by Lily Lower
Last Thursday, the Monetary Policy Committee at the Bank
of England (BoE) decided not to expand quantitative easing
further this month.
So with monetary policy taking a backseat, at least for now,
the merit of continuing fiscal adjustment is coming under
increasing scrutiny as, two years into the coalition
governments experiment with expansionary fiscal
contraction, the UK economy flat-lines.
While the government is unwilling to consider Plan B, the
case for doing so is becoming compelling.
In its most recent World Economic Outlook last month, the
IMF published research that confirmed what many economists
have been suggesting for some time austerity is a
almost as bad as, if not worse than, the illness it is
intended to treat.
In the past, the fiscal multiplier was widely assumed to be
0.5, meaning that for every 1% of GDP by which the government
reduced its annual deficit, economic activity (GDP) would fall
by 0.5%. However, the IMF now believes this significantly
underestimates the true effects of fiscal adjustment. Instead,
it puts the fiscal multiplier in the range of 0.9-1.7. This
suggests that for every 1% contraction in the fiscal deficit,
the rate of GDP growth will contract by anything from 0.9% to
The IMF partly attributes this increase in the multiplier to
simultaneous fiscal adjustment taking place across the
world. The zero lower bound on interest rates is also to blame,
says the Fund, since it limits the extent to which monetary
policy can offset the damage of fiscal consolidation.
The implications of this are significant. The aim of fiscal
adjustment is to bring down public debt and government
borrowing costs to sustainable levels. However, this research
suggests that fiscal adjustment could in fact be
self-defeating. And if the multiplier is indeed greater than
1.0, any contraction in the budget deficit would lead to a
comparatively greater contraction in output, and debt-to-GDP
ratios would rise.
As George Magnus, senior economic adviser at UBS, warns:
Multiple austerity programmes are intensifying economic
frailties and sustaining a [so far] mild depression in Europe
that makes fiscal targets ever more elusive.
The graph below is based on forecasts from the Office for
Budget Responsibility (OBR), the UKs independent fiscal
watchdog, and illustrates this theory in practice. It shows
that, initially, the government cut the annual budget deficit
as a percentage of GDP faster than both it, and the previous
Labour government, had planned in 2010.
|Public sector net borrowing
Percentage of GDP
However, in 2011, the budget deficit becomes higher than the
government had planned in 2010. And from around 2013, the OBR
forecasts that deficit reduction will deviate even further from
the governments 2010 plan, predicting it will even
fail to be cut as much as planned under Labour.
For all its rhetoric about difficult but necessary decisions,
the government has not cut the deficit as much as it had
projected in 2010. And yet the UK economy fell into a second
recession at the end of 2011. No one should be fooled by a
seemingly encouraging return to growth in the third quarter of
this year. Once one-off factors such as
the Olympics and the Diamond Jubilee are considered, the
underlying economic picture is much bleaker. The IMF predicts
that GDP will contract by 0.4% in 2012, and will grow by just
1.1% in 2013.
Perhaps the rhetoric of austerity is as damaging to the
economy as the fiscal adjustment itself. The governments
perpetual message of doom and gloom does not instil much
business or consumer confidence, and this could go some way to
explaining why the economy still has not recovered its losses
Quantitative easing undoubtedly prevented things from being
much worse, but it has not been as effective in stimulating
demand as hoped. The BoE has pumped liquidity back into the
banks, but this is not translating into an increase in appetite
among creditworthy companies to borrow and invest.
David Walker, chairman of Barclays, speaking at a British
Bankers Association conference last month, said: We
are not constrained by capital as long as borrowers are
creditworthy. The bank approves 80% to 85% of SME loan
applications. The thing that concerns me is that there
isnt enough demand I wish there were more,
added Walker, warning that there is a great need for
In 2010, the government argued that if the deficit was cut
at the slower pace suggested by Labour, there would be a panic
in the bond markets and borrowing costs would soar. However,
the bond markets have enough access to information and
brainpower to see that, two years on, the government is
unlikely to meet even Labours deficit-reduction
targets, let alone its own. And yet bond yields are at