The Importance of Being Prudent

I was thrilled by George Osborne's first budget last month, which resisted the temptation to increase government borrowing and instead set about reducing Gordon Brown's gargantuan deficit. Of course, our dear old friends- the Labour Party and Scotland's beloved First Minister, Alex Salmond- have condemned the coalition's budget, pretty much accusing us off trying to turn off the life-support machine whilst the patient floats between this life and the next. I do not believe that such a charge is credible- it is based on a misunderstanding of macroeconomic theory and cheap point-scoring.

The problem that faces this government is that of the possibility of a return to recession- in effect, a second credit-crunch. In economic terms, the rate of monetary expansion is slowing down and is thus reducing the volume of available credit which banks can lend to the private sector, subsequently leading to declining growth. Now, the Labour Opposition and Alex Salmond would have us believe that a massive reflationary package- low interest rates combined with an expansion of government borrowing- will keep us out of recession. But will it?

Imagine a person who decides to start a business. They might have some money to start up this venture, but in order to keep their business afloat until they have a steady income stream they will have to rely on bank loans and overdrafts to pay bills, wages and other such overheads. If the economy is tipping into recession, then bank loans are going to harder to come by as banks will be worried about risky lending. So, in order to help keep the economy going, the government may decide to run a deficit to maintain a given level of demand. However, if banks are not lending money due to worries about increasing inflation, government borrowing will only push interest rates up further due to increased demand for a declining volume of credit. An increase in interest rates could be the difference between solvency and insolvency for some companies- particularly those which are in the early stages of start-up.

So what if the government decides to reduce a deficit during a credit crunch? Obviously, if the government is not borrowing money then there will be less competition for loans, and thus there will be more credit available for struggling businesses. A reduction in government borrowing will also lead to lower interest rates, again because there is less competition for credit in the market place. A fall in the rate of interest charged on loans is seen in the same light as manna from heaven in such difficult circumstances.

George Osborne, like Norman Lamont in 1992, has rightly decided that this economic crisis can only be solved by a loose monetary policy and a tight fiscal policy: in lay terms, low interest rates and cuts in government borrowing. We need low interest rates and an abundance of bank lending to help producers expand their businesses, and to help consumers buy goods. We need to reduce government borrowing so that the private sector is not starved of resources. When one is hard-up, one needs to prioritise one's budget: the size of our public sector and its total budget would have made the late Luciano Pavarotti look emaciated. If we want public services free at the point of use, we need to create more wealth in order to have the tax revenues to finance them. The only to do this is for the government to reduce its spending and live within its means. I believe that George Osborne accepts this fact- unlike his predecessor who behaved like the man about to be bankrupted and decided that the only possible course of action was to go out and buy a mansion. But thankfully we have George Osborne as Chancellor, and not his predecessor.