Today marks the end of the first 100 days of the Coalition Government. So how is it doing? Well its still very early days, but I think its a fair guess that the defining issue for this Government, as for most others, will be the economy. If the economy recovers well from the current recession, then voters will be likely to give it further support. If not then the odds would be that Labour would win back power at the next election.
My assessment of progress so far is pretty postive; the medecine is undeniably bitter, but so far it looks like being the cure we need. The central issue is the budget deficit and how fast to cut it.
It is important to recognise that the budget deficit consists of two very different components. One element is the usual result of a recession - as the economy falters (as it was doing in the summer of 2008 before the banking crisis that followed made it much worse), tax revenues fall and the demand for benefits and public services rise. Economists refer to this the cyclical deficit, because it disappears again as the economy recovers and taxes revenues recover and public spending falls back again. Cyclical deficits are good things because they help to reduce the impact of the recession on the economy and those dependent on public services.
The problem now is that even when you strip the cyclical deficit out, we are left with a huge long-term or structural deficit. You can dress it up how you like but the simple fact is that this reflects the fact that by the end of the last Labour Government in May we were living well beyond our means. Countries that do this for any length of time, end up going bust. People will only lend to them for short lengths of time and even then will only if there is a clear plan on how the deficit will be reduced.
While its pretty obvious we dont want to go bust, as this would mean effective loss of control of our economic policy, and much harsher cuts to spending and services, its also the case that its vital to keep a significant distance from any risk of going bust. The second international investors think there is even a small risk of the UK defaulting on its loans, they will start to demand a risk premium on their loans. They do this by charging higher interest rates. As interest rates rise, business investment falls, consumers have to cut back on spending and the public sector gets into a vicious spiral of having to borrow more and more money just to pay the interest on our debts.
As a country borrowing £150bn this year (thats around £2,500 for every man woman and child in the UK just for this year) we are dangerously close to getting into such a vicious spiral. This is why the current cuts in spending are so necessary. Painful for a country that had got used to living beyond its means, but vitally necessary to bring our economy back into balance. By taking the medecine now, we will keep interest rates low, boosting investment and long term economic growth.
For sure there is a risk that the cuts in public spending, that are necessary to bring the budget back into stuctural balance will reduce growth in the short-term. But such economic weakness is nothing like the disaster that would follow if we failed to tackle the deficit and interest rates shot up. What’s more there are clear signs that the weakness of the pound is already helping exports to grow and the private sector to compensate for the loss of public sector jobs.
The key thing is to get the economy back into balance and well positioned for sustainable growth. If we get into this situation by the time of the next election, the Government will be well positioned to argue for another term in power.
