An email from David Cameron to Conservative supporters on Monday evening promised that the new Government would “tackle Labour’s legacy of debt”. No mention, of course, that the Conservative party were complicit in calls for light touch regulation and had been calling for years for an end to “burdensome” and “unnecessary” regulation. They will do this by focusing on “benefits, tax credits, and public sector pensions“. But there is an alternative to “Osborne’s bombshell“.

The graph below from the Institute for Fiscal Studies shows how Government revenue and spending has widened since the recession started. It shows clearly that before the crash, current spending excluding capital projects and revenues were virtually in balance. The deficit has been caused by increased spending – primarily due to automatic stabilisers such as unemployment benefits and the financial sector bail outs – but also by falling tax receipts.

In this public finance environment, it is extraordinary that the Coalition Agreement argues for several tax cuts including:

• an increase in the personal allowance for income tax – a Lib Dem priority which does nothing for the poorest families;

• a regressive move to cut to the planned increase in employer National Insurance – dubbed Labour’s “jobs tax“, ironic given the Government’s focus on cutting public sector jobs;

• reductions to the corporation tax rate which will do little to boost private sector output;

• a freeze to Council Tax in England for at least a year; and

• the introduction of a transferable tax allowances for married couples to “recognise marriage in the tax system” – a policy which will discriminates against single parents, widows, and married couples where both couples are in full-time work.

Recent research by Stan Greenberg shows that tw0-thirds of voters believe that “it is not the time to cut taxes” (p.44). Some spending cuts will, of course, be necessary (who really mourns the loss of ID cards?) while the overall level of spending will fall if the recovery is secured. But the Government’s planned attacks on the solidarity and redistributive impact of the welfare state is only one approach to deficit reduction. The alternative is to abandon these tax cuts and push ahead with many of the progressive tax raising proposals in the Compass report, ‘In place of cuts‘.

UPDATE 13.10:

Paul Krugman has an excellent blog outlining why the “fiscal austerity” of Cameron, Merkel and others is affecting the rest of the world:

We do have a framework for thinking about this issue: the Mundell-Fleming model. And according to that model (does anyone still learn this stuff?), fiscal contraction in one country under floating exchange rates is in fact contractionary for the world as a hole. The reason is that fiscal contraction leads to lower interest rates, which leads to currency depreciation, which improves the trade balance of the contracting country — partly offsetting the fiscal contraction, but also imposing a contraction on the rest of the world. (Rudi Dornbusch’s 1976 Brookings Paper went through all this.)

http://www.leftfootforward.org/2010/06/the-alternative-to-osbornes-bombshell/

The UK should tighten fiscal and monetary policy now, in the depths of a slump. That, in essence, is what the Organisation for Economic Co-operation and Development calls for in its latest Economic Outlook. I wonder what John Maynard Keynes would have written in response. It would have been savage, I imagine.

The OECD argues: “A weak fiscal position and the risk of significant increases in bond yields make further fiscal consolidation essential. The fragile state of the economy should be weighed against the need to maintain credibility when deciding the initial pace of consolidation, but a concrete and far-reaching consolidation plan needs to be announced upfront.” Furthermore, monetary tightening should begin no later than the fourth quarter of this year, with rates rising to 3.5 per cent by the end of 2011.

Let us translate this proposal into ordinary language: “If you are unwilling to starve yourself when desperately ill, nobody will believe you would adopt a sensible diet when well.” But might it not make sense to get better first?

Here are some facts, to keep the hysteria in check: the UK economy is operating at least 10 per cent below its pre-crisis trend; the OECD estimates the “output gap” – or excess capacity – at slightly over half of this lost output; the UK government is able to borrow at a real interest rate of below 1 per cent, as shown by yields on index-linked gilts; the yield on conventional 10-year gilts is 3.6 per cent; the ratio of gross debt to gross domestic product was 68 per cent at the end of last year, against 73 per cent in Germany and 77 per cent in France and an average of 87 per cent since 1855; the average maturity of UK debt is 13 years, according to the International Monetary Fund’s Fiscal Monitor; and, yes, core inflation has risen to 3.2 per cent, but that is hardly a surprise, given the large – and essential – sterling depreciation.

Above all, the private sector is forecast by the OECD to run a surplus – an excess of income over spending – of 10 per cent of GDP this year. On a consolidated basis, the UK’s private surplus funds nearly 90 per cent of the fiscal deficit. Thus, fiscal tightening would only work if it coincided with a robust private recovery. Otherwise, it would drive the economy into deeper recession. Yes, that is a Keynesian argument. But this is a Keynesian situation.

I agree that there needs to be a credible path for fiscal consolidation that would lead to a balanced budget, if not a surplus. That will be essential if the UK is to cope with an ageing population in the long term. I agree, too, that the path needs to be spelled out. Given the high ratios of spending to GDP – close to 50 per cent – the best way to proceed is via tight, broad-based, long-term control over expenditure. But a substantially faster pace than envisaged by the last government might threaten recovery: the OECD, for example, forecasts economic growth at 1.3 per cent this year and 2.5 per cent in 2011. Even this would imply next to no reduction in excess capacity.

Of course, one might argue that ultra-loose monetary policy should be used as an offset. But the OECD wants to remove that support, too. Why the OECD makes this recommendation is beyond me.

A good argument might be that monetary policy is a damaging way of refloat the economy, since it tends to weaken the exchange rate (and so raise inflation), increase prices of houses and other assets, and encourage borrowing by a grossly over-indebted private sector. But if one took this line, one should surely argueagainst rapid fiscal tightening. Thus, while the conventional wisdom is that the best combination is tight fiscal policy and ultra-loose monetary policy, that might be a mistake.

Against the background of rapid fiscal tightening, even ultra-loose monetary policy might prove ineffective. The growth of broad money and credit remains very low, for example. Moreover, sterling’s real effective exchange rate has stabilised since early 2009 and the pound has recently strengthened against the euro. None of this suggests that monetary policy is now too loose. That would be still more true after a big fiscal contraction. If there were a sharp monetary tightening as well, the chances of renewed recession are very high, particularly now that the eurozone seems likely to be more feeble than hoped a few months ago.

The OECD seems to take the view that the only big risk is a loss of fiscal and monetary “credibility”. It is not. The other and – in my view, more serious – risk is that the economy flounders for years. If that happened, eliminating the fiscal deficit would be very hard.

If, as the OECD and Britain’s coalition government believe, fiscal tightening must be accelerated, the corollary is ultra-loose monetary policy, until recovery is established. If, alternatively, monetary policy is ineffective, as it may be, fiscal tightening should be announced, but implementation should be postponed until recovery is secure. I have now lost faith in the view that giving the markets what we think they may want in future – even though they show little sign of insisting on it now – should be the ruling idea in policy. So now should the OECD.

martin.wolf@ft.com

More columns at www.ft.com/martinwolf

What’s the greatest threat to our still-fragile economic recovery? Dangers abound, of course. But what I currently find most ominous is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.

When the financial crisis first struck, most of the world’s policy makers responded appropriately, cutting interest rates and allowing deficits to rise. And by doing the right thing, by applying the lessons learned from the 1930s, they managed to limit the damage: It was terrible, but it wasn’t a second Great Depression.

Now, however, demands that governments switch from supporting their economies to punishing them have been proliferating in op-eds, speeches and reports from international organizations. Indeed, the idea that what depressed economies really need is even more suffering seems to be the new conventional wisdom, which John Kenneth Galbraith famously defined as “the ideas which are esteemed at any time for their acceptability.”

The extent to which inflicting economic pain has become the accepted thing was driven home to me by the latest report on the economic outlook from the Organization for Economic Cooperation and Development, an influential Paris-based think tank supported by the governments of the world’s advanced economies. The O.E.C.D. is a deeply cautious organization; what it says at any given time virtually defines that moment’s conventional wisdom. And what the O.E.C.D. is saying right now is that policy makers should stop promoting economic recovery and instead begin raising interest rates and slashing spending.

What’s particularly remarkable about this recommendation is that it seems disconnected not only from the real needs of the world economy, but from the organization’s own economic projections.

Thus, the O.E.C.D. declares that interest rates in the United States and other nations should rise sharply over the next year and a half, so as to head off inflation. Yet inflation is low and declining, and the O.E.C.D.’s own forecasts show no hint of an inflationary threat. So why raise rates?

The answer, as best I can make it out, is that the organization believes that we must worry about the chance that markets might start expecting inflation, even though they shouldn’t and currently don’t: We must guard against “the possibility that longer-term inflation expectations could become unanchored in the O.E.C.D. economies, contrary to what is assumed in the central projection.”

A similar argument is used to justify fiscal austerity. Both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea — not only does it deepen the slump, but it does little to improve the budget outlook, because much of what governments save by spending less they lose as a weaker economy depresses tax receipts. And the O.E.C.D. predicts that high unemployment will persist for years. Nonetheless, the organization demands both that governments cancel any further plans for economic stimulus and that they begin “fiscal consolidation” next year.

Why do this? Again, to give markets something they shouldn’t want and currently don’t. Right now, investors don’t seem at all worried about the solvency of the U.S. government; the interest rates on federal bonds are near historic lows. And even if markets were worried about U.S. fiscal prospects, spending cuts in the face of a depressed economy would do little to improve those prospects. But cut we must, says the O.E.C.D., because inadequate consolidation efforts “would risk adverse reactions in financial markets.”

The best summary I’ve seen of all this comes from Martin Wolf of The Financial Times, who describes the new conventional wisdom as being that “giving the markets what we think they may want in future — even though they show little sign of insisting on it now — should be the ruling idea in policy.”

Put that way, it sounds crazy. And it is. Yet it’s a view that’s spreading. And it’s already having ugly consequences. Last week conservative members of the House, invoking the new deficit fears, scaled back a bill extending aid to the long-term unemployed — and the Senate left town without acting on even the inadequate measures that remained. As a result, many American families are about to lose unemployment benefits, health insurance, or both — and as these families are forced to slash spending, they will endanger the jobs of many more.

And that’s just the beginning. More and more, conventional wisdom says that the responsible thing is to make the unemployed suffer. And while the benefits from inflicting pain are an illusion, the pain itself will be all too real.

By PAUL KRUGMAN

The government’s proposed cure for the ailing British economy could be a bit like applying leeches to 18th century patients: worse than the disease

Like all sensible people, I hope that David Cameron and George Osborne know what they are doing when they set out to chill our collective spine as they do in all the newspapers this morning about the scale of the coming cuts to public expenditure.

It was a warm-up for the PM’s big “everyone’s life is going to change” speech today.

But like many sensible people I have my doubts about the wisdom of this carefully choreographed exercise ahead of the chancellor’s 22 June budget. If they do what they say – I am still hoping that they don’t meant it – the cure could be a bit like applying leeches to 18th century patients: worse than the disease.

It was wholly predictable that when they came to power they would open the Treasury books and declare it all to be much worse than they feared. All new governments say that. So it doubtless is in some respects.

But in those respects that matter most it’s not, it’s better, not least when compared by some airheads with the plight of Greece. Even that £156bn deficit they keep talking about is £20bn less than it was predicted to be not so long ago. That is not an insignificant sum.

The urgent case for cuts is that a combination of Gordon Brown’s structural budget deficit – 4%? 6%? – and the cost of rescuing the banking system is unsustainable and must be rectified as soon as possible.

The fear is that without a clear plan for deficit reduction the belatedly panicky credit rating agencies – the people who failed to spot the emerging banking crisis – will mark down Britain’s triple-A credit rating, as they recently did Greece and Spain: the sovereign debt crisis that has engulfed the eurozone.

If that happens lenders will require higher interest payments in return for funding our debts and more cuts will be required to keep up the payments: the kind of downward spiral that so hurt public spending in the Thatcher-Major years.

All true enough, but the key word is “plan”. We need ministers to sound as if they mean it, as Alistair Darling was starting to do with his deficit reduction plan after facing down Brother Brown.

The papers today are full of talk of the Lib-Con coalition’s “Geddes Axe” in the 1920s and – more recently the federal Canadian government’s 20% cuts in the 1990s, as here in the Daily Telegraph. When I wrote about it last year – it was promoted by the new Institute for Government – I made a serious error. I forgot that the Canadian provinces do most of the spending, so the parallel is inappropriate.

But that’s a detail. The real threat lies in all states that have overdone it – the US is the prime example – dashing to rebalance their economy, public and private sectors, as advised by the hairshirted states – Germany is the prime example.

The result: hopes of renewed growth collapse and the world falls back into beggar-my-neighbour recession. It’s growth that will float the debt away most effectively. Remember, Margaret Thatcher’s savage cuts in the early 80s worked in market terms but did unnecessary damage to UK industry in the process.

In the IMF crisis of the 70s Denis Healey – a man of great self-confidence – had to fight gloomy Treasury predictions that with hindsight turned out to be excessive. The Treasury will be keen to take advantage of the new team’s youth and inexperience to reverse both Labour mistakes and Labour’s values. None of them resigned in protest, I note in passing.

Bear in mind the following facts as you soak up the masochism. The UK economy is currently operating at 10% below its pre-crisis trend. The British government can borrow at real interest rates below 1%. The ratio of debt to GDP was 68% by the end of 2009-10 against 73% in Germany, 77% in France and an average of 87% over the last century or so.

Cheer up. British debt, mostly funded by British lenders who are saving madly – as in so much, unlike Greece – also has a much longer maturity, 13 years on average: no panic. British savers can finance British borrowing, and until the private sector recovers the state sector had better keep on spending if we are to avoid renewed recession.

If the new government raises taxes, cuts spending and – just for luck – tightens monetary policy too via higher interest rates and does so too quickly, we are all going to feel the pain all right. And soothing words from Nick Clegg in yesterday’s Observer – soft cop to Dave’s tough cop – will not save us.

Michael White Guardian