What’s at stake
Under Prime Minister David Cameron and Chancellor George Osborne, the Tory-Liberal coalition in the United Kingdom has run an experiment in the theory of expansionary fiscal contraction – the result of which is likely to influence how governments in other advanced economies approach the issue of fiscal consolidation. Although the bulk of fiscal tightening has yet to come – the cyclically adjusted tightening is planned to be a full 6.9 per cent of GDP between 2010-11 and 2015-16 – the weak preliminary estimates of Q1 GDP released by the Office for National Statistics has made the opponents of front-loaded fiscal consolidations more vocal.
Confidence, oxymoron, and zombie ideas
In a recent WEO chapter, the IMF debunked the evidence on expansionary fiscal contractions by showing that the standard approach used to identify periods of fiscal consolidations – which is based on the change in the cyclically adjusted primary balance (CAPB) – tends to select periods associated with favourable outcomes in which no austerity measures were actually taken and omits cases of fiscal austerity associated with unfavorable outcomes. In particular, the standard approach spuriously identifies Germany in 1996, Japan in 1999 and 2006, Finland in 2000, and Belgium in 1994 as periods of fiscal consolidations. The increase in the German CAPB in 1996 reflects the end of a one-time capital transfer, while the one recorded for Finland in 2000 reflects an asset price boom, which generated an increase in revenue beyond what the revenue elasticties used to compute the CAPB assume. The standard approach also fails to identify Ireland in 1982 and 2009, Italy in 1993, and Finland in 1992 and 1993 as periods of fiscal consolidations – most often because the fall in the CAPB is especially large during severe recessions.
Paul Krugman writes that despite this much of the world of movers and shakers bought into the exotic notion that expectational effects — the confidence fairy — would make contractionary policy expansionary. Barry Eichengreen, argued in a July 13, 2010, Project Syndicate column that fiscal consolidation in Southern European countries with unsustainable fiscal deficits could help reduce interest rates and counter-party risk. But in economies like the U.S., Japan and Germany, where yields are low with little investor concerns about sovereign risk so far, fiscal consolidation would do little to boost private spending and could prove strongly contractionary. The IMFstudy finds that, when identified correctly, a budget cut equal to 1 percent of GDP typically reduces domestic demand by about 1 percent and raises the unemployment rate by 0.3 percentage points.
In a response to the IMF study, Alberto Alesina argues that evidence of expansionary fiscal contractions have been found based on different sets of countries and methodologies– referring namely to the work by Ben Broadbent, ex-Goldman Sachs now at the MPC of the BoE, Jürgen von Hagen (Bonn and Bruegel) and the OECD. Alesina furthermore argues that the methodology of the WEO chapter used to identify episodes of fiscal consolidations using descriptive IMF and OECD reports is not particularly careful. While these reports usually describe what happens to the deficit in a particular period, they do not go into the details of policy makers’ intentions, discussions and congressional records, as the narrative approach requires.
Spending cuts vs. tax increases; normal times vs. liquidity traps; and the role of exchange rates
Alberto Alesina points out that the IMF authors find the same critical result, and potentially the most important one: tax increases are much worse for the economy than spending cuts. The WEO Chapter argues that this effect comes mainly from different reactions of monetary policy, but their claim of having identified separately all of these channels is overstated because interest rates, current and expected, and exchange rates are endogenous to both fiscal and monetary policy.
The IMF writes that, in normal times, central banks usually offset some of the contractionary pressure by reducing policy rates cushioning the impact on domestic demand. But if – as is currently the case in a number of countries – interest rates are near zero and central banks are constrained in their ability provide monetary stimulus, undertaking fiscal consolidation is likely to have more negative short-term effects. Similarly, a decline in the real value of the domestic currency typically plays an important cushioning role by spurring net exports and is usually the result of nominal depreciation or currency devaluation, which argues against front-loaded fiscal retrenchment implemented across all large economies at the same time.
The great UK fiscal experiment
According to the numbers published by the Office for Budget Responsibility, fiscal tightening has just started. Cyclically adjusted public sector net borrowing shrank by 1.5 per cent of GDP between 2009-10 and 2010-11 and is forecast to shrink by a further 2.1 per cent of GDP in 2011-12 and 1.6 per cent of GDP in 2012-13. Cumulatively, the cyclically adjusted tightening is planned to be a full 6.9 per cent of GDP between 2010-11 and 2015-16.
Martin Wolf and Jonathan Portes– former chief Cabinet economist and now director of the National Institute for Economic and Social Research – argues that the bad Q1 GDP calls for a fiscal rethink. The UK growth for Q1 of 0.5 per cent (2 per cent annualised) might seem tolerable compared with the US rate of 1.8 per cent. But the latter’s followed annualised 3.1 per cent growth in the fourth quarter of 2010, while the UK’s followed an annualised 2 per cent contraction. UK GDP is much the same as in the third quarter of 2010 – that is to say still 4 per cent below its pre-crisis level, while US GDP was 0.6 per cent higher.
Garyn Davies argues that the Q1 GDP data for the UK are not as weak as they look like. Since the weakness in the official GDP data has not been confirmed by any decline in business survey data, or by any signs of renewed trouble in the UK labour market, it seems unlikely that this represents a true reflection of the underlying growth rate in the economy at present. George Osborne– Chancellor of the Exchequer – was of that view and even qualified as particularly good the news that manufacturing is growing so strongly when we've had such an unbalanced economy in recent years and manufacturing hasn't done well.
Kevin Daly points that the ONS’s preliminary estimates of GDP tend to be biased downwards on average and the upward revisions appear to be especially large during and subsequent to recessions (when economies undergo significant structural changes): Of the 31 occasions between 1975 and 2008 when the initial estimate of GDP was negative, the average upward revision was +0.95%qoq (+3.9% annualised). In the two years subsequent to a trough in activity, the average upward revision to quarterly growth in the past three recessions has been +0.3%qoq (1.1%qoq annualised). The largest revisions to GDP typically occur a number of years after the initial release, when the ONS has access to more comprehensive datasets (such as income tax returns).
David Blanchflower disagrees and writes since the start of 2007 the average revision has actually been to reduce growth by 0.1% a month, not +0.5 per cent, as Daly has claimed. Data revisions before 1993 are unlikely to be much of a guide to what happens today, given technological advances and computerisation. The likelihood is that data revisions today will be smaller than in the past. The average revision since Q1 2007 has actually been a reduction of 0.1 per cent. The most striking data revision has been to the data for Q2 2008, which had an initial estimate of 0.2 per cent, which has now been revised to a reduction of 0.3 per cent. The consequence of this revision, of course, has been to move the starting point for the onset of recession that most commentators failed to spot. The three quarters at the depths of the recession, from Q3 2008 to Q1 2009, which were initially estimated to show output drops of 0.5 per cent, 1.5 per cent and 1.9 per cent respectively, have had the biggest revisions downwards. They are now estimated as -0.9 per cent; -2.1 per cent and -2.2 per cent.
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