When Confidence Is Shattered: George Osborne's Fiscal Contraction Will Lead to a Fall in Growth. His Best Hope of Avoiding Another Slump Is to Print Even More Money, but This Trick Is No Cure-All. He May Soon Need That Plan B

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In economics, you cannot convict your opponents of error, only convince them. Economics is not like physics; you can't conduct controlled experiments to prove or disprove your theories. History provides a very partial way of overcoming this weakness. No event repeats itself exactly, but past events offer some kind of test of current theories about the economy. The main question of present interest is the effect of fiscal consolidation.

The programme of fiscal consolidation has just been unveiled by George Osborne. The claim behind it is that slashing the deficit--removing [pounds sterling]123bn from the economy over the next five years, partly by raising taxes, mostly by cutting spending--will make the economy recover faster and more vigorously from the recession. This theory goes under the name of "expansionary fiscal contraction".

It became popular in the 1980s as a counter to Keynesian orthodoxy at a time when fiscal policy was in flux. President Ronald Reagan, while proclaiming strict fiscal rectitude, in fact ran unprecedented (for that era) peacetime budget deficits. For Keynesians, the US boom of the 1980s was the direct consequence of the huge volumes of extra demand being pumped into the US economy, mainly for military spending. Keynesian economists warned against premature curtailment of this stimulus. As Ralph Bryant, John Helliwell and Peter Hooper (in Bryant et al's Macroeconomic Policies in an Inter-dependentWorld, 1989) put it, "an unanticipated cut in US federal purchases could have a substantial negative impact on the level of US real output for several years". Yet two other economists, Gerhard Fels and Hans-Peter Frohlich, writing in Economic Policy 4 (April 1987), studied a different episode, that of fiscal consolidation in the Federal Republic of Germany. They noted that the "anti-Keynesian" policy there had coincided with a rapid recovery of the economy from the 1981-82 recession, and attributed this "coincidence" largely to the favourable effect of consolidation on expectations in the private sector. A similar conclusion was drawn in Britain from Geoffrey Howe's 1981 Budget. Indeed, it became part of Thatcherite folklore that Howe's fiscal retrenchment was followed shortly by a resumption of rapid growth, despite dire warnings by hundreds of Keynesian economists.

The proposition that cuts in government spending can grow the economy relies on "Ricardian equivalence"--the oft-repeated claim, made by the likes of Osborne, that government borrowing is just deferred taxation. If households and investors factor in future levels of taxation when they are making spending decisions now, a stimulus would have no effect on economic growth: households will simply cut back on their consumption in anticipation of inevitable tax increases. So public spending "crowds out" private spending.

But now let's ask: what would households and firms do in response to a cut in government spending? Ricardian equivalence says that reduced borrowing will create an expectation of lower taxes in the future (even if in the short term the deficit reduction includes tax rises). Freed of the burden of future taxes, private agents will happily spend more now, providing the required boost to demand when the government steps back. Increased demand means more jobs created in the private sector. The resulting increase in spending may well be enough to outweigh the money taken out of the economy by the government, and thus it will increase output overall.

The effect on investor and consumer confidence is likely to be still greater if spending cuts are seen to prevent an even more painful readjustment in the future. This can happen if the national debt is believed to have reached an extreme level. Dispelling fears of a Greece-style debt crisis might contribute more to growth than the loss of public money propping it up.

The other way cutting the deficit can reverse "crowding out" is by leading to lower interest rates. …