Ed Balls's grasp of economics will hurt his party

Almost alone among an anodyne generation of British politicians, Ed Balls has the ability to divide opinion. When the Labour Leader Ed Miliband appointed him shadow chancellor last week, many people saw him as too addicted to back-stabbing and briefing to make an effective team player. But most praised his economic expertise, and concluded that his combative approach would make life harder for the Conservative-Liberal Democrat coalition.

In fact, that consensus is upside-down. Balls's aggression, and his ability to make life hard for his rivals, are his strengths. His weakness is his shaky grasp of economics. He's got just about every major call on the economy wrong.

He's made himself the leading exponent of a crass version of Keynesianism that is going to end up making him look absurd. By constantly making the wrong predictions, and attacking the government for quite sensible policies, Balls will ruin his party's credibility. He will make the re-election of the coalition in 2015 far easier.

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Balls's record provides plenty of ammunition for his opponents. He was the key economic adviser to Gordon Brown during his ten years as chancellor. He boastfully claims authorship for many of his former boss's policies, even though most of them later turned out to be catastrophic. Take the new system of financial regulation put in place after 1997. It led to the worst string of bank collapses for more than a century. The decision to run up a vast budget deficit even while the economy was booming also looks to have been a costly mistake. The housing market was allowed to run riot, mortgage lending spiralled out of control, and the trade deficit reached new heights. It wasn't much of an economic record.

Balls points to the independence of the Bank of England and keeping Britain out of the euro as achievements. But, at the very least, this is questionable. The Bank hasn't done a great job of managing the economy. First it gave us the housing boom, now it is giving us rampant inflation. As for the euro, the Labour government could never have signed up to it without a referendum, which would have been decisively lost. So that was hardly a personal victory for Balls it was never going to happen.

But electorates aren't much interested in history. Right now, and for the next five years, Balls is relentlessly pushing the line that the cuts are too fast, and will push the economy back into recession. Much of the media has fallen for this line as well. If you listen to the news, you'll constantly hear that reducing the deficit may derail the recovery. That's nonsense. The latest economic research suggests that, contrary to what we keep being told, deficit reduction leads to faster economic growth.

Governments that cut spending tend to be rewarded with re-election. Take a look at the work of Harvard's Alberto Alesina, for example. "The conventional wisdom about the political economy of fiscal adjustments goes more or less as follows," he wrote in a paper for Ecofin last year. "Deficit reduction policies cause recessions, which create political problems for incumbent governments. The latter, therefore, see fiscal adjustments as the kiss of death." That's very much how Balls sees it. The cuts will cause a recession and a backlash against the coalition. "Fortunately the accumulated evidence paints a different picture," continues Alesina. "First of all, not all fiscal adjustments cause recessions. Many sharp reductions of budget deficits have been accompanied and immediately followed by sustained growth rather than recessions, even in the very short run."

Indeed so. It was true in this country in the early to mid-1990s, when big cuts in spending led to a sustained recovery. It was also true of Sweden and Canada in the 1990s. Alesina's study looks at 107 examples of fiscal consolidation, defined as cutting the deficit by 1.5% of GDP or more, within countries in the Organisation for Economic Cooperation and Development since 1980. He found that in nearly all cases it was followed by higher growth. There's no mystery about why that is. Cutting spending takes demand out of one part of the economy, but puts it back in somewhere else, either because the government taxes less or borrows less. There's no reason why the overall level of demand in the economy should change.

Cutting the deficit helps in other ways. It improves confidence, as consumers and businesses worry less about future tax rises. Real interest rates may fall as the markets grow more confident about government finances, and that stimulates investment. The stockmarket usually rises, increasing demand as people's wealth rises. And, since a smaller state and lower taxes are usually good for the economy, anything that makes government smaller rather than larger will help promote growth. Another finding of the research is that the more that spending cuts, rather than tax rises, are used to cut debt, the higher the rate of growth that follows.

But Balls doesn't get it. He insists the opposite is true. A shadow chancellor who spends five years issuing blood-curdling warnings about the economy, none of which come true, is not going to impress the electorate. He's just going to make himself and his party look daft.