Editor's Note: Andrés Velasco, a former finance minister of Chile, is a visiting professor at Columbia University. For more from Velasco, visit Project Syndicate or follow it on Facebook and Twitter.
By Andrés Velasco, Project Syndicate
Visit London nowadays and you will notice something strange going on: the worse the British economy tanks, the more fervently Prime Minister David Cameron’s ministers and Tory economists insist that draconian spending cuts are good for economic growth.
Some observers see this as an act of faith (presumably in the virtues of the unfettered market). Others, such as the economist Paul Krugman, see it as an act of bad faith: the Tories just want smaller government, regardless of the consequences for growth.
The question remains whether there is a non-faith-based argument for cutting back spending to stimulate an economy. The answer is yes. In fact, there are two. Academic research has shown them at work in the past – for example, in Ireland and Denmark during the 1980’s. Unfortunately for the Tories, neither case for stimulative spending cuts fits Britain’s predicament today.
One argument emphasizes the links between fiscal and monetary policy. In a country with large fiscal deficits, the central bank may have to keep interest rates high to control inflation. In this scenario, budget cuts create room for interest rates to fall. If the country has a floating exchange-rate regime, the currency depreciates, too.
Both of these changes are good for demand and growth. If their combined impact more than outweighs the initial contractionary effect of expenditure cuts, then the economy may well pick up after a round of fiscal tightening.
Read: Dying to grow?
But little effort is needed to see that this not the British story today. The Bank of England’s policy interest rate has remained just above zero for more than two and a half years. Regardless of the government’s fiscal-policy stance, this interest rate cannot move below zero.
The second case for expansionary fiscal contraction is subtler. In an economy in which public debt is growing quickly, the longer fiscal adjustment is put off, the larger and costlier it will have to be. Households and companies understand this and cease to consume or invest in anticipation of the painful spending cuts and tax hikes to come. So, the argument goes, a courageous Tory government that cuts spending today spares citizens that future pain. Then, feeling richer and brimming with optimism, the private sector goes on a spending spree and the economy booms.
Put differently: without the budget cuts, Britain would have been Spain – or perhaps even Portugal or Greece. With the budget cuts in place and the markets reassured, Britain no longer risks resembling an unruly Mediterranean country. Thus, Britons will soon start spending again and economic growth will ensue.
So far, so good – except that this story, too, does not apply to Britain. There is no sign of a crisis narrowly averted. Ten-year yields on British government bonds were at historic lows long before Cameron took office. If a crisis was imminent, the markets clearly took no notice. And if the coalition government’s budget cuts had improved expectations about future output, that greater confidence would have shown up in higher equity prices – but there is no evidence of this, either.'
Read: Italy's capital fight.
In short, private demand in Britain is flatlining rather than surging. Add to the mix the collapse in public-sector demand that comes from deep budget cuts, and you have all the ingredients necessary for prolonged stagnation. And stagnation, if not worse, is precisely what recent British economic reports are showing.
The longer this goes on, the more serious the problem will become. The long-term unemployed will drop out of the labor market. Firms that invest little will become uncompetitive. In the jargon of economists, low demand will engender low supply, making a non-inflationary recovery even more difficult to achieve.
What is to be done in Britain? With the eurozone tumbling from crisis to crisis, salvation will not come from abroad. At home, all that is left is unconventional monetary policy. The Bank of England recently injected an additional £75 billion into the economy via so-called quantitative easing. Now, that is real cash, not just an act of faith.
The views expressed in this article are solely those of Andrés Velasco. Copyright: Project Syndicate, 2011.
What the English need to do is to take Great Britain out of NATO, make draconian cuts in it's military spending and just ignore the politicians in Washington! Today, nobody poses any kind of threat to that country whatsoever! Their politicians need to wake up and wise up. The best thing they can do is to get both the Karzai regime and the Taliban to the negotiating table.
On Monday night the British MP's staged a revolt against Prime Minister David Cameron. A split with the coaltion was in the air over the issue of leaving the European Union. Indeed public voices are loud, stating after 40 years of larceny, bullying, over-regulation and all-round interference by Brussels, the time has come for the Brits to "win back their country and restore legitimacy and accountability to their political process".
What do the politicians in Washington have to do with Great Britain?
GB may have lost its prime super power status and much of its Empire after World War 2, however, despite her very limited geographical size she remains one of the leading major powers of the world and with that comes responsibility. Not least, it still has responsibility for the 'fragments' of its former Empire such as the Falkland Islands which willingly wish to remain a British territory despite threats from other countries (like Argentina in the case of the Falklands). Therefore, GB must remain significant military capability to at least deter those who may wish to threaten her interest and pocccessions.
However, agreed, she could certainly save money by stop being 'America's deputy' on the world stage (as per Iraq). She could also arguably take a more limited role in world affairs outside of her immediate sphere of influence (e.g the Middle East)
The Brits dont want to spend more. I maybe wrong but dont you need to spend more as the population grows otherwise how will it grow. Inflation may not be as bad as they think it is.
This is a lot of malarkey. All the English need to do is declare war on France again. It's always worked in the past and it will work again.
Europe is a lost cause. The quasi-socialist, big public sector union economies are beginning to collapse on themselves. The pension obligations are not sustainable.
Are you paying attention, America?
You will see a number of modifications to pensions laws, that can occur via april ... Dan Woodruff is often a licensed financial adviser operating out of Colchester, london, british.emerytura w anglii
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