In his latest blog, Andrew Bell, CEO of Witan Investment Trust, reviews the various approaches to UK fiscal policy.

Who would have thought economists would be so popular? One political party was reportedly delighted to have had 20 economists writing to a Sunday paper saying that the budget deficit needed to be addressed more aggressively. This was followed by over 60 economists writing to another paper to support the government’s line that the deficit could be left until an economic recovery had become established. (Less prominently reported was that the second group also said more detail was needed on how the deficit would be addressed in future years.) Should politicians regard support by armies of economists as reassuring? Mrs Thatcher happily ignored the views of no fewer than 365 economists who wrote to the Times in 1981 to oppose the tight budget introduced during that year’s recession.
 
Election campaigns usually feature more heat than light, so to expect a rational debate over the manner and timing of addressing the UK’s increasing debt and deficit problems would be a triumph of hope over experience. Nonetheless, with an astronomical deficit of over £177bn forecast for this year (enough £20 notes end-to-end to reach to the Moon and back then do 13 laps around the Earth) and the National debt expected to reach 77% of GDP by 2015 (using the Treasury’s own figures) ignoring it is not a long term option.  Maintaining the confidence of the overseas suppliers of the capital needed to fund our deficit requires evidence that we are willing to develop a plan to put the public finances on a sustainable footing. Sterling and gilts are likely to contain an extra risk premium until the post-election outlook is clear.
 
Stripping away the politics, there appear to be broadly four camps in the debate. The “fingers crossed” brigade hopes that economic recovery will restore the fiscal fortunes and prevent the need for difficult decisions. In the words of Voltaire’s Dr Pangloss, all will be for the best in the best of all possible worlds. This, broadly, appeared to be the policy stance of the Greek government until bond investors lost confidence in them and forced changes. The Mickawberish tribe is a close ally of the Panglossians, recognising that “Annual income 20s, annual expenditure 20s 6d, result - Misery” is an unattractive prospect but hoping for something to turn up.  However, hoping for the best is not sustainable if you need other people’s money to support your lifestyle.
 
The Scrooge tendency would address the deficit with urgency, fearing a loss of market confidence if borrowing is not cut soon. They also argue that public sector deficits crowd out private sector investment and therefore crimp growth in the economy so if governments spend less, private spending will fill the gap. Despite the classical economic support for this view there are two objections in the current environment. The first is that, with consumer debt levels high in many countries and overcapacity in many industries the private sector may be slower than usual to step up if fiscal policy “makes room”. The second is that, with interest rates close to zero worldwide it is not possible to offset tighter fiscal policy with lower interest rates, unlike the aftermath of Geoffrey Howe’s budget in 1981 when base rates fell from 15% to 10% between late 1981 and December 1982.
 
The current policy consensus (in which most politicians find themselves even if they choose to exaggerate their differences in more strident public stances) is to plan for a fiscal tightening when recovery is established but to put a time delay on implementation, in line with St. Augustine’s prayer “give me chastity and continence but not yet”. The argument for delay is that, with a weak economy, immediate tax rises and spending cuts would precipitate a further recession and worsen the deficit despite the efforts to tighten policy. The trouble with a “Prudence must wait” policy is that it can be difficult to distinguish from the “fingers crossed” view of the Pangloss and Mickawber schools. For it to carry credibility, “time-lapse” fiscal tightening must enact the decisions quickly to make the delayed discipline as inevitable as possible. Otherwise there is the risk of complacency once deficits start to reduce under the influence of resumed economic growth.
 
The delay in tackling the part of the deficit that will not melt away with economic recovery increases the risk for bonds – loose policy might create inflation, while fiscal procrastination could be habit forming. From the point of view of the broader economy, the delay may be welcome but the need to attract capital in a world free of exchange controls means taking the hard decisions early, before asking for time. In coming months, financial markets are likely to be buffeted by uncertainty over what the next government will propose, whether it will have the majority needed to implement its policies and whether the right balance will be struck between maintaining the bond vigilantes’ confidence and sustaining the move back to economic growth.
 
The weak fiscal position of the UK and other developed economies is likely to contribute to a less than vigorous bounce back from recession but this is already widely expected. Economic forecasters have been described as falling into two categories – those who know they don’t know and those who just don’t know.  Forecasting pitfalls aside, it seems likely that in a low caffeine growth environment the available sources of faster growth will attract a premium relative to companies or countries not buoyant enough for a weak tide to refloat them. These hotspots seem likely to include a number of emerging economies but the attractions of established companies in other markets with global brands and proven survival abilities should not be neglected. After all, not every emerging economy emerges.