Con-Dem fiscal policy at the mercy of the bond vigilantes

A guest post by The Obscurer

We are all familiar with the narrative between the Con-Dem coalition government and Labour on the depth and rate of speed in cutting the deficit and the consequences that this will have on the economy as a whole. Today’s VAT rise has brought the so-called ‘debate’ back into the public spotlight.

The Con-Dem belief is that unless public spending is cut drastically, the bond vigilantes will raise the cost of borrowing for the government and for home owners (as mortgage rates are affected by long-term interest rates) and the Bank of England will have to raise its base rate.  The effect of this would then induce a slowdown in growth if not provoke a double-dip recession.  For some in the Con-Dem coalition this presents an ideal opportunity as they are ideologically committed to the small state and look forward to a private sector led recovery.

Labour does not oppose the logic of the Con-Dem narrative per se, but instead emphasises the danger that cutting public spending, so far and so quick, may have in sending the economy into a double-dip recession (although Shadow Chancellor Alan Johnson got a bit muddled over his party’s policy on the Today programme this morning).  Furthermore, they argue that the national debt may not be that high historically (depending on what and how it is measured) and that the bond vigilantes may not know what is in their own interests. After all, if a drastic cut in public spending does tip the economy into a double-dip recession, then the government will get less tax receipts and will have to borrow even more.  As such, making the temptation to go to the printing press (thus devaluing gilts) that much greater.

So here we have it.  In order to reassure the bond market that Britain will not inflate its debts away, a savage attack on the size and role of the state is demanded.  Yet, for fear that this may cause the economy back into recession, the bond market demands another round of quantitative easing. 

To put it simply: cuts to prevent the printing of money; the printing of money to prevent recession.

As absurd as the paradox appears to be at first sight, it may benefit the Con-Dems.  It must be remembered that the Bank of England has consistently been on the high side of its inflation target for the last year.  But with the government fulfilling the demands of the vigilantes, the yield on government gilts has remained low

The government may then be able to borrow cheaply, and not pay some of it back due to inflation, and reduce the size of the state at the same time.  This presupposes one big ‘if’: the logic only holds of nothing bad happens to the world economy during the course of the next parliament. That’s a very big if indeed.

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