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Why George Osborne should stick to ‘Plan A’

This week’s GDP figures, which show a quarterly drop of 0.7 per cent, should not have come as a surprise. Nor should they induce a reversal of the Chancellor’s drive to cut public spending and the deficit. The truth is that economies with big public-spending-to-GDP ratios have difficulty growing. And Britain is a big public spender. We now spend around 50 per cent of GDP according to some estimates, after Gordon Brown allowed this figure to creep up from 36 per cent.

The question now raised is whether George Osborne, who wants to cut the deficit and has begun to curb levels of public spending (‘Plan A’), should change course and go for ‘Plan B’, a Keynesian stimulus?

Such a decision would be misguided to say the least. Not only are UK public spending levels historically high, but there’s little evidence that another stimulus would bring growth. That’s partly because today’s recession is characterised by unprecedented debt – domestic, cross-border and international, which is one reason why Politeia’s economic analysis distinguishes present conditions from those of the interwar depression. (See  here).

Next week Politeia publishes Realistic Recovery: Why Keynesian Solutions Will not Work. The author, Professor Vito Tanzi, a former IMF Fiscal Affairs Director, explains that this recession is marked by the unsustainable deficit and debts in many countries, by the precarious fiscal balances which developed even before 2008, and by distorted economies where boom industries have gone bust and borrowing costs rocketed.

The solution is not more debt to finance so-called stimulus, but a policy that cuts levels of public spending and embarks on structural reform. The state will have to downsize. If the UK is to protect its social provision, it will have to make judicious use of competition among private contractors to provide efficient public services. As Vito Tanzi says, the magic number for public spending is around 35-40 per cent of GDP. Countries which have reached this figure are able to provide a full package of social goods like healthcare and education, without crippling levels of taxation. Just look at Canada and Switzerland.

Few will doubt the difficulties faced by the Chancellor: international economic instability, inherited debt, unprecedented public-spending-to-GDP ratios. George Osborne has made a sensible start. But if the UK is to recover and go for growth, Mr Osborne will have to aim in the longer term for public spending at around 35-40 per cent of GDP. This will bring down the level of tax. And the evidence is that only with a smaller state will the economy really grow.