Gambling on Fiscal Restraint

June 22, 2010

One of the greatest uncertainties faced by policymakers concerns whether economies that are now recovering can tolerate fiscal restraint.  Expert opinion is divided on this question, and historical precedents provide conflicting answers.  Fiscal cutbacks in 1937 and a VAT increase of two percentage points to 5% in April 1997 respectively pushed the U.S. and Japanese economies back into severe downturns, whereas fiscal medicine early in the Clinton Administration paved the way for robust U.S economic growth in the second half of the 1990s.  In light of the severity of the 2008-9 world recession, the first two examples above seem most instructive about present circumstances.  Also, ten-year sovereign bond yields in 1993 averaged 5.86% in the United States and 7.41% in Britain but just 3.61% and 3.88% so far this year.  The point is that much less scope exists now for long-term rates to decline — and thereby stimulate capital spending  — in response to an improved policy-engineered fiscal outlook than was the case in the early 1990s.  The hope is that fiscal consolidation now will prevent a market crisis a la Greece and pay dividends by avoiding an undue future spike in long-term rates and inflationThe risk is that fiscal discipline at this nascent stage of the business cycle could abort recovery, depress tax revenues, and undercut the priority of reducing budget deficits.

Britain gives analysts a laboratory in which to test the merits of fiscal consolidation now.  A new Conservative-led government elected last month has rejected the cautious strategy of the previous Labour government and today proposed a very tight budget.  Britain for various reasons is a great test case.

  • Britain’s economy is larges as well as quite developed.  Greece’s experience has created a sense of urgency in other countries to get fiscal affairs in order, but Greece is a special case in several respects, one being its small size, another that officials had run fiscal policy very irresponsibly for years, and a third that Greece suffered from enormous debt as well as humongous ongoing deficits that widened additionally when the world recession hit. 
  • Britain had the biggest deficit to GDP ratio in the Group of Seven.
  • Britain’s recession was particularly severe, with GDP rising just 0.5% in 2008 and plunging about 5% last year.
  • U.K. real GDP is even now growing very tentatively, gaining by an annualized 1.2% last quarter and recording a dip of 0.2% between 1Q09 and 1Q10.  Consumption stalled last quarter, and inventories accounted for much of the activity.
  • CPI inflation has been stubbornly higher in Britain at 3.4% in the year to May than inflation in other advanced economies like the United States (2.0%), Canada (1.4%) or Euroland (1.6%).  The indirect economic stimulus from lessening uneasiness about the budget would seemingly be larger in the U.K. than any other major advanced economy.  If fiscal restraint at this juncture fails in Britain, it would like do the same in many other economies, too.
  • Bank of England policy has been extremely loose.  The base rate has been at 0.5% for nearly sixteen months, and the central bank eased extensively from a quantitative standpoint last year.  Policymakers need to find out if a weak economy lacking scope for offsetting interest rate cuts can tolerate budget cutbacks. 
  • Britain has well-developed capital markets.  Offshore holdings of sterling are extensive, and the pound historically has suffered several major speculative runs.  The global investment community has the leeway to express support or concern regarding British fiscal policy.  The point here is that scope will be ample for market feedback on British fiscal policy.  Such information will be important for policymakers in other countries wanting to learn the optimal timing for fiscal consolidation.

British Chancellor of the Exchequer George Osborne today presented a revised budget that introduces incremental restraint, expressed as a percent of GDP, that amounts to about 0.5% in fiscal 2010-11, 1.0% in fiscal 2011-12, 1.5% in 2012-13, and a bit over 2.0% in the following two years.  Value added tax, which was restored to 17.5% from an emergency setting of 15% this past January, will be raised to 20% next January.  The capital gains tax is climbing to 28%.  Over a five-year period, spending cuts account for about three-quarters of the Gbp 120 billion of proposed austerity, but in the early part of the forecast interval, higher taxes will deliver about two-fifths of the burden.  Public-sector wages and child benefits are being frozen.  Welfare of all kinds comprises a sizable chunk of all spending cuts, but the entire package of proposed measures has some pain for all socioeconomic groups.  Analysts are calling the plan the largest British dose of austerity since the 1970s.

Osborne proposes that the new course of austerity will not create a fresh recession, will cut public-sector net borrowings from 10.1% of GDP to 1.1% of GDP by fiscal 2016, and will allow debt to crest in fiscal 2013-14 at 70.3% of GDP (compared to a ratio now of 62.2%) and then fall to 67.4% of GDP by 2015-16. Real GDP is projected to expand only 1.2% this year but accelerate to 2.3% in 2011 and 2.8% in 2012. 

There is an appointed time for everything. And there is a time for every event under heaven—  Ecclesiastes 3:11

Britain’s new political leadership believes the optimal timing to begin fiscal back-pedaling mustn’t be delayed and that the task should not proceed tentatively because the amount of the fix is going to have to be very large.  The ousted Labour government campaigned warning unsuccessfully that the Conservatives’ blueprint was a recipe for a double-dip recession that would additionally add to the deficit burden.  Each side has its academic supporters.  The dye is cast, and we’re about to find out which team has better instincts regarding the best timing for a shift in fiscal policy.  The verdict will not be crystal clear, however.  Budget plans deal with rolling multi-year periods of five years or more and are constantly updated.  External shocks will occur during the journey, and other assumptions will go awry and need correction.  That said, for a policy matter of utmost importance to most countries, this is about as good an opportunity as any for expanding knowledge on this critical policy challenge.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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