What’s surprising about the rating agency’s decision to downgrade the UK’s triple A rating is not that it happened, but it did not happen sooner. The evidence is that Britain’s fiscal situation has been drifting off course almost since the day that the Coalition took office. Although not the end of the world from an economic perspective, it is a major embarrassment for Mr Osborne: he committed himself to maintaining Britain’s AAA rating despite neither being in a position to control the decisions of the independent rating agencies nor appearing ready to take the harsh political decisions needed to bring the public finances – especially, the spending side – under proper control.
The only ‘good news’ associated with Britain’s downgrade is that there are few alternative outlets for international bond investors that appear to be in better shape. This reflects the sharp rise in government consumption (spending) burdens internationally during the present century. These have now overshot the upper limit to taxable capacity – around 38 to 40 per cent of national output in a typical developed economy. With just about every leading nation facing large and unsustainable structural budget deficits, international bond investors have to put their money somewhere and the UK should continue to be able to fund its deficit in the short term. Furthermore, the rise of 30 basis points plus in UK long bond yields since late 2012 suggests that financial markets had already anticipated the Moody’s decision to some degree, or simply reacted more quickly to the same facts.
Should the Chancellor now change course? The Moody’s downgrade most definitely does not justify the ‘Plan B’ policies proposed by Ed Balls, the Shadow Chancellor. The reason Mr Osborne has failed to achieve his fiscal goals is because he has attempted what is known in the fiscal stabilisation literature as a ‘timorous’ Type 2’ consolidation programme. In particular, tax increases have been front-end loaded, public investment has been cut, and current government expenditure and welfare costs have been allowed to overshoot their planned levels. Mr Osborne has either failed properly to get to grips with the spending departments or has been sabotaged in his endeavours by his Lib-Dem coalition partners. There exist countless international studies showing that Type 2 consolidation packages lead to unexpected output weakness and a worsened fiscal position. This literature has been well summarised in earlier Politeia pamphlets by authors such as Vito Tanzi (Realistic Recovery, 2012 and Poverty or Prosperity, 2010) and Ludger Schuknecht (Going for Growth, 2012 and Booms, Busts and Fiscal Policy, 2009).
The Conservatives had thirteen years in opposition to make the case for such an approach. The tragedy is that they wasted the time on modish irrelevancies, such as ‘sharing the proceeds of growth’ and trying to re-brand themselves as the ‘nice’ party.
By contrast to current policies, what is needed is a bold Type 1 package of tax cuts, public consumption reductions, tight control of welfare bills and no public investment cuts. That’s the programme which the Conservatives should have prepared while in opposition and then implemented. And it brings benefits! For it’s normally associated with positive output surprises, reduced joblessness and an improved fiscal position.
*David B Smith is Visiting Professor, Derby Business School, the Chairman of the IEA’s Shadow Monetary Policy Committee and author of Politeia’s Crisis Management: How British banks should face the future.