The government is sticking to its deficit reduction plan. But with worries about a lack of economic recovery, or even a double dip recession, some economists are calling for a Plan B. They back up their arguments by referring to the lack of consumer confidence, falling real incomes and rising commodity prices. Without a slowing down in cuts and tax rises, the lack of aggregate demand, they claim, will prevent a recovery.
The government maintains that sticking to the cuts and tax rises helps maintain international confidence and thereby helps to keep interest rates low. Also, it argues, if the economy does slow down, then automatic stabilisers will come into play. Finally, even though fiscal policy is tight, monetary policy is relatively loose, with historically low interest rates.
But will there be enough confidence to sustain a recovery? Economists are clearly divided. But at least the IMF seems to think so. In its latest assessment of the UK economy, although it has cut the growth forecast for 2011 from 2% to 1.5%, that is still a positive figure and thus represents a recovery, albeit a rather fragile one.
Coalition’s spending plans simply don’t add up Observer letters, 52 economists (5/6/11)
Is George Osborne losing his grip on Britain’s economic recovery? Guardian, Heather Stewart and Daniel Boffey (4/6/11)
George Osborne plan isn’t working, say top UK economists Guardian, Heather Stewart and Daniel Boffey (4/6/11)
How are the Coalition fixing the economy? The Telegraph, Tim Montgomerie (28/5/11)
Cameron’s new cuts narrative The Spectator, Fraser Nelson (27/5/11)
The changing narrative of Chancellor George Orborne Channel 4 News, Faisal Islam (17/5/11)
The UK could be leading with a new economic approach, instead we follow Guardian, Will Hutton (4/6/11)
The coalition’s strategy is courting disaster Observer, (5/6/11)
Government faces fresh calls for a Plan B BBC News (5/6/11)
‘Serious debate’ needed on economy BBC Today Programme, Stephanie Flanders (6/6/11)
IMF cuts UK growth forecast for 2011 BBC News, John Lipsky (Deputy Director of the IMF) (6/6/11)
IMF says hope for best, plan for worst BBC News, Stephanie Flanders (6/6/11)
IMF set out a ‘Plan B’ for George Osborne BBC News, Paul Mason (6/6/11)
How to rebalance our economy Independent, Sean O’Grady (6/6/11)
IMF maps out a Plan B for the UK economy The Telegraph, Jeremy Warner (6/6/11)
A long and hard road lies ahead for the British economy Financial Times, Martin Wolf (6/6/11)
United Kingdom – 2011 Article IV Consultation Concluding Statement of the Mission (6/6/11)
OECD Economic Outlook 89 Annex Tables (June 2011): see especially Annex Table 1
Output, prices and jobs The Economist
- Explain what is likely to happen to each of the components of aggregate demand.
- Is monetary policy loose enough? How could it be made looser, given that Bank rate is at the historically low level of 0.5% and could barely go any lower?
- What are automatic fiscal stablisers and how are they likely to affect aggregate demand if growth falters? What impact would this have on the public-sector deficit?
- What is meant by the ‘inventory cycle’? How did this impact on growth in 2010 and the first part of 2011?
- What is likely to happen to inflation in the coming months and why? How is this likely to impact on economic growth?
- Referring to the economists’ letter (the first link above), what do you think they mean by “a green new deal and a focus on targeted industrial policy” and how would this affect economic growth?
The debate about how much and how fast to cut the deficit has often been presented as a replaying of the debates of the 1920s and 30s between Keynes and the Treasury.
The justification for fiscal expansion to tackle the recession in 2008/9 was portrayed as classic Keynesianism. The problem was seen as a short-term one of a lack of spending. The solution was seen as one of expansionary fiscal and monetary policies. There was relatively little resistance to such stimulus packages at the time, although some warned against the inevitable growth in public-sector debt.
But now that the world economy is in recovery mode – albeit a highly faltering one in many countries – and given the huge overhang of government deficits and debts, what would Keynes advocate now? Here there is considerable disagreement.
Vince Cable, the UK Business Secretary, argues that Keynes would have supported the deficit reduction plans of the Coalition government. He would still have stressed the importance of aggregate demand, but would have argued that investor and consumer confidence, which are vital preconditions for maintaining private-sector demand, are best maintained by a credible plan to reduce the deficit. What is more, inflows of capital are again best encouraged by fiscal rectitude. As he argued in the New Statesman article below
One plausible explanation, from Olivier Blanchard of the IMF, is that the Keynesian model of fiscal policy works well enough in most conditions, but not when there is a fiscal crisis. In those circumstances, households and businesses react to increased deficits by saving more, because they expect spending cuts and tax increases in the future. At a time like this, fiscal multipliers decline and turn negative. Conversely, firm action to reduce deficits provides reassurance to spend and invest. Such arguments are sometimes described as “Ricardian equivalence” – that deficits cannot stimulate demand because of expected future tax increases.
Those on the other side are not arguing against a long-term reduction in government deficits, but rather that the speed and magnitude of cuts should depend on the state of the economy. Too much cutting and too fast would cause a reduction in aggregate demand and a consequent reduction in output. This would undermine confidence, not strengthen it. Critics of the Coalition government’s policy point to the fragile nature of the recovery and the historically low levels of consumer confidence
The following articles provide some of the more recent contributions to the debate.
Keynes would be on our side New Statesman, Vince Cable (12/1/11)
Cable’s attempt to claim Keynes is well argued — but unconvincing New Statesman, David Blanchflower and Robert Skidelsky (27/1/11)
Growth or cuts? Keynes would not back the coalition – especially over jobs Guardian, Larry Elliott (17/1/11)
People do not understand how bad the economy is Guardian, Vince Cable (20/5/11)
The Budget Battle: WWHD? (What Would Hayek Do?) AK? (And Keynes?) PBS Newshour, Paul Solman (29/4/11)
Keynes vs. Hayek, the Rematch: Keynes Responds PBS Newshour, Paul Solman (2/5/11)
On Not Reading Keynes New York Times, Paul Krugman (1/5/11)
Would a More Expansionary Fiscal Policy Be Effective Right Now? Yes: On the Invisible Bond Market and Inflation Vigilantes Once Again Blog: Grasping Reality with a Prehensile Tail, Brad DeLong (12/5/11)
Keynes, Crisis and Monopoly Capitalism The Real News, Robert Skidelsky and Paul Jay (29/4/11)
- What factors in the current economic environment affect the level of consumer confidence?
- What are the most important factors that will determine whether or not a policy of fiscal consolidation will drive the economy back into recession?
- How expansionary is monetary policy at the moment? Is it enough simply to answer this question by reference to central bank repo rates?
- What degree of crowding out would be likely to result from an expansionary fiscal policy in the current economic environment? If confidence is adversely affected by expansionary fiscal policy, would this represent a form of crowding out?
- Why may fiscal multipliers have ‘turned negative’?
- For what reasons might a tight fiscal policy lead to an increase in aggregate demand?
- Your turn: what would Keynes have done in the current macroeconomic environment?
Periodically, the BBC hosts debates on major global topics. The following links are to the January 2011 debate on the state of the world economy and on what policies governments and central banks should pursue.
Should governments be boosting aggregate demand by raising government expenditure and cutting taxes in order to stimulate growth and plan to bring down deficits over the long term once growth is established? Or should they embark on tough fiscal consolidation now by cutting government expenditure and/or raising taxes in order to stimulate confidence by international financiers, thereby keeping long-term interest rates down and creating the foundations for sustainable economic growth? The debate considers these two very different policy approaches.
The participants in the debate are Joseph Stiglitz (Professor of Economics, Columbia University), Christina Romer (Professor of Economics, University of California, Berkeley and Adviser to Barack Obama (2009–10)), George Papaconstantinou (Finance Minister of Greece), Dominique Strauss-Khan (Managing Director, IMF) and Zhou Xiaochuan (Governor, Chinese Central Bank). The debate is in five separate webcasts.
World debate on the global economy BBC World Service (20/1/11)
- What are the arguments for maintaining economic stimulus, at least for the time being? What are the relative merits of fiscal and monetary stimulus? Explain whether such policies are consistent with Keynesian polcies.
- What are the arguments for tough fiscal consolidation? Explain whether such policies are consistent with new classical policies.
- How successful have US policies been in stimulating the US economy?
- What role can China play in the recovery and long-term growth of the global economy and are there any imbalances that need correcting?
- Why might countries’ domestic policies result in currency wars? Is currency realignment necessary for sustained global growth?
- How important are consumer and business confidence to short-term recovery and long-term growth and to what extent do government policies respond to swings in confidence?
So what’s £81.6 billion and still rising? The answer is the UK public-sector budget deficit so far this financial year. Given all the talk over the past week about the state of the Irish public finances it is perhaps timely to review the state of the UK public finances. To do this we take a look at the latest release of public sector finances from the Office for National Statistics. It is worth pointing out that the figures we will refer to take into account the impact of those financial interventions which were designed to ensure the stability of the financial system following the financial crisis. These interventions include the transfer of financial institutions like Northern Rock and HBOS to the public sector, injections of capital into financial institutions and the Asset Protection Scheme whereby institutions insured themselves against losses on assets placed in the scheme. The main impact of these interventions has been on the overall stock of public-sector debt following the incorporation of some financial institutions into the public sector.
We consider three key statistics of the public finances. Firstly, we consider the UK’s level of net borrowing. This is a flow concept measuring the degree to which the public sector’s expenditures exceed its receipts. In October net borrowing was recorded at £10.3 billion and, as we said at the outset, this takes the level of net borrowing so far this financial year (i.e. since April) to £81.6 billion. This compares with £87.5 billion in the same period in 2009. If all these numbers leave you a tad cold then perhaps it may help to note that since the beginning of January 2009 the public sector has been running an average monthly deficit of around £12 billion.
Another widely quoted fiscal indicator is the public-sector current budget. The current budget measures whether the public sector has been able to afford what are known as current expenditures and so net investment by the public sector is excluded from this fiscal indicator. Current expenditures include the wages of public sector staff, such as teachers and nurses, welfare payments and expenditures on a whole range of inputs consumed in the current financial year. Net investment by the public sector adds to our country’s capital stock and includes expenditures on such things as roads and school buildings as well as investment grants to the private sector, for example money to help better insulate our homes.
The public sector’s current budget was in deficit in October to the tune of £7.1 billion. This means that in the current financial year the current budget deficit has reached £64.1 billion which compares with £69.1 billion in the same period last year. Again to put the current budget into perspective we note that since January 2009 the average current budget deficit has been running at just under £8 billion per month.
The third key statistic reported by the ONS is public-sector net debt. This is the value of the sector’s stock of debt less its liquid financial assets (largely foreign exchange reserves and bank deposits). As of the end of October, the stock of net debt (excluding the impact of the financial interventions) stood at £845.8 billion, equivalent to 57.1% of GDP. If we include the impact of the financial interventions then the stock of public sector debt at the end of October was actually £955 billion and so not too far off the £1 trillion-mark. This figure is equivalent to 64.5% of GDP and shows quite clearly the impact of incorporating the balance sheets of those financial institutions now classified as public monetary and financial institutions.
But what about the future prospects for our 3 key indicators of the public finances. The Office for Budget Responsibility central projections at the time of the June Budget predicted that the government’s fiscal consolidation plan will see the current budget in balance across financial year 2015/16. This is expected to come about as the current budget deficit begins falling each year following the current financial year. It is also predicts that if we take into account the negative impact of the economy’s expected negative output gap on the public finances that the structural current budget deficit will have been removed by 2014/15. In other words, any current budget deficit in 2014/15 will be a cyclical deficit resulting from higher expenditure and/or lower receipts because of the economy’s actual output being below its potential output.
Of course, while the OBR is predicting that the actual current budget (i.e. without any adjustment for the cycle) will be in balance by 2015-16, this still means that the public sector will remain a net borrower because there is also net investment expenditure to take into account. Nonetheless, if the forecast is proved correct, this would see net borrowing across the whole of 2015-16 of only £20 billion. As for net debt, the OBR is predicting that it will peak at 70.3% of GDP in 2013-14 before falling to 69.4% by 2014-15.
U.K. had larger-than-expected budget deficit in October amidst modest growth Bloomberg, Svenja O’Donnell (18/11/10)
UK Oct public sector borrowing rise more than expected International Business Times, (18/11/10)
UK government borrowing at £10.3 billion in October BBC News (18/11/10) )
Deficit target still in sight despite new UK borrowing high Telegraph , Emma Rowley (18/11/10)
UK public sector borrowing rises Sky News, Goldie Momen Putrym (18/11/10)
Britain slumps another £10 billion in the red Independent, Holly Williams (18/11/10)
Latest on Public Sector Finances Office for National Statistics (20/11/10)
Public Sector Finances Statistical Bulletin, October 2010 Office for National Statistics (20/11/10)
Public Sector Finances (First Release) Time Series Data Office for National Statistics
Public Sector Finance Statistics HM Treasury
- What do you understand to be the difference between the concepts of deficits and debt? Illustrate your answer with reference to the public sector and a household’s finances.
- What types of public expenditures would be categorised as being current expenditures and what types as capital expenditures?
- What is the difference between the current budget and net borrowing? Why might governments want to measure both these budget balances?
- Explain what you think is meant by a cyclical deficit and a structural deficit? Can you have cyclical surpluses and structural surpluses?
- What is meant by an output gap? What impact would you expect an output gap to have on the public finances?
- In 1988/89 the UK ran a budget surplus equivalent to 6.3% of GDP. After cyclically-adjusting this surplus is estimated to have been a deficit with net borrowing equivalent to 1.3% of GDP. Can you explain how this is possible and what the economy’s output gap is likely to have been?
- Imagine that you have been asked by government to design either a fiscal rule (or rules) or a set of principles for fiscal policy. What sorts of considerations would you take into account and so what rule or principles, if any, would you suggest?
Keynes referred to the ‘paradox of thrift’ (see, for example, Box 17.5 on page 492 of Sloman and Wride, Economics, 7th edition). The paradox goes something like this: if individuals save more, they will increase their consumption possibilities in the future. If society saves more, however, this may reduce its future income and consumption. Why should this be so? Well, as people in general save more, they will spend less. Firms will thus produce less. What is more, the lower consumption will discourage firms from investing. Thus, through both the multiplier and the accelerator, GDP will fall.
What we have in the paradox of thrift is an example of the ‘fallacy of composition’ (see Sloman and Wride, Box 3.7 on page 84). What applies at the individual level will not necessarily apply at the aggregate level. The paradox of thrift applied in the Great Depression of the 1930s. People cutting back on consumption drove the world economy further into depression.
Turn the clock forward some 80 years. On 26/27 June 2010, leaders of the G20 countries met in Canada to consider, amongst other things, how to protect the global economic recovery while tackling the large public-sector deficits. These deficits have soared as a result of two things: (a) the recession of 2008/9, which reduced tax revenues and resulted in more people claiming benefits, (b) the expansionary fiscal policies adopted to bring countries out of recession.
But the leaders were divided on how much to cut now. Some, such as the new Coalition government in the UK, want to cut the deficit quickly in order to appease markets and avert a Greek-style crisis and a lack of confidence in the government’s ability to service the debt. Others, such as the Obama Administration in the USA, want to cut more slowly so as not to put the recovery in jeopardy. Nevertheless, cuts were generally agreed, although agreement about the timing was more vague.
So where is the fallacy of composition? If one country cuts, then it is possible that increased demand from other countries could drive recovery. If all countries cut, however, the world may go back into recession. What applies to one country, therefore, may not apply to the world as a whole.
Let’s look at this in a bit more detail and consider the individual elements of aggregate demand. If there are to be cuts in government expenditure, then there has to be a corresponding increase in aggregate demand elsewhere, if growth is to be maintained. This could come from increased consumption. But, with higher taxes and many people saving more (or reducing their borrowing) for fear of being made redundant or, at least, of having a cut in their incomes, there seems to be little sign that consumption will be the driver of growth.
Then there is investment. But, fearing a ‘double-dip recession’, business confidence is plummeting (see) and firms are likely to be increasingly reluctant to invest. Indeed, after the G20 summit, stock markets around the world fell. On 29 June, the FTSE 100 fell by 3.10% and the main German and French stock market indices, the Dax and the Cac 40, fell by 3.33% and 4.01% respectively. This was partly because of worries about re-financing the debts of various European countries, but it was partly because of fears about recovery stalling.
The problem is that cuts in government expenditure and rises in taxes directly affect the private sector. If government capital expenditure is cut, this will directly affect the construction industry. Even if the government makes simple efficiency savings, such as reducing the consumption of paper clips or paper, this will directly affect the private stationery industry. If taxes are raised, consumers are likely to buy less. Under these circumstances, no wonder many industries are reluctant to invest.
This leaves net exports (exports minus imports). Countries generally are hoping for a rise in exports as a way of maintaining aggregate demand. But here we have the fallacy of composition in its starkest form. If one country exports more, then this can boost its aggregate demand. But if all countries in total are to export more, this can only be achieved if there is an equivalent increase in global imports: after all, someone has to buy the exports! And again, with growth faltering, the global demand for imports is likely to fall, or at best slow down.
The following articles consider the compatibility of cuts and growth. Is there a ‘paradox of cuts’ equivalent to the paradox of thrift?
Osborne’s first Budget? It’s wrong, wrong, wrong! Independent on Sunday, Joseph Stiglitz (27/6/10)
Strategy: Focus switches from exit to growth Financial Times, Chris Giles (25/6/10)
Once again we must ask: ‘Who governs?’ Financial Times, Robert Skidelsky (16/6/10)
Europe’s next top bailout… MoneyWeb, Guy Monson and Subitha Subramaniam (9/6/10)
Hawks hovering over G20 summit Financial Times (25/6/10)
G20 applauds fiscal austerity but allows for national discretion Independent, Andrew Grice and David Usborne (28/6/10)
To stimulate or not to stimulate? That is the question Independent, Stephen King (28/6/10)
Now even the US catches the deficit reduction habit Telegraph, Jeremy Warner (28/6/10)
George Osborne claims G20 success Guardian, Larry Elliott and Patrick Wintour (28/6/10)
G20 accord: you go your way, I’ll go mine Guardian, Larry Elliott (28/6/10)
G20 summit agrees on deficit cuts by 2013 BBC News (28/6/10)
IMF says G20 could do better BBC News blogs: Stephanomics, Stephanie Flanders (27/6/10)
Are G20 summits worth having? What should the G20’s top priority be? (Economics by invitation): see in particular The G20 is heading for a “public sector paradox of thrift”, John Makin The Economist (25/6/10)
Why it is right for central banks to keep printing Financial Times, Martin Wolf (22/6/10)
In graphics: Eurozone in crisis: Recovery Measures BBC News (24/6/10)
A prophet in his own house The Economist (1/7/10)
The long and the short of fiscal policy Financial Times, Clive Crook (4/7/10)
The G20 Toronto Summit Declaration (27/6/10) (see particularly paragraph 10)
- Consider the arguments that economic growth and cutting deficits are (a) complementary aims (b) contradictory aims.
- Is there necessarily a ‘paradox of cuts’? Explain.
- How is game theory relevant in explaining the outcome of international negotiations, such as those at the G20 summit?
- Would it be wise for further quantitative easing to accompany fiscal tightening?
- What is the best way for governments to avoid a ‘double-dip recession’?