The 'do nothing' school is making matters worse. If the state takes risks, it will generate tax revenues
As we enter another recession, economics is now firmly in three camps. There are the rightwing supply-siders who want to cut employment protection to force people into work alongside tax cuts that encourage more private spending. There are the Keynesians, who cheerlead for the state and argue that only the government can restore confidence and stimulate growth. And there is a school of thought that justifies governments sitting on their hands.
This tactic, adopted by the Treasury with the backing of the Bank of England governor, Mervyn King, recommends policymakers do whatever the money markets tell them, which in the UK means a deflationary freeze on spending for seven years. Sit tight and wait for the private sector to shake off its debts. While Whitehall obsesses about balancing its books, the inevitable upturn will magically appear.
This last group has come to dominate economic thinking not only in the UK, but also in the main capitals of Europe over the three years since the collapse of the G20's Keynesian consensus.
George Osborne is not alone in thinking that politicians, sandwiched between the markets and change-resistant voters, have nowhere else to go. From Finland to Austria and the Netherlands to Germany, it is the policy du jour.
Angela Merkel said the terms of the EU's spending freeze (bringing annual overspends to within 3%) were set in stone and could only be wrecked by a no vote in the Irish referendum. The election of a Keynesian socialist French president in a fortnight would be irrelevant, the German chancellor added.
But the European consensus is breaking down as it becomes obvious that snipping and nibbling at the problem is only making the situation worse.
Greece has been joined by Belgium, Portugal, Italy, Spain, the UK, the Netherlands and Slovenia in recession. Germany may be exporting almost everything it makes to the Chinese, but like France, two more years of virtually zero growth await.
Herman Van Rompuy, president of the EU, on Friday hinted at what is blindingly obvious to everyone else: that growth remains elusive and this fact should be recognised and debated. Merkel told a German newspaper that while she had not shifted her position, generating growth would be her chief economic concern at the summit of EU leaders in June.
Senior officials in Brussels, while instructing Spain and others to maintain self-defeating austerity measures, are seeing the error of their ways. But admitting that their economic plan has flopped fails to answer the question, which way to turn?
Osborne is under intense pressure to adopt the supply-side reform model. The Conservative former defence secretary Liam Fox is gaining a hearing for his calls to remove employment protection. Last week he said: "We need to have a combination of increased labour market flexibility and spending cuts, to make room for employers' tax cuts, if we are to create non-inflationary growth and improve the productivity and exportability upon which any sustained recovery will depend."
Even if his ideas to cut maternity leave subsidies and other employee benefits are rejected by colleagues including John Redwood, MP for Wokingham and a leading Tory thinker on the economy, they all agree the £10bn in extra welfare cuts suggested by the chancellor are essential and must be agreed by the Liberal Democrats.
Redwood is aligned with the owners of the Daily and Sunday Telegraph, the Sunday Times, and the Daily Mail and Mail on Sunday in calling for tax cuts for families to be paid for by a bigger welfare squeeze. A bonfire of employment protection is also on these newspapers' shopping list.
This weekend, the Sunday Times said in an editorial under the heading "Britain needs the spirit of the 1980s" that proposals by private equity millionaire Adrian Beecroft for a hire and fire business culture, published last year, should be dusted off and implemented without delay. It accused the Lib Dems and the deputy prime minister, Nick Clegg, in particular, of burying a report that could help Britain's economy bounce back rapidly.
Rightwing Tory MPs, many of them part of the 2010, post-expenses scandal intake, are pressing Osborne to ditch the consensus. Labour, unsure of its footing, decries the 10 lost years it says are inevitable from following current policies without having the confidence to put forward an alternative.
Step forward US economist Paul Krugman, who with fellow Nobel laureate Joseph Stiglitz is trying to convince policymakers in Europe that the US failed to go far enough in deploying government funds for investment to boost recovery.
Worrying about the "confidence fairy" and the "invisible bond vigilantes" who stalk the money markets in search of vulnerable countries, as Krugman puts it, is for economic illiterates. Borrowing money is not so frightening, especially when central banks can create money to buy their own bonds, as the UK and US have done to some extent.
He said last week in a blog: "For the past two years most policymakers in Europe and many politicians and pundits in America have been in thrall to a destructive economic doctrine. According to this doctrine, governments should respond to a severely depressed economy not the way the textbooks say they should – by spending more to offset falling private demand – but with fiscal austerity, slashing spending in an effort to balance their budgets."
Krugman agrees the consensus is falling apart but says most of the pressure for change is coming from the right.
What is strange about the debate is that Keynesianism is seen as a gamble, whereas the champions of austerity must be waving a magic wand.
In 2009, most mainstream forecasters predicted cuts in public spending would release the private sector from its chains to spur growth of 2% by 2011. In 2010 they said it would take a little longer and delayed 2% plus growth until 2012. Now the forecasters suggest 2% growth will arrive next year – without explaining how.
The Bank of England is one of the chief culprits, mainly because its independence gives some respectability to the zombie economics (Krugman's term) followed in Brussels and London.
What the supply-siders get wrong is their view of risk. They believe entrepreneurs just need the boulders of regulation and decent pay to be removed for them to increase output and jobs. But there is no evidence for this. What is clear is that governments which maintain investment in crucial areas, stand behind their banks and invest in education and training, at the cost of higher spending, will reap more in tax receipts from growth. From Silicon Valley to Germany's corridors of manufacturing, state subsidies (for research, for training, for worker's sickness payments) are what fosters innovation. If there is rebalancing to be done, it can take place once the economy is back on its feet and not before.