Shock N Awe

Austerity and stimulus: Ricardo, Ed Balls and shock'n'awe | The ...

IS IT time for the UK government to change course on its austerity programme? That is the case made by Ed Balls, the opposition finance spokesman (and a one-time colleague of this blogger). He takes the view that the government is trying to cut the budget deficit too quickly and thus damaging the economy; it needs to reverse course and cut VAT.

But has austerity really bitten in the UK? Take a look at the data . On page 4, you will see the comparison between April 2010 (when Ed Balls was still in office) and April this year. Tax receipts are down by £300m, while expenditure is up by £2.6bn. Some £700m of that is down to higher social benefits which Mr Balls might blame on government policy (although in fact the unemployment record has been pretty good; see Martin Wolf in today's FT ). General spending excluding benefits and interest has risen.

Ah, Mr Balls might say, we have still had the rise in VAT and the weakness in the economy followed the autumn spending review when the government unveiled the scale of the cutbacks. But the weak quarter for GDP growth came in the last three months of 2010, before VAT went up, while (as we have seen) public spending has not yet dropped.

It could be, of course, that the prospect of the VAT increase depressed spending in the fourth quarter and the prospect of public spending cuts is affecting consumer decision now.  This is close to a concept known as Ricardian equivalence, and is named after the 19th century economist David Ricardo*. The idea is that individuals adapt their behaviour to adjust to government budget shifts. But this is tricky ground for Mr Balls to occupy since, if one believes in Ricardian equivalence, the whole idea of a government stimulus flies out of thew window; people will recognise that a deficit now means higher taxes tomorrow and will adjust spending accordingly.

The debate also raises another point about budget deficits, which one might call the shock'n'awe trap. Start by considering that public spending, in cash terms, is slated to rise every year for the next five; that the budget will be in deficit all that time; and that the government is aiming only to eliminate the structural deficit, not the cyclical portion that allows for the weak state of the economy. On that basis, the programme doesn't sound very austere at all.

But the key factor, as far as economists are concerned, is not whether the budget is in deficit or in surplus; it is whether that deficit is larger or smaller than the previous year. If the deficit falls from 10% to 8% of GDP, that still counts as policy tightening, even though the government may be spending well beyond its means.