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 government’s 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 medicine 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 1.7%.
The IMF partly attributes this increase in the multiplier to the 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 UK’s 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 government’s 2010 plan, predicting it will even fail to be cut as much as planned under Labour.
Perhaps the rhetoric of austerity is as damaging to the economy as the fiscal adjustment itself. The government’s 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 since 2008.
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 isn’t enough demand – I wish there were more,” added Walker, warning that “there is a great need for confidence”.
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 Labour’s deficit-reduction targets, let alone its own. And yet bond yields are at record lows.
The government has been quick to insist that reducing the deficit by a quarter is largely responsible for the falling bond yields. In fact, successive rounds of asset purchase programmes by the BoE, financed through printing money, have put considerable downward pressure on bond yields.
As UBS’s Magnus observes, monetary policy can only buy time, but “the time isn’t being used productively”.
Moreover, “it is important to distinguish between good and bad money creation”, warns Mervyn King, governor of the BoE, who says the central bank cannot stimulate the recovery on its own. “Good money creation is where an independent central bank creates enough money in the economy to achieve price stability; bad money creation is where the government chooses the amount of money that is created to finance its expenditure.”
If the BoE ignores the limits of its mandate, and simply prints money to finance the deficit, this could spark a “crisis of confidence in the pound, and we could see hyper-inflation like that experienced by the Weimar Republic in the 1920s,” warns James Carrick, adviser at Legal & General Investment Management.
At some point, it will be necessary to address the issue of debt sustainability. However, the appropriate timing of this is what must be reviewed. The IMF has said that “countries with room to manoeuvre should smooth their planned adjustment over 2013 and beyond”. The UK’s independent monetary policy and low bond yields provide it with this breathing space.
“Albert Einstein supposedly said that insanity is doing the same thing over and over again, and expecting different results,” says Magnus. “This may be self-evident in the case of scientific experiments, but contemporary economic and monetary policy experiments fit the script too.”
It seems likely that just like the alchemists of the past, George Osborne will continue this experiment to turn fiscal adjustment into something expansionary. And his chances of succeeding do not look any better.