"It's easy! Cut your spending, dummy!"

So the axe finally has fallen. After a summer of multiple announcements of public expenditure cuts, the crescendo was reached this afternoon when Chancellor George Osborne delivered his statement on the comprehensive spending review to a packed House of Commons. Over the next four years, most government departments will be expected to reduce their budgets by an average of 19%. Health, which was ring-fenced, is only to receive a marginal increase in its budget. By the end of this Parliament, Britain’s structural deficit—the deficit that the government still runs even if the economy is operating at full capacity—should be eliminated. Together the spending review will fundamentally change how the British economy will be structured, possibly for many years to come.

Keynesian economists and the Labour party worry that contractionary fiscal policy at a time when private sector recovery has not been secured would dampen aggregate demand and trigger a double-dip recession. They have a point. This is especially since the normal engine to private sector-led recovery, the financial sector, is still not operating at full capacity yet. If the public sector is going to cut now, who will fund private sector recovery?

While the argument is valid, it misses a key point. Running public deficits may be important to stimulate economic recovery, but deficits do not finance themselves; money has to be borrowed from elsewhere. Partly to rescue the banks from failure, public sector borrowing has reached stratospheric heights, standing at more than 11% of Britain’s gross domestic product at the time of the Mr Osborne’s emergency Budget in June.

The Labour government was right to take decisive action to stabilise the banking sector, but it also created a problem by borrowing so much extra. Loans mean interest, and as Britain’s debt increased, so did its interest obligations. This year alone, £43 billion will be paid to financial institutions simply to service Britain’s debt. That amount is more than what the government spends on the police, housing and the environment, industry, or defence. Servicing debt represents a deadweight loss to the British economy, as the money is not spent to stimulate the economy. The more we borrow, the higher the debt interest, and the greater the deadweight loss to society. Therefore it makes much sense to rein in spending in order to reduce our borrowing.

The Keynesian argument isn’t completely dead yet, however. The government has pledged to protect many investment projects in infrastructure, research, sunrise industries, education and enterprise creation. Public sector job losses, projected to amount to half a million over the next four years, will be achieved mainly through natural wastage and unfilled vacancies. When money is tight, one should spend on what will be most likely to guarantee greater revenue in the future. 

Almost fortunately, the cuts are being implemented by a coalition government whose dominant party is ideologically inclined to have a smaller state*. The spending cuts match the natural ideology of the Conservatives: shrinking the state and encouraging the private sector, local government and civil society to take more of the burden of running the country. That will make implementing the whole package of reforms a smoother and more logical process. Reform in schools and the benefits systems and updating Britain’s defence capabilities to reflect the post-Cold War world should all eventually contribute to long-term reductions in public spending and more effective governance.

It won’t be a surprise to readers when I say that I feel that the broad direction of the government’s plan is right: debt over-accumulation is generally bad, and I am all for a smaller state in exchange for a larger private sector-led economy and volunteer-led society. In any case, I haven’t got much choice; credible or not, the coalition’s plans are the only ones on the table at the moment. For all its predictable protestations, the Labour party has yet to come up with any kind of updated proposal to sort out the economy and the public finances (the 19% spending cuts announced today are on par with Labour’s initial proposals of 20% anyway). Perhaps Alan Johnson is waiting for his copy of “Economics for Dummies” to arrive from Amazon. Britain now badly needs the opposition to get its act together. Let’s hope it gets it sooner rather than later.

* I don’t know why British politicians, including the Prime Minister, use “ideology” as if it’s a dirty word; it’s just a synonym for a set of principles, and nobody complains about government by principle. In fact, the years of state expansion under Labour have, I suspect, been in part driven by the socialist instinct of “Father knows best”. Under Labour, government grew by piecemeal, building up huge complexities and inefficiencies. It makes sense now to wield the shears to trim away the overgrown branches. After all, if a crisis doesn’t force us to take drastic action, what will?

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