Paul Krugman, the Nobel prize-winning economist, warned a decade ago against thinking about budget deficits in terms of “bond vigilantes” and “confidence fairies”. He said politicians – mostly, though not exclusively, on the right – argued that unless governments cut their deficits, bond vigilantes would pressurise them by forcing up interest rates. But if they did cut them, the story went, then the “confidence fairy” would magically stimulate so much private spending that this would compensate for the loss caused by budget cuts. This fiction was heard across the EU, Britain and the US.
Prof Krugman was right. Austerity didn’t produce economic growth. The confidence fairy is as unreal as the one looking for children’s teeth. But the political rhetoric has not gone away. Every major UK political party wants more economic growth, and the message is that to grow the economy means bearing down on the deficit. The Office for Budget Responsibility forecast in March that the UK economy would grow by about 2%. This looks wildly optimistic. The International Monetary Fund sees two years of about 0.5% growth. It is a dangerous delusion to think that economies can cut their way to growth.
Higher interest rates have also resurrected old fears about western nations’ public debt, and the idea that they are determined solely by “market forces”. But bond vigilantes don’t exist. What is being exposed are financial institutions’ speculative bets. The crisis for Liz Truss began when pension funds started dumping UK bonds, sending the long-term interest rates on gilts soaring and forcing the Bank of England to step in. Last month came a warning that hedge funds pose a similar threat to the US bond market.
On Friday Jeremy Hunt, the chancellor, said “difficult decisions” lie ahead on the public finances. He was looking at the recent sell-off in government bonds, and the rise in their yields, pointing to higher debt interest bills. Central banks won’t let governments default in their own currency. But they are happy to go along with the idea that fiscal extravagance makes a bond-market attack on heavily indebted governments likely. Mr Hunt is signalling that it is spending on the poor, not the rich, that needs to be cut.
The economist Bill Mitchell blogged this week that under Mr Hunt’s self-imposed debt rule “significant cuts in recurrent spending” would be needed unless, under the fluttering wings of confidence fairies, businesses invested at unprecedented levels. Even if the money were there, wrote Prof Mitchell, the workers – barring massive migration or a rapid decrease in unemployment – are not. The Labour party ought to take note.
Until 1984 the postwar consensus was that economic growth was secured through the fiscal stimulus of an enlarged budget deficit and quiescent rate policy, while regulation and price controls kept inflation in check. Mr Hunt’s predecessor, Nigel Lawson, argued that the reverse should be the case: growth would be obtained by doing away with government regulations, and inflation brought down by cutting the budget deficit and aggressive rate hikes. Economics is a religion where rhetoric persuades voters to believe bad policies can have good results. All this came tumbling down in 2008 with governments pumping trillions into the world economy to save it. It is another crisis – around inflation – that has seen a public who had abandoned the old faith find comfort in it once again. If history is any guide, their conversions won’t last long.
