Britain Must Get Its Fiscal House in Order

A group of leading economists, including one former chief economist of the International Monetary Fund and a former deputy governor of the Bank of England, recently signed a letter, warning of the need for significant fiscal tightening in the U.K.:

“In the absence of a credible plan, there is a risk that a loss of confidence in the UK’s economic policy framework will contribute to higher long-term interest rates and/or currency instability, which could undermine the recovery.”

Among the signatories is Harvard economist Kenneth Rogoff, co-author of This Time Is Different, in which he shows how, throughout history, financial crisis often lead to fiscal crisis.

Britain is a case in point. Its “budget deficit is now the largest in our peacetime history and among the largest in the developed world,” the letter states. The conservatives, if they gain power, will push for fiscal consolidation soon after the general election coming up in May. Labour thinks this is too early, as the British economic recovery is still in a fragile state. However, by tightening its fiscal policy too late, the government could make things much worse. Public borrowing, needed to finance the unprecedented peace-time deficit, will crowd out private investment, thereby further weakening the country’s fiscal position.

This will in turn put pressure on the central bank to “accommodate” public borrowing (bond issuing) by printing more money. This is one reason why the pound is weakening. On the suspicion of further depreciation of the pound, foreign holders of British debt will demand even higher yields, pushing long-term funding costs even higher, and making the debt burden harder to service as interest payments shoot up. This is in other words a recipe for fiscal disaster, unless drastic measures are taken in the near future.

By bidding away capital from the private sector, and by pushing up long-term interest rates, the British government will make it hard for a full private sector recovery, thereby increasing the possibility of a sluggish recovery for years to come.

The alternative would be a painful, but highly necessary fiscal tightening, leading to significant spending cuts and tax increases. The signatories of the letter recommend the authorities to focus on the first, as this will be more conducive to economic recovery:

“The bulk of this fiscal consolidation should be borne by reductions in government spending, but that process should be mindful of its impact on society’s more vulnerable groups. Tax increases should be broad-based and minimize damaging increases in marginal tax rates on employment and investment.”