Is less really more?

Searching for the roots of trans-atlantic economic policy divergences.

In the early 1980s, the infamous Laffer curve, named after Arthur Laffer, a professor of economics at the University of Chicago, was the economic concept right-wing Republican politicians deployed to help them justify the economic policies of the then US president, Ronald Reagan. 

In its political guise, it was a simple idea designed to seduce simple souls. Republican tax cuts would pay for themselves. The cuts would stimulate economic activity to such a degree that tax revenues from the extra growth would rise by more than the revenues lost from cutting tax rates.

There is a parallel today in the debate about budget deficits and fiscal austerity in the United Kingdom and other EU countries.

In the UK, simple souls on the right are saying that the swingeing cuts to government spending that the new Conservative/Liberal administration is about to announce will mirror the ‘less is more’ Laffer paradox.

Don’t worry about the impact on growth, they say. The cuts will unleash the animal spirits of the private sector from the burdens of state spending and the taxes needed to support it. This will liberate entrepreneurs, who, red in tooth and claw, will rebuild the British economy, even its hollowed-out manufacturing sector.

For left-of-centre politicians in the UK, such as the recently elected Labour Party leader Ed Miliband, this is moonshine, and Ireland’s experience, they argue, proves it.

When the financial crisis struck in 2007, Ireland was widely praised for quickly battening down the hatches and beginning to rein in government spending. A fat lot of good it has done them, lefties say.

Ireland’s economy has slumped and the financial markets taken fright anyway. Last week (30 September) this required another bank bail-out, this time a massive one, up to €50 billion, which could drive the budget deficit to 32% of gross domestic product (GDP). Even so, another round of fiscal austerity will still be needed later this year.

The new UK government’s planned budget austerity, these left-wing critics say, is just an old-fashioned, right-wing ideological assault on the welfare state. Just as in Ireland, it will suck demand out of the economy and probably trigger the dreaded ‘double dip’ recession.

Policymakers divided

Interestingly, some top policymakers at the Bank of England seem worried too. Last week (27 September), Professor Charles Bean, a member of the Bank of England’s monetary policy committee and a man known to be close to Mervyn King, the bank’s governor, astonishingly called for people to spend to support the economy, even if this meant running down their savings.

The next day Adam Posen, another board member, albeit an American known to be close to Ben Bernanke, the chairman of the US Federal Reserve Board, came out in favour of the Bank of England injecting money into the economy by buying government bonds directly with money it has created, so-called quantitative easing.

The Fed, which is as divided as the Bank of England, is also thinking along these lines. Posen, like Bernanke, seems to believe that even more easy money is the tool to use to jolt the economy into a swift, normal ‘V-shaped’ recovery and head off the deflation they fear today, as they did (wrongly) in 2001.

Eurozone members, meanwhile, are taking a more measured view. The European Commission has drafted legislation for a new and tougher stability and growth pact. And in the past few weeks, Greece, Portugal and Spain (seen to be among the most vulnerable EU economies, along with Ireland) have embraced more fiscal austerity. France too produced a relatively tight budget last week (28 September).

But it is not just massive post-crisis deficits, huge debt levels, the heavy burden on state finances of unreformed welfare systems and ageing populations that are encouraging eurozone members to embrace fiscal consolidation.

They recognise that both short- and longer-term interest rates are at unsustainably low levels, driven there partly by unprecedented monetary-policy efforts to deal with the 2007-09 crisis. At some point, assuming no double-dip recession, they will have to rise to ‘normal’ levels, something economists at Barclays Bank expect in the second half of next year. This will put added pressure on budget deficits.

This business cycle will almost certainly turn down again at some point within the next five years. Eurozone governments do not want to enter that cyclical downturn with official debt to GDP ratios of above 100% – a level to which many are heading – and with both monetary and fiscal policy flexibility in a state of paralysis.

But there are signs that, despite worrying divergences, the eurozone economic recovery is on track. In a development remarked upon too little, German consumers may finally be purchasing more. If so, this will underpin the vibrant, export-led recovery under way in Europe’s economic dynamo, offering the eurozone a shaft of light not visible in the UK or the US.

So, far from following the Bank of England/Fed line and considering even looser monetary policies and running the intensifying inflationary risks associated with such a step, the European Central Bank is, rightly, continuing cautiously to reverse its exceptional, crisis-induced liquidity-injection policies. For a visibly strengthening eurozone economy, this is the right stance.

The new UK coalition government is, for longer-term electoral (as well as ideological) reasons, almost certainly dangerously front-loading its budget cuts onto an unbalanced economy. It should cut more slowly. Washington, facing near 10% unemployment levels, is playing politics too, looking for ways to both boost demand at home and, through the tacit threat of dollar devaluation, putting pressure on China (and Europe) to follow suit.

Like the simplistic versions of the ‘Laffer curve’ peddled by right-wing ideologues 30 years ago, measuring these differing fiscal and monetary stances by their position on some ‘austerity meter’ is to promote an ideological, not an analytical, response to widely differing political-economic realities.

Stewart Fleming is a freelance journalist based in London.

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