Fun public debate about deficit reduction between Tim Besley and Alan Manning at LSE last Thursday. Tim Besley: smart suit, clean-cut image. Alan Manning: loud shirt, lots of curly grey hair. Guess who is in more of a hurry to cut the deficit?
Obviously I'm instinctively with the 'don't worry crowd', for entirely ideological reasons, I have to confess. Besley has models, serious models on which to base his analysis. The striking thing though, is that the models seem to me - on a superficial viewing - pretty indeterminate, due to the difficulties in pinning down a key variable: market confidence. If markets are confident that governments will not default (either formally, or informally through high inflation), then deficits can be sustained for a long time. Put another way, governments have to have credible commitments.
But credible commitment seems more and more like an equation filler to me. How are we to independently observe the credibility of a commitment? Argentina's dollar peg collapsed despite low inflation, low deficits and low debt-GDP ratio. Because: markets don't find Argentina credible. So, will markets trust Britain not to default? Well, maybe they will, maybe they won't. My guess is the outcome will not depend on observable political or economic phenomena in any predictable way. After all, financial markets have shown that they have little grip on financial risk. Why should they have any better a grasp of political risk? Some market participants will make instinctive bets, others will follow, and that will be that.
In other words, my feeling is that the response could be pretty random, and therefore hard to theorize about. Now, this may not seem to be much help, but realizing the limits of predictability is still useful. And under high uncertainty, we start to grab hold of familiar and reassuring templates and memes, as Blyth and others tell us. I do it, and I think market participants do it too. So, my guess is that a Conservative government will get away with rather more than a Labour one will, because traders will perceive them as more sympathetic to bond-holders than the unemployed. But this will probably have little to do with real policy choices or commitments.