Why has the general public bought into the TINA (There Is No Alternative) deficit reduction story? And what about our political class? Cameron, Clegg and Cable have allegedly ‘seen the light’ and emerged convinced that Britain needs huge cuts to stave off disaster. Brown and Darling differed only with respect to the timing of deficit reduction and size of the tax increase relative to expenditure reduction, Labour cuts/tax balance being 65/35 as against 80/20 for the Tories.

And it’s not just Britain’ politicians who suffer from deficit hysteria. Even Barrack Obama is coming under pressure from the US Congress. In Europe, the disease is rampant. First it was Ireland where draconian spending cuts have led to an estimated 9% annual fall in GDP this year and resulted in widening the budget deficit. Then Greece, where an EU-IMF imposed deficit-reduction plan of 10 percentage points over two years will probably lead to a 20% fall in GDP over the same period.

Spain and Italy have recently announced €15bn and €25bn respectively in austerity measures. Portugal has accelerated its budget reduction programme to get from 9% in 2009 to below 3% by 2013, or by about 2.5% a year. In France, where the budget deficit is 8% – well below Britain’s – President Sarkozy is under pressure to follow Ms Merkel’s budget balancing act. Lest anybody forget, in 2009 Ms Merkel committed Germany to a permanently balanced annual budget after 2016, the so-called ‘debt-brake’ law, which means extra budgetary cuts amounting to €10bn per annum.

As though all this fiscal tightening were not bad enough, in May the OECD recommended monetary tightening as a precaution against inflation. Both the Bank of England (BoE) and the ECB are thought to be considering raising interest rates at the end of 2010, despite the fact that the ECB forecasts that the Eurozone will contract by 4.6% in 2010 and that June inflation measure showed the lowest inflation rate for the core EU countries since 1953.

Clearly, it’s not rocket science to conclude that continued deficit hysteria could lead to a double dip, at very least to many years of stagnation – a Japanese style L-shape. What possible justification can be found in economic theory for the sort of pain these ‘belt tightening’ packages will inflict? Consider the arguments for budget balance now – as opposed to budget balance over the full business cycle; ie, when recovery is well-established.

First, there’s the argument that government debt has become unmanageable and that we are burdening future generations unjustly. In truth, in countries with developed financial markets, most public debt is held domestically by the private sector in the form of government bonds. Public liabilities are thus income-earning private assets and, from the point of view of the nation as a whole, the books balance. Our children, far from being burdened with public debt, will receive assets. The choice of what proportion of their wealth to hold in the form of gilts (or other paper) is theirs, not ours.

Another argument is about the effect of public borrowing on interest rates. For example, George Osborne regularly argues that increased government borrowing will drive up interest rates, thus ‘crowding out’ private investment. This argument fails on two counts. Under present circumstances, the Bank of England can keep medium and long term interest rates down through quantitative easing, as indeed it has done in the recent past. But even allowing that borrowing raises interest rates, such a rise would need to lead to ‘full crowding out’ for the argument to be correct. In economists’ jargon, Britain’s aggregate supply curve would need to be perfectly inelastic for full crowding out to occur.

For most economists the opposite is true; namely, that the private sector is not investing because the effectiveness of interest rates is limited by the ‘liquidity trap’. In reality it is effective demand which is too low. As the case of Japan in the early 1990s shows clearly, even zero nominal interest rates cannot get an economy out of recession. What is needed in the sort of public spending which will ‘crowd in’ private investment; ie, spending on new, better and greener economic and social infrastructure.

Yet another pro-cuts argument is that as government borrowing rises, consumers see that this will mean taxes must rise in the longer term and so reduce consumption in order to increase their saving. This is known in economics jargon as ‘Ricardian equivalence’, an argument popularised in the Thatcher-Reagan era by the ‘rational expectations’ school of thought. Willem Buiter at the LSE, in a seminal paper in 1980, by dismissed this as ‘the economics of Dr Pangloss’. And indeed, there is no evidence that it is increased public borrowing during a Depression causes consumers to reduce consumption. What lowers consumption demand is a fall in income!

The ultimate refuge of the conservative politician is ‘Ah, but if we don’t reign in public spending we will be attacked like Greece’. This argument has gained much traction in continental Europe, particularly on the centre-right in Germany. Again, the argument is hollow. Unlike Greece, most other large European countries (including Britain) can borrow at home; moreover, the ratio of Britain’s stock of net debt to GDP is just over 60% (low by OECD standards) and most of the debt is of long maturity. In the case of Germany, its bunds still serve as a benchmark for financial soundness of the rest of Eaurope, and to imagine that the money markets would attack a country with a huge and rising export surplus seems quite absurd.

To borrow a phrase from a recent piece by David Banchflower: ‘No reputable economic theory justifies this bleeding.’ So why then is our political class acting in this way? The best answer, courageously set out by Harriet Harman in her reply to Osborne’s budget speech, is that ‘it’s all ideological’; ie, that conservative politicians are using the need for budget balance as an excuse to roll back the state. Indeed, Cameron and Osborne make no secret of it; their analysis of the financial crisis was, and still is, that what’s wrong is the ‘big state’.

I share Harman’s view. At the same time, there’s an important economic argument to accompany it. In the 1930s, Europe was plagued by competitive devaluations as each country sought to export its unemployment abroad – albeit unsuccessfully since multiple competitive devaluation served to amplify the crisis. Today, such policies are not available to countries within the Eurozone (except for Britain, which is a ‘free rider). So ‘beggar-thy-neighbour’ behaviour must take the form of competitive wage cuts. And of course, this is what balanced budget policies are all about. The cost of the financial and economic crises is being passed from the rich to the poor, from capital to labour.

But – just as with the successive devaluations of the 1930s – the exercise quickly becomes self-defeating. If wages are squeezed too much, where will the aggregate demand be generated to sustain growth? Perhaps China and Japan hold the answer. Yes, but only if (like Germany) you can generate a huge export surplus. And if not in Asia, where then? As Paul Krugman has written, we’d better find another planet that wants our goods and services.