Osborne Needs A Plan C

Robert Skidelsky is a very great man. A founder-member of the SDP, he never joined the Lib Dems, he resigned from the Conservative front bench in the House of Lords over the NATO bombing of Kosovo, he is no longer a member of that party either, he is active in Balanced Migration, he recently published Keynes: The Return of The Master, and he writes:

George Osborne expected to inherit a booming economy. In September 2007 – the month Northern Rock collapsed – he promised to match Labour's spending plans for his first three years as chancellor. He said that because the economy was set to grow faster than projected government spending, this would leave the Conservatives room for tax cuts. It is worth recalling this pledge in the light of the later Conservative charge that Gordon Brown ruined the economy. In 2007 both parties shared the same rosy growth expectations, and differed only on the question of how to divide the medium-term spoils between tax cuts and public spending.

In fact, Osborne unexpectedly inherited an economy ruined by the great global contraction which started in 2008. When he became chancellor the British economy had shrunk by 5.5% from its pre-recession peak, and the budget deficit had risen from 2.5% of GDP to 10%, the second being a counterpart of the first. But it also soon became conventional to say that the Labour government's revenue projections had been based on quite unrealistic growth expectations, and that therefore the "structural deficit" – that bit of the deficit not due to the downturn – was nearer 8% than 2.5%. There is a lot of truth in this. But, pre-crash, the Conservatives did not challenge Labour's revenue estimates. Osborne and Alistair Darling were equally fooled by the brittle buoyancy of the British economy.

The economy started to recover from the recession in the last quarter of 2009. This recovery had nothing to do with the cuts, because they had not happened. The two most likely causes were the 21% depreciation of sterling against competitor currencies, and a £200bn injection of cash into the banking system, starting in February 2009. However, there is no golden light at the end of the tunnel.

Broadly speaking we are bouncing along the bottom, with growth expected to slow down, not to speed up. It is still way below the trend growth rate of 2.5% a year. Unemployment has remained flat at 7.7%. Bank lending to British businesses contracted by 4.3% in the 12 months to February 2011, and the effective rate on new mortgage lending, at 3.85%, was exactly the same as it was at the beginning of 2010. The FTSE 100 index is the same as it was just before the election. Britain is very much in the slow lane of global recovery, and this is all before the cuts have started to bite.

In 2010 both Darling and Osborne produced deficit reduction plans, mainly through spending cuts. The Labour chancellor Darling promised to take £73bn out of the economy in four years, Osborne to take out £112bn over the same period. But the cuts proper would only start in April 2011. Osborne claimed that his tighter reduction plan was necessary to restore the confidence of the markets – which by June 2010 were reeling from the Greek crisis. The important point to note is that in Osborne's first year the bulk of public spending remained untouched. So far his Iron Chancellorship has been rhetorical. The extra pain is yet to come.

What will be the effect of reducing the deficit by £112bn in the next four years? The Osborne theory is that any reduction in government borrowing is equivalent to transferring money to the private sector. The private sector will have £83bn more (£112bn minus the £29bn in higher taxes) to spend – to invest in and lend to businesses rather than the state. Workers released from the public sector will be absorbed in private sector jobs. Since private spending is more profitable than public spending and since, in addition, the tighter Conservative deficit reduction programme will boost confidence in the economy, the result will be a net increase in aggregate demand, and a higher growth rate. Fiscal contraction is the royal road to buoyant recovery.

The Keynesian view is the exact opposite. Taking £112bn out of the economy will be a net subtraction from aggregate demand. The £83bn cuts in public spending will not be matched by an equivalent increase in private spending because their first effect will be to reduce employment, and hence reduce the national income. (The newly unemployed will earn less than before.) So part of the money the government "saves" will simply disappear as the national income shrinks. Fiscal contraction is the royal road to stagnation, not recovery.

These two theories are about to be tested. The Keynesians – among whom I number myself – will have to eat their words if growth picks up and unemployment falls in the next 12 months, as £32bn is subtracted from the economy in taxes and spending cuts. Osborne should eat his words if there is no improvement in growth and unemployment, but he almost certainly won't. If things fail to go his way, he will claim that a sound strategy was "blown off course" by unforeseen events. Politicians always claim that it is the world that is wrong, not their policy.

Nevertheless, even the chancellor will find it prudent to have plan B up his sleeve if the economy continues to stagnate (though of course he will never admit it). Most analysts expect plan B to be another bout of the "quantitative easing" that helped stabilise the economy in 2009-10. So, despite the – probably temporary – spike in inflation, I would expect the Bank of England to try again.

But monetary policy is a very uncertain instrument. It's not the printing of money, but the spending of money that is important for recovery, and printing money does not ensure that it is spent, if the public is not in a spending mood. As Keynes graphically put it: "If … we are tempted to assert that money is the drink which stimulates the economy to activity, we must remind ourselves that there may be several slips between the cup and the lip."

That is why we may need a plan C. I have been advocating a National Investment Bank, with a mandate to invest in green projects, transport infrastructure, social housing and export-oriented businesses. A limited fiscal commitment of say £10bn over four years would allow the bank to spend say £100bn with conservative gearing, provided it was allowed to borrow. It would create a new class of bonds with a slightly higher yield than gilts, which would suit long-term investors like pension funds, while offering loans at slightly below the commercial rates. The chancellor already possesses the necessary instrument in the green bank, but with a meagre capitalisation of £3bn and no borrowing power, it cannot do any good over the period of the cuts.

An investment bank of the kind I am suggesting would enable the chancellor to continue to preach public austerity while silently undermining its depressive effects. And who could ask better than that?