We must face the cuts or face inflation
By
MoneyWeek editor-in-chief
Merryn Somerset Webb Jun 29, 2010
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T he Budget went down pretty well. Commentators have called it "ambitious", "brave", "clever" and all manner of nice things. The markets are pleased too: the pound hit €1.22 on Thursday – its strongest against the euro since November 2008. That's nice.
However, it also might be a tad optimistic. Why? Because saying isn't doing. It sounds good to say that 25% will be cut from departmental budgets and that your forecasts have the deficit gone by 2016. But, while we know more than we did a week ago, we still don't really know how these major cuts will come about – we won't until the spending review in the autumn – and we don't know how the nation will react to them.
Cutting free swimming when it has only just been introduced was never going to be much of a big deal. And capping housing benefit at £400 a week is hard for anyone to argue against.
Much the same goes for the various other things announced this week: pay freezes, fiddles with tax credits and shifts in indexation from RPI to CPI for benefits. They might irritate, but they aren't exactly worth taking to the streets for.
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So, when do people start to get really upset? When the rise in VAT actually takes effect next January? When the old get their free TV licences taken away? When their child's teacher is fired as 20% cuts kick in across the education budget? When their bins are emptied only every three weeks? When their last local bus service is cut? When they finally lose their job?
And, when people do get upset, will the coalition stick to its guns? I'd like to think it will, but you only have to listen to poor Nick Clegg being badgered on the Today programme for a minute to grasp the extent of the tensions inside his party.
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My point is not that the LibCons can't deliver on the Budget, just that it is not a given that they can. Their forecasts rely entirely on their economic growth figures being correct: the deficit will be gone by 2016 as long as the UK economy grows 1.2% this year, 2.3% next year and close to 3% in the following three years.
It is hard to see how this can happen: not with Europe no closer to resolving its banking and sovereign debt crises; not with house prices in the US falling again; not with deleveraging continuing across the west; and not with our own public spending cuts chucked in, too.
My worry is that we start to see unrest with the spending cuts here at about the same time as it becomes clear that our growth forecasts are really no more than aspirations. Then what? Can we really expect the coalition to keep cutting?
It is possible, surely, that they will do what governments always do under such circumstances instead: skip the spending cuts and monetise the debt, with more quantitative easing (QE). I even have on my desk a note from a broker suggesting just that: we get the Bank of England to create enough money to buy up all our debt, thereby "cancelling the debt burden of the past through extension of QE".
Fans of this approach point to the way the Japanese finance minister Takahashi Korekiyo did something similar in the 1930s, rescuing Japan from the depression suffered everywhere else as he did so. Critics, however, point to the way Germany's central bankers did the same after the Great War, kicking off the worst hyperinflation in history.
Given the obvious deflationary pressures in the UK economy – private sector earnings rose a mere 1.5% annualised in March – policymakers here are likely to think that their experience of monetisation would be more Japanese than German. Not necessarily, says Société Générale's Dylan Grice. He notes that it is possible to print money without inflation if you don't do very much of it – and if you stop before the banks start lending again. But once they have started, central banks tend to find it impossible to stop – and that makes inflation "inevitable" – at "20% plus".
It is perfectly possible, of course, that in spite of the conspicuous lack of detail on cuts and the double dip, Osborne and Cameron go ahead with everything, and the population decides to take the deflationary pain without too much fuss. All might just turn out well: the public sector is sliced back to size, the debt goes and the long term drag on real growth is removed.
But just in case that doesn't turn out to be the case, investors might like to note that while deflation is truly awful for stock markets, inflation – even high inflation – often isn't.
Historian Adam Fergusson points out that, in 1919 in Weimar Germany, when the middle classes had already traded most of their pianos for potatoes, "gambling on the stock exchange . . . was the only way to avoid losing all one's money and perhaps to add to it".
• This article was first published in the Financial Times
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