That’s the opposite of what you are talking about, isn’t it? A sort of “balanced budget shrinkifier”.

Yes it is.

Is that good?

Not so good, no.

But surely your balanced budget multiplier theory can’t be true? Or the Soviet Union would have been the economic success story of the 20th century.

You’re right. There’s a time and a place. The short-run boost to the economy will have a long-run cost as the household spending cuts are spread across several years. What’s more, most taxes have a distortionary effect, which is wasteful. And on top of that, government spending is often inefficient too.

So Liam Fox is right!

He’s almost certainly right in the long term. The UK government is spending
46 per cent of national income this year; most people will think that’s on the high side. But during a recession the balanced budget multiplier is relevant: there are plenty of slack resources that could be used cheaply by government spending programmes. Is that article demanding that action be postponed?

No, he says we must “act urgently”.

Ah. What else does he say?

He wants labour markets to be deregulated so that it’s easy to fire people. This will increase employment, apparently.

That’s not as stupid as it sounds. If it’s difficult to lay people off, employers will be very anxious to postpone hiring new workers for as long as possible, just in case there’s another downturn.

And is that a problem for the UK labour market?

Not really. Paul Gregg, an economist at Bristol University, recently told an RSA summit on jobs that the UK labour market actually performed very well during previous recoveries and, given the severity of this recession, it was surprising that even more people hadn’t lost their jobs. For Professor Gregg, the key problem was unemployment black spots – both geographically and demographically – rather than some basic regulatory flaw in the way the labour market was organised.

At least Mr Fox published his thoughts in the FT.

Indeed. In that respect his judgment is impeccable.

Also published at ft.com.