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«George Osborne: Recovery through fiscal responsibility Speech at the London School of Economics and Political Science (LSE) Friday 31 October 2008 On ...»

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But the head of one fund has already warned that the Treasury can no longer take it for granted that foreign buyers will turn up at bond auctions: “We are nearing the point where Asian and Middle East investors are going to charge a much higher premium for holding British sovereign debt. Once a government loses credibility, these investment shifts can happen with alarming speed.” Already the spread on credit default insurance for UK Government debt has widened from almost zero a year ago to 60 basis points today.

That’s 50% higher than for French debt and twice as high as for German debt.

And there’s another vital reason why we must resist spending splurges and irresponsible borrowing.

An IMF survey published earlier this month concluded that “increases in interest rate risk premiums as a result of debt concerns can render fiscal multipliers negative, suggesting that discretionary fiscal stimulus may do more harm than good.” Put another way, there’s no point pumping more government money in one end of the economy if it delays the lower interest rates that will stimulate private sector activity at the other end.

There’s another reason for fiscal responsibility in a recession.

If you don’t keep control of public finances, you risk saddling your economy with so much debt that it stifles the recovery for many years to come.

That is not a rock of stability. It is more like a ball and chain.

So everyone needs to understand the true weakness of our fiscal position under Labour.

But the head of one fund has already warned that the Treasury can no longer take it for granted that foreign buyers will turn up at bond auctions: “We are nearing the point where Asian and Middle East investors are going to charge a much higher premium for holding British sovereign debt. Once a government loses credibility, these investment shifts can happen with alarming speed.” Already the spread on credit default insurance for UK Government debt has widened from almost zero a year ago to 60 basis points today.

That’s 50% higher than for French debt and twice as high as for German debt.

And there’s another vital reason why we must resist spending splurges and irresponsible borrowing.

An IMF survey published earlier this month concluded that “increases in interest rate risk premiums as a result of debt concerns can render fiscal multipliers negative, suggesting that discretionary fiscal stimulus may do more harm than good.” Put another way, there’s no point pumping more government money in one end of the economy if it delays the lower interest rates that will stimulate private sector activity at the other end.

There’s another reason for fiscal responsibility in a recession.

If you don’t keep control of public finances, you risk saddling your economy with so much debt that it stifles the recovery for many years to come.

That is not a rock of stability. It is more like a ball and chain.

So everyone needs to understand the true weakness of our fiscal position under Labour.

“The speed with which the political debate already is turning to fiscal loosening raises risks that the overall fiscal loosening in the recession and pre-election period will be so big that the fiscal deficit itself will become a destabilising factor for the economy in coming years.” In other words, that Gordon Brown’s desire to spend his way out of the recession will not only make the recession worse, it will undermine the recovery too.

This is not some argument about economic theory.

This is about real lives, real jobs, real homes.

The risky consequences of irresponsibility are not merely a theoretical possibility, they are happening all around us.

The citizens of Ukraine, Hungary and Pakistan are now learning what happens when the markets lose confidence in a whole country.

Their sources of external financing that appeared to be reliable have dried up with astonishing speed.

Several countries in Eastern Europe, Asia and Latin America now risk a repeat of the Asian financial crisis of the late 1990s.

At the moment these problems are limited to emerging markets, but given the remarkable events of recent weeks we cannot be certain they will remain so.

The Governor of the Bank of England himself has highlighted Britain’s unusual dependence on external finance.

The coverage of Mervyn King’s speech last week was dominated by his use of the “R” word, but in a sobering passage he noted that “those external inflows have fallen sharply – a mild form of the reversal of capital inflows experienced by a number of emerging market economies in the 1990s.” That is an extraordinary parallel for the Governor of the Bank of England to have to make.

Even more sobering was the warning that followed: “Unless they are replaced by other forms of external finance, the adjustments in the trade deficit and exchange rate will need to be larger and faster than would otherwise have occurred, implying a larger rise in domestic saving and weaker domestic spending in the short run.” Rising domestic saving and weak domestic spending are central banker’s code for a severe and lasting recession.

Most of these capital inflows have been used to finance private sector borrowing, but the same dangers now apply to government borrowing.

In the fourteen quarters from the beginning of 2005 to the middle of this year, overseas investors bought three quarters of total net UK gilt issuance.

But the head of one fund has already warned that the Treasury can no longer take it for granted that foreign buyers will turn up at bond auctions: “We are nearing the point where Asian and Middle East investors are going to charge a much higher premium for holding British sovereign debt. Once a government loses credibility, these investment shifts can happen with alarming speed.” Already the spread on credit default insurance for UK Government debt has widened from almost zero a year ago to 60 basis points today.

That’s 50% higher than for French debt and twice as high as for German debt.

And there’s another vital reason why we must resist spending splurges and irresponsible borrowing.

An IMF survey published earlier this month concluded that “increases in interest rate risk premiums as a result of debt concerns can render fiscal multipliers negative, suggesting that discretionary fiscal stimulus may do more harm than good.” Put another way, there’s no point pumping more government money in one end of the economy if it delays the lower interest rates that will stimulate private sector activity at the other end.

There’s another reason for fiscal responsibility in a recession.

If you don’t keep control of public finances, you risk saddling your economy with so much debt that it stifles the recovery for many years to come.

That is not a rock of stability. It is more like a ball and chain.

So everyone needs to understand the true weakness of our fiscal position under Labour.

But, as we all now know, it was always more image than reality.

Gordon Brown started to abandon the practice of prudence almost as soon as he had delivered the Mais lecture in which he most extensively set it out.

Instead of using monetary policy to manage demand, an unsustainable debt-fuelled bubble was allowed to develop.

And instead of fiscal responsibility, reckless government borrowing meant that fiscal policy proved totally unsustainable as soon as the bubble burst.

This was contrary to the tenets of even Keynesiansim, never mind the new consensus around Conservative fiscal responsibility – because Keynes did not just argue that governments should borrow in the bad times – he also argued that they should put money aside in the good times.

But as the Institute for Fiscal Studies put it, “Mr Brown did not leave his successor as Chancellor with the fiscal room to cope with even a modest economic slowdown, let alone the problems we currently face.” That is a technical way of saying that he didn’t fix the roof when the sun was shining.

The facts show that our economy is in significantly worse shape to cope with this recession than it was before the last one.

In the last full fiscal year before the recession of the early 1990s, Britain had a small budget surplus of 0.2% of GDP.

In the last full fiscal year before this recession we had a deficit of 2.6% of GDP.

That’s a difference of £39 billion in today’s money - in the wrong direction.

But if Gordon Brown’s practice of prudence was already long dead, what’s striking is that in the last four weeks he has abandoned the rhetoric of prudence as well.

In the process he has explicitly abandoned the modern mainstream consensus on fiscal responsibility and returned to the failed and discredited approach of the 1970s.

He has surrendered the intellectual ground of responsible economic management in favour of good oldfashioned Keynesian demand management.

So he has abolished the fiscal rules.

But he has not replaced them with anything.

He has encouraged speculation about Keynesian spending splurges.

But he has not set out any kind of plan.

In fact if you listen to the Government’s pronouncements it’s not very clear what their position actually is.

Just consider the headlines:

“Darling: We must spend spend spend our way out of crisis” “Darling to reassure on borrowing” “Darling: tax may rise in the downturn” “Darling hints at tax cuts to help poorer families” But let’s take Alistair Darling and Gordon Brown at their word. Let’s assume they really mean it when they say they’re abandoning any pretence of fiscal responsibility, returning to 1970s Keynesian demand management, and are going to try to spend their way out of a recession.

That means that there is a choice emerging between the political parties about how to tackle that recession.

First there is the choice of spending without restraint and borrowing without limit – the choice Gordon Brown seems to be making.

It is a weak and irresponsible choice.

Weak because his talk of a spending splurge is only designed to give the impression of activity and action.

Irresponsible because it is the road to economic ruin.

For it makes it more difficult for the Bank of England to achieve a sustained reduction in interest rates.

It saddles this generation and the next with a burden of debt that could take a decade or more to pay off.

It means you end up spending more on paying debt interest than defending your country or educating your children.

It means damaging tax rises in the future at the very moment when you want to be reducing taxes to help the recovery.

It may even involve another 10p style tax con where he tries to fool people again, but under Gordon Brown everyone knows we will have higher taxes for many many years to come.

Even a modest dose of Keynesian spending – say increasing it by an additional 1% of GDP - means that in the end taxes will have to rise by the equivalent of almost 4p on income tax.

That’s not just a tax bombshell, it’s a cruise missile aimed at the heart of a recovery.

And in extremis, it can mean you lose the confidence of the international markets.

Gordon Brown doesn’t understand that there are limits to borrowing, even after he’s abandoned his fiscal rules.

They are not his limits.

Today everyone assumes the only question is ‘how much more does the British government want to borrow from the markets?’ Talk to former Chancellors and they will tell you that at some point the question becomes ‘how much more are the markets prepared to lend?’ That’s why there are limits to borrowing – not political limits, but actual limits.

Limits to what can be lent and limits to what a country can carry into recovery.

Amazingly there are signs that some parts of the political world need to learn these lessons all over again.

As Michael Saunders of Citi Group, one of the few leading economists who foresaw the current crisis, put it

last week:

“The speed with which the political debate already is turning to fiscal loosening raises risks that the overall fiscal loosening in the recession and pre-election period will be so big that the fiscal deficit itself will become a destabilising factor for the economy in coming years.” In other words, that Gordon Brown’s desire to spend his way out of the recession will not only make the recession worse, it will undermine the recovery too.

This is not some argument about economic theory.

This is about real lives, real jobs, real homes.

The risky consequences of irresponsibility are not merely a theoretical possibility, they are happening all around us.

The citizens of Ukraine, Hungary and Pakistan are now learning what happens when the markets lose confidence in a whole country.

Their sources of external financing that appeared to be reliable have dried up with astonishing speed.

Several countries in Eastern Europe, Asia and Latin America now risk a repeat of the Asian financial crisis of the late 1990s.

At the moment these problems are limited to emerging markets, but given the remarkable events of recent weeks we cannot be certain they will remain so.

The Governor of the Bank of England himself has highlighted Britain’s unusual dependence on external finance.

The coverage of Mervyn King’s speech last week was dominated by his use of the “R” word, but in a sobering passage he noted that “those external inflows have fallen sharply – a mild form of the reversal of capital inflows experienced by a number of emerging market economies in the 1990s.” That is an extraordinary parallel for the Governor of the Bank of England to have to make.

Even more sobering was the warning that followed: “Unless they are replaced by other forms of external finance, the adjustments in the trade deficit and exchange rate will need to be larger and faster than would otherwise have occurred, implying a larger rise in domestic saving and weaker domestic spending in the short run.” Rising domestic saving and weak domestic spending are central banker’s code for a severe and lasting recession.

Most of these capital inflows have been used to finance private sector borrowing, but the same dangers now apply to government borrowing.



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