Are you thinking , what I’m thinking!?

Hey, it’s not as though Cameron promised to make “savage cuts”, is it?

Without a more credible deficit reduction plan than any of the parties have spelt out thus far, there is a serious risk of the markets losing confidence and forcing big pro-cyclical cuts (ie, while the economy is still weak).

It may be that they will continue to give the UK the benefit of the doubt until the general election, on the basis that whoever is elected will take the problem seriously – although last week’s warning from one of the world’s most influential bond investors, Bill Gross, that UK gilts sit on “a bed of nitroglycerine” and are a “must avoid” is hardly encouraging…

What is clear is that any party that did not introduce a budget cutting public spending within a couple of months of the election (even if the cuts did not take effect until 2011) would be running an unacceptable risk with the bond markets and sterling, and the result could well be the failure of gilt auctions and a big spike in long-term interest rates.

That wouldn’t just push up debt service costs for taxpayers – forcing yet deeper cuts in spending on desirable things – but derail the very private sector recovery that is the only sustainable way out of the recession in the medium term.

So ‘financial reality’ is not simply a matter of Keynesian theory about pump-priming demand, but of the reality in the market place where the government has to fund its deficit, which in turn requires the confidence of the people lending the money.

Of course it is true that cutting public spending, other things being equal, will tend to reduce aggregate demand – but other things wouldn’t be equal, because in the absence of spending cuts monetary policy will have to be much tighter to fund the deficit and long-term interest rates will be higher, which would also squeeze demand.

Inflation may force the Bank of England to raise base rate anyway, but it has made it clear that it would have a stronger case for keeping rates low if the deficit was on a clear downward path.

Given the scale of the deficit, the indebtedness of UK households and the difficulty businesses are having getting credit, a fiscal squeeze and relatively loose monetary policy would seem a better way of nurturing the recovery than the converse.

As I’ve argued before, the cuts could be phased in gradually and take effect mainly after 2011 – the key issue is the CREDIBILITY of the plan to cut the structural deficit, which means spelling out the scale of cuts required (something like £90bn over and above the drop in spending and rise in revenues created by a growing economy), saying where they are going to fall, and pledging to use any “upside surprises” to reduce the deficit more quickly than planned.

Clearly what to do this year is a particularly tricky balancing act; it’s certainly not as black and white as “any cuts in 2010 will be disastrous”.

This is not borne out by historical experience either domestically or internationally, for starters. The notorious case is Howe raising taxes and cutting spending in the depth of the 1980-81 recession – and growth resuming just after he introduced his hugely controversial budget, which the Keynesian establishment economists had predicted would tank the economy further.

You might object that the circumstances were different because that was at a time of high inflation, so there was no option of stimulating the economy, but in fact the heavy lifting against inflation had already been done via a (probably excessive) monetary squeeze, and the 1981 budget was actually a means of rebalancing macroeconomic policy and burying simplistic monetarism.

Those who emphasise the differences between then and now stress how we’re now in a deflationary environment – although that is less apparent by the month as both CPI and RPI inflation spike – and have no capacity to grow our way out of recession through investment, consumer spending and net trade.

But the case of our recovery from the early ’90s recession (when inflatikon was subdued and there was high consumer indebtedness) also saw a robust economic rebound despite a big fiscal squeeze which began when the recovery was far from well established. That time the main tax rises were deferred until 1994-95, but the spending cuts started earlier.

So, while on balance I agree it would be better to delay the more severe cuts until the 2011-12 financial year, I think the evidence for saying there will be an economic disaster if a start is made in 2010-11 is flimsy. And the more you think it should be delayed, the more specific you have to be about the cuts that you will eventually make if you are to retain market credibility (plus the pace of deficit reduction will probably have to be more ambitious once it begins).

@Alex Sabine.

Agree on the idea of credibility – if Brown had been a statesman and not scrambling for next weeks opinion poll, the government could have portrayed all its actions in terms of an overarching plan, less jittery, and so more favopurable to the bond market. But the extent to which fundholders will flee from gilts is questionable. Where else are they to go? USA? Eurozone? Everywhere has problems.

Thats not to say that a loose monetary policiy is not desirable, or indeed necesary – and if the trade off is lower fiscal stimulus than that will be necessary. The effects of QE are as yet unknown (although I doubt large infaltion will follow as some of the more excitable commentators foresaw). However the key test is to erad the numbers. If inflation continues to climb, and gilt rate soars, then obviously something will need to be done.

But otherwise I agree: a credible, spelt out plan is necessary. And Cameron’s insane ring fencing brings up another issue: how the budget is cut is jsut as important (and far more difficult) as the extent. That is why Cable’s refusal to follow Osbourne and Darling in ring fencing is laudable. Cutting soecific projects entirely (ID cards, Child Bond) mixed with general, across the board departemtal cuts is a good starting point. Nevertheless, some areas (education, science) that are vital to recovery should have a lesser axe than others – again, exactly and Cable has said.

Alex Sabine-

I think your point about health highlights that many government programmes are necessary and cutting them will be difficult – health has had the most investment, but environment, education and so on are also neccesary. As such it is liekly that thwe best savings will be made in the health service (the ‘shock’ that productivity has fallen in the health service is not a good argument here though: it is only to be expected that any additional spending won’t be as efficent as what has already been spent – that doesn’t say, however, that the spending isn’t well used)

All this suggests that whilst spending needs to be reigned in – in the long term – rushing will be more disastrous and costly than only cutting after deliberation. It is not right to rush and say what should be cut now (only that everything will be hit, and over time will be large)