Almost everyone agrees Britain needs to cut its budget deficit. The action is needed whether it is because British government debt is rising at an unsustainable pace; because there is a sizable risk that the cost of servicing each pound of debt will rise sharply; because we think it is unfair our children should fund our profligacy; or because spending much more on debt servicing limits government’s ability to spend money on things we really care about.
The question is how fast. In this big debate, there are two sorts of people: fundamentalists and equivocators.
The fundamentalists include almost all politicians. Gordon Brown insists fiscal tightening now is dangerous for the recovery. On the opposite side, the equally fundamentalist David Cameron asserts that the truth lies with the reverse argument. “To get the economy moving you’ve got to lift the black cloud of the deficit,” he says repeatedly. Business organisations, such as the CBI and IoD are fundamentalists. And many economists have also been overcome with fundamentalist tendencies, as evidenced by the spate of letter writing to newspapers.
The other group are equivocators. These people are reasonably sure there needs to be a credible plan to reduce the deficit, but are unsure about its timing, its effects, and whether history tells them very much. Many Treasury officials I know are equivocators, so was the recent Green Budget from the Institute for Fiscal Studies, so are significant elements of the Monetary Policy Committee and, to my surprise, so is the governor of the Bank of England. Mervyn King is often portrayed as a fundamentalist on fiscal policy, but his answers at the latest Inflation Report (pages 7 to 9) can be summarised as: ‘The effect of fiscal policy on the economy? Well, it depends’. I am also firmly in the equivocators’ camp.
Being unsure about the best policy is rather uncomfortable, feeble even. But I’ll try to explain why the decision is so difficult. To do so I’ll use a couple of very simple equations, which do not prove anything, but just help to show the effects of potential policies in a consistent way.
GDP = C + I + G + (X – M); and
Y = C + S;
where GDP = national income, C = household consumption, I = investment, G = government consumption, X = exports, M = imports, Y = household income and S = household saving
Both equations are just accounting identities and, as such, they are true. They do not tell us anything other than what are the component parts of national income and household income. To make things easier, I will just substitute the second equation into the first to give:
GDP = (Y – S) + I + G + (X – M).
From this equation, I think four things follow
1. Fiscal tightening initially reduces demand
Look at the initial effects of different policies to reduce the budget deficit
- Cut current government spending. This is the favourite policy of business lobby groups – and in practice it would be met by policies, such as closing prisons, sacking classroom assistants or cutting state pensions. These are just examples so that we can be clear what current government spending actually is: the first two reduce G and the third reduces Y for pensioners. Obviously the reduction in G will also be a reduction in Y for prison officers and classroom assistants, but these are knock on effects, which I am ignoring for now. The simple point is that regardless of the policy choice, cutting current government spending puts downward pressure on GDP.
- Cut government investment spending. The consensus objects to this form of balancing the books, even though it is important in the government’s plans. An example of this policy is a delay in Crossrail. It cuts the deficit because it cuts I, under which government investment is measured. Again, this puts downward pressure on GDP.
- Raise taxes. Both direct and indirect tax rises reduce Y for the people affected, either because incomes are cut directly or because their income buys less if consumption taxes are raised. Tax rises also put downward pressure on demand and GDP.
All the above is pretty clear cut and should not be contentious. All it says is that government withdrawal of money is contractionary unless it is offset. We will get on to the potential offsets later.
2. The form of fiscal tightening is probably a second order issue
This is now getting more contentious and lots of people have religion on this, but I think when you look at the equation above, it is difficult to argue that cutting current spending is obviously better for the economy than raising taxes. Cutting Y, G or I all have the same initial effect on GDP.
Sure, they will not have the same ultimate effect. But that ultimate effect is highly uncertain because each of these big categories is extremely diverse. A big new tax on business investment is probably worse for output than an initial reduction in civil service numbers? But is a broad-based rise in income tax or value added tax worse than closing all Britain’s prisons? Probably not. For all the bland statements around about the need to cut current government spending, I wish there were half as many spelling out what should get the chop.
3. The initial demand shock can be offset
There are a bunch of reasons why the initial demand shock might be offset and might, in some limited circumstances, be offset to such an extent that GDP rises when fiscal policy is tightened. Here is a list:
- Momentum: If the economy is already growing quickly for reasons of rising productivity, labour supply or rising population, the contractionary forces of fiscal tightening can co-exist with the momentum of the economy, leaving GDP still rising, albeit at a slower rate. If we see signs of robust demand, then the argument for a rapid fiscal contraction becomes very powerful, but we are not there yet.
- Monetary policy: If interest rates can fall, providing an offsetting boost to demand, fiscal tightening does not need to be contractionary. That was true in the early 1980s and partially true in the 1990s, but with monetary policy impaired is much less likely to be true today.
- Ricardian effects: If greater clarity about future lower deficits persuade households to borrow or reduce saving, then a fall in S can offset the reduction in Y, G or I. This is a tricky case to make at the moment because the main cause of the recession was a collapse in business investment, not a rise in household saving in response to a deteriorating fiscal position.
- Imports: Some of the effect of fiscal tightening will leak abroad through lower imports. This can offset the initial effects of the action taken.
- Exchange rate: If sterling falls in response to the fiscal tightening – a result of a Mundell-Fleming model of the economy with perfect capital markets – rising (X – M) can offset the effect of falling Y, G, and I, perhaps fully offset it. This is the hope from the 25 per cent fall in sterling since 1997 and some effect should still happen, but it has not happened yet.
- Animal spirits: If, for some difficult-to-define reason, companies become much more confident about the future after a fiscal tightening, I might rise, again offsetting the tightening.
4. The initial demand shock can be amplified
There are also some reasons the initial contractionary effect might be amplified
- Keynesian multipliers: Cutting government spending or raising taxes has an initial contractionary effect, which can become multiplied, for example, as the out-of-work prison officer spends less in Tesco, reducing demand from vegetable growers. Traditionally we would think that the multipliers are likely to be largest for current government spending, which might make it the most dangerous thing to cut, not the safest. It was the clear evidence of these multipliers working to reduce GDP after the collapse of Lehman Brothers that convinced everyone that a fiscal stimulus was worth the risk.
- Animal spirits. If companies become alarmed by the initial contraction of demand from a fiscal tightening, there is every chance that investment spending might drop. That is the problem with animal spirits, you cannot know in which direction they will go, nor how strong they will be.
So, given we know:
a) a fiscal tightening is needed;
b) the initial effect of a fiscal tightening is contractionary, and
c) some of the normal offsets are not functioning properly,
I am not sure about the right speed of budgetary consolidation. I fully recognise that there might well be no pleasant outcome – a rapid tightening could lead to a double dip and a fiscal crisis, while a slow tightening could lead to a fiscal crisis and then a double dip.
We must hope that it soon becomes clear that economic momentum is great enough for the risks from further fiscal tightening to be low. Then, we really should go for it. But at the moment, I am firmly in wait and see mode. And I am worried by those who profess to know the truth, on both sides of the debate.
