Ring-fencing healthcare, redistributing the education budget towards schools and keeping the defence cut below 10% has left other big spending departments with finding savings even greater than the headline 25%, as a result of the Comprehensive Spending Review (CSR).

David Cameron playing pool Creative commons image Credit: Andrew Parsons/The Conservative Party under CC-BY-NC-SA licence
David Cameron

The political challenge for Cameron, Osborne and Cable is to explain why public services and public investment should bear the brunt of reducing the fiscal deficit, when it was private banks' excessive lending that caused it to jump – and why professionals in the 'real' economy should pay for banks bailout with higher taxes, lower benefits and job losses, when most financial professionals are still in work and getting bonuses again.

The costs of the coalition strategy are very clear, and run wide as well as deep. Although lowest-income households will inevitably be hardest hit by the £81m of spending cuts to 2014, and around £29bn of tax increases focused on VAT, the government has bravely loaded much of the costs of adjustment onto its own middle-income supporters.

This middle will suffer a loss of newly means-tested benefits (even as inflation takes more into higher tax brackets), new risks to pay and promotion in public-sector professions, and significant cost increases for transport, early-years provision and higher education as user charges replace tax funding.

The impact will be especially severe on UK regions where state agencies and manufacturing are large employers – especially Northern Ireland, Wales, Northern England and Scotland – and on women, whose employment is more concentrated in public services.

The payoff from the emergency budget and CSR is less clear. If we simply compare official projections for the March 2010 (Labour) and June 2010 (coalition) budgets, the government will now be paying less in debt interest by 2014/15.

But most of its deficit reduction will have been achieved by taking more in tax from the public, and spending less on their behalf.

Public debt will have been reduced, but private debt will have had to expand – to finance investments in infrastructure, social provision and education that the state used to provide.

An abandoned men at work sign Creative commons image Credit: BIgTallGuy under CC-BY licence
Will private money pick up the investments in infrastructure?

From Thatcher to Rooflessness

This is an uncomfortable contrast to the Thatcher-era Conservative spending cuts, which were immediately matched by middle-class tax cuts. Indeed, in the 1980s under the Conservatives cut taxes without a matching expenditure reduction, triggering a boom under Chancellor Nigel (now Lord) Lawson.

Then, the UK was helped by a similar accidental expansionism in the US, and more deliberate stimulus policies in Europe. Now, a tightening of budgets across Europe leaves much less room for higher exports to plug the gap in UK domestic demand.

Instead of up-front tax cuts, the CSR targets a deficit reduction whose impact won't be immediately detectable. To keep voters onside, Chancellor Osborne must haunt them with a hypothetical alternative: the loss of sovereign creditworthiness and jump in public and private borrowing costs that would have hit the UK - if budget strategy hadn't changed in June.

Political battles aren't easily won with hypothetical arguments. Labour, whose shadow Chancellor Alan Johnson has chosen to back its March budget strategy, can simply argue that creditworthiness was already assured – the AAA rating was intact after Alistair Darling's announcements – so that their successors are delivering extreme pain for no gain.

While the government inherited a record deficit from Labour, part of this is a 'cyclical' gap that will close when the economy recovers, and part is a consequence of having to buy a large stake in the banking sector, which will eventually be sold again.

The coalition also inherited a strong recovery (1.2% across the second quarter) which may be hard to sustain unless private business leaders – like the 35 who recently endorsed present strategy in the national press – quickly follow up with investment and recruitment, alongside their verbal support.

The coalition's reforms run large risks at the political level, by scaling down public services that substantially benefit middle income earners while also transferring much of the costs of those services to the same group of taxpayers.

It has tried to soften the immediate impact of the cuts by focusing them on capital rather than current spending. But lower public investment can quickly have a wider downward effect on employment and income, especially via the construction sector, and in the longer run it blunts the reduction in public debt by running-down the stock of public assets.

So the strategy carries even greater risks at the economic level.

The Chancellor insists that public finances are just like household finances. If, as all sides agree, the growth in public debt must be reined in, the only solution is to reduce the public deficit. But he - like other deficit-cutting finance ministers across Europe - is battling a powerful alternative argument that public finances are fundamentally different. Reducing the deficit can increase public debt, if it slows the growth of national income (from which come the taxes that pay off the debt) or eliminates inflation (which erodes public and private debts over time).

Cash cascading Creative commons image Credit: Stuart63 under CC-BY-NC licence
Does public money behave like houshold finances?

Bold experimenters - or public sector vivisectors?

The banking crisis that started in 2007 has added a powerful new strand to this 'Keynesian' counter-argument. Banks abruptly ceased lending (and called in existing loans) in 2008, because houses and other assets were falling in value, wiping out their shareholders' and depositors' equity.

If the economic recovery slows, so will the revival of asset values that would enable the banks to stop putting money aside as capital and provisions, and start lending again. Banks' failure to restart lending could prolong the asset deflation, and deprive business of the capital needed to redeploy public-sector labour.

At times like this, there is still a strong Keynesian case for the government to borrow and spend because the private sector can't or won't.

Unfortunately for the coalition, most of the economic forecasts made since Spending Review details began to emerge show a seriously negative macro-economic impact. A PricewaterHouse Coopers assessment of the spending cuts' impact identified the loss of half a million public-sector jobs (before the figure leaked from Danny Alexander's briefing papers) and calculated that almost the same number could be lost from private firms that rely on public contracts – with business services and construction the hardest hit.

That's especially worrying when the growth in private employment following the post-recession budget cutting spree in1991-3 mainly depended on financial and business services.

Meanwhile the highly respected National Institute of Economic and Social Research forecasts growth of only 1.6% in 2010 and 2011, as consumer spending stagnates next year, and expects net public sector borrowing still to be 3.6% of GDP (instead of the Treasury's 2.1% projection) in 2014/15, as expansion stays below target.

Economists often complain that their scope for scientific investigation is limited by not being able to run experiments on the economy. But the coalition government is running something very close to a live experiment, whose outcome will be easily and quickly measurable.

If the economic recovery retains its momentum, with the private sector creating jobs and output to substitute the public, then the structural (non-cyclical) deficit will disappear as planned and the economy will successfully re-balance, vindicating the economic orthodoxy of Cameron and Osborne.

If the critics are correct, economic recovery will now be stalled by falling disposable income and continued asset deflation, the public deficit won't close and the pain won't be salved by future income and employment gain.

The new Treasury team believes its releasing private-sector dynamism and public-spirited voluntarism long suppressed by an overgrown state. It risks leaving scorched earth on which the Keynesian dinosaurs will freely roam once more.

Reviewing the spending review

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