The UK government is making a big bet that the large cuts in government spending will be more than made up for by increases in private sector spending: the hundreds of thousands of jobs that will go from the public sector will reappear on private sector payrolls. This is of course the same logic behind the US Tea Party backlash against Obama’s post-crisis state spending: step back Obama and let the private sector run the US.
To understand this battle it is important to understand how a country’s growth is calculated. Growth is about changes in the Gross National Product of a nation which is the summation of the total spending by consumers, private business, government, and net exports (what we others buy from us minus what we buy from them: C+I+G+(X-M). Hence if G is reduced through the spending cuts, for GNP to stay the same, or grow (the objective), one of the other categories must increase. The bet that is being made is that it will be I that increases (in fact, the spending cuts, affecting jobs and incomes, will likely reduce consumption spending C).
The bet will be successful only if the cuts positively affect ANIMAL SPIRITS. One of Keynes’ big insights was that investment I is not a technical variable that increases automatically if, say, taxes fall, interest rates fall or if profits rise. He claimed that I will only rise if animal spirits do, defined as “...a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities” (Keynes, 1936, The General Theory of Employment, Interest and Money). This is why I did not increase with the reductions in corporate income taxes in the UK and the USA with Reagan and Thatcher’s supply side (and ‘trickle-down’) policies in the 1980s. The dependency of I on animal spirits also helps explain why I is the most volatile of the 4 spending categories in GNP. Consumption C is the largest, but relatively stable since it depends on more predictable factors like disposable income and interest rates.
So the big question is whether the spending cuts will increase animal spirits. My view is that if the spending cuts have a negative effect on the country’s education system (with the 40% cuts in teaching budgets), if they reduce the social fabric of society (with the cuts in youth clubs, playgrounds, and various community organisations) , if they increase the numbers under the poverty line, and if they reduce the creative energy of society through the cuts in arts, then animal spirits will fall drastically. There is in fact increasing evidence that entrepreneurship and creativity are highest internationally in cities that have the most scientists, university professors, poets, architects, and people in design, education, arts, music and entertainment (Florida,2002, The Rise of the Creative Class) . Given that the spending cuts have hit all these categories very hard, it is likely that the massive whole in the GNP equation that is generated with the reduction in G will only get larger—with subsequent falls in I and C— not smaller. A very dangerous bet.