Fiscal policies: illusion of manoeuvrability

The markets and the currency are taking a hit, after the inconclusive result of the general election. It was clear since the beginning of the election campaign that whoever forms the next government will have to tackle the government’s deficit. European Commission’s European Economic Forecast – Spring 2010 suggests that the UK’s deficit will be at 12% this year and therefore the highest in the EU.

There was a clear dividing line between the Conservatives, who saw the necessity of cutting the deficit by reducing public spending, and Labour which argued for a prolonged stimulatory input by the state to secure economic recovery, therefore decided that an increase in NICs was necessary. The Liberal Democrats also argued that state still has a role in supporting the economy, but they also wanted to restructure the tax system. In one respect, this is a question of timing: the Tories would focus on reducing the deficit immediately, whereas Labour and the Liberal Democrats saw danger in turning off this supply which may lead to a double-dip recession, yet their risked a loss of market confidence. In another respect, it is about proportion: how much of the money will come from public spending, and how much will be raised from taxes?

The problem is that markets do not seem to have made up their mind about the limit of debt that the UK can afford. The UK hasn’t borrowed beyond its credit line, but it doesn’t know what that amount is. If the markets think that the UK has the ability to repay, then running a reasonable deficit should not present a huge problem. If, however, the markets believe that the UK is spending profligately and unsustainably, then the state can land in big trouble.

The Irish and Greek politicians had to accept that drastic measures were absolutely necessary. However, because of the gravity of the situation, there was little that politicians could do, but to make cuts in public spending and implement tax rises. There were a few alternatives, such as bankruptcy, which were really no options. The room for manoeuvre for the governments in these countries was very limited, and to that extent, their decisions became de-politicized, or at least serious parties could not oppose the measures.

If the incoming government’s fiscal policies lack credibility and direction, then the country may face acute problems in the Irish or Greek model. The situation will be exacerbated, if the government is unstable, because it does not enjoy a majority in the Commons, or because there is a huge gulf in policies between parties in a coalition.

Perhaps even more dangerous for the country than a stark fiscal situation is the illusion of manoeuvrability, in which the government can’t do much, while people believe that governments can change things. The new government must control the state’s finances. Givn it is borrowing huge amounts, there are only a few ways to deal with such deficit: cutting the expenditure by reducing public spending, raising income to cover the expenditure and pay for the debt (i.e. taxes), print money ("quantitative easing").

The government may think it has a room for manoeuvre, and perhaps more importantly, the opposition also thinks the same, and act as an adversarial opposition. So political points will be scored. The government will shy away from making the really tough, vote-losing, policies, especially if an election is imminent because of its minority or fracture within the coalition. If the government decides to cut the deficit by cutting public spending quickly, it can result in a double-dip recession, but if the spending cuts are not made early enough, then the markets decide that the government is borrowing too much, then the there will be a financial meltdown.

The new prime minister may share some of the same experiences as Mr Brown. He has handled the economic crisis reasonably well by most accounts, and he did provide leadership, when the world was stuck with a lame-duck Mr George W Bush, and some Europeans were in denial. It’s impossible to know what would have happened had someone not done something that he or she had had done. The new prime minister and his cabinet may be competent and manage to avoid the worst, yet people will still feel that they have been hard done by the fiscal and economic situation, thus blame the government. It’s difficult to convince people about hypothetical situation: it could have been much worse, but then it didn’t happen, because we took the necessary measures.

Given the onerous burdens that the UK state bears at the moment, hurtful reforms – both cuts in public spending and a rise in taxes – are unavoidable. Any party that denies such would be stretching everyone’s credulity. If only all political parties can come out clean to tell the people of Britain how deep and serious the problems are. If not, the British electorate may have the same, almost phoney, debates that they saw between the three main parties prior to this election. If none can be honest, political parties will try to hide and deny the depth of the problem, promise a lot, and blame the other parties for the woe, since they all believe that the parties, government and parliament can change things, even when they do not.

On this issue, I believe Mr Clegg was right in the campaign to stress the need for a broad consensus. At the moment, politicians are not forced to take a hugely prescriptive course of action determined by outside institutions and markets. While the room for manoeuvre is not large, there is still room. If the politicians cannot agree on a workable plan soon that is bearable for the people and satisfies the markets, the room will become progressively smaller. This may well be the last chance for the politicians to show that they can deal with the fiscal problems, without being told in no uncertain terms by someone else.