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The wrong cure

What’s the best way to reduce the deficit?

The first thing we have to do here is junk the idea that the national economy is like a household's.

Every time a politician says we have to do with the nation's finances what a prudent householder would do with a credit card bill, you can stop listening. It's nonsense.

There are many reasons for this, but here are two important ones.

The first reason why the chancellor is not like you or me with a big credit card bill

A householder can take decisions about how much to spend, how much debt to take on and how fast to pay it back without it having any effect on their wages.

But this is simply not true for a nation. If a country spends less, then it also has an effect on its tax income. This can even cancel out the cut.

If a householder cuts down on their supermarket bills, they do not have to care about what happens to the supermarket.

But if a country decides to economise by cancelling building of new schools and hospitals, they don't simply get a straightforward saving. There are knock-on effects that can be more damaging than the benefits of the cut to the public finances.

Let's investigate why. A cut in orders means that the construction companies will make less profit and pay less corporation tax. They will buy fewer bricks. They and the brick factory will cut their staff.

In turn these newly unemployed will pay less income tax as they become unemployed. They will also spend less in supermarkets, thus hitting their profits and ability to pay tax. Other tax payers will face a bill for their unemployment benefits.

A householder does not have to worry about what their spending decisions mean for other people or the wider economy. For a nation it's the most important consideration.

The second reason why the chancellor is not like you or me with a big credit card bill

When politicians talk about their ideal householder they assume that he (and we suspect they imagine a he) has a full-time job – and can't work harder to pay off their credit card debts.

This is not the same as the UK. We are not working full-time. We have high unemployment and high levels of people with part-time jobs who want to work full-time. If we have policies that get people back to work, and doing good, economically productive jobs, then the deficit falls because the costs of unemployment go down, and the income from tax goes up – even without changing a single tax rate.

The proper way of looking at the deficit

So if a credit card bill is not the right way to think about the deficit, what is?

The best way is to think it consists of two parts.

  1. The biggest slice of the deficit is caused by the recession. The unemployed are not working and paying tax. Companies are not making profits and paying tax. Factories are not using all their machinery efficiently. Ending the recession means using these spare resources. That increases the tax take and reduces benefit spending, bringing down the deficit.
  2. But there is a second part of the deficit. The crash was caused when a finance bubble turned out to be an illusion. We thought it was real prosperity, but it was a mirage. This means that even when we get the economy working again, it won't be as productive as we once thought it to be.

This second part of the deficit is much smaller than the first, but it will hang around even when we get proper growth and the economy working efficiently again. This is why it is called the structural deficit. Dealing with this part does require difficult decisions that involve tax and spending. But no-one can know what the size of this structural deficit will be until we have got the economy working properly again.

The priority therefore must be to get the economy growing and the unemployed back to work so we can fill the bigger part of the deficit caused by the recession. This is called a cyclical deficit precisely because it will disappear when the economy is back on track.

The danger of cutting spending or raising taxes like VAT now is that they will reduce growth. At worst we might even be driven back into recession again – the double-dip. What is certain is that the cuts will reduce economic growth. The government is fond of scaring us with numbers. Here's our own scary number. The spending review will depress growth in the UK economy by £60 billion, according to official figures. That's £1,000 for everyone in the UK.

So the best way to cut the deficit is to encourage growth. That's not always easy for governments to do, but consider the environmental challenge. To make the transition to a low-carbon economy we need to stimulate a huge investment programme in new forms of energy and energy efficiency at work and home. That's a good thing to do in its own right, but will also create jobs, help companies and cut the deficit.

Next: How cuts will make Britain more unfair »

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Quick fact

The spending review will depress growth by £60 billion. That’s £1,000 for everyone in the UK

Cuts are not the cure
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