The IMF on UK macroeconomic policy: What [the IMF] means, in carefully modulated bureaucratic prose, is that the economy is not doing at all well….
Does the Fund Staff’s call for a possible rethink on fiscal policy make sense? The answers are: yes and no.
Yes. There is no question that, if further monetary and credit-easing measures fail to push the economy out of its rut (which is all too likely, given the weak impact of monetary policy so far, the difficulty of making “credit-easing” work swiftly, and the dire news from the eurozone, much), then present fiscal policy must be reconsidered…. No. There is no case for further delay, as soon as one accepts the argument that the economy suffers from severe and entrenched weakness of demand. Of course, if you believe that the economy is always in equilibrium or that the stagnation is a proper punishment for past evil, even if it is the innocent who are suffering, you will not share this view.
If one ignores these views, one sees that the worst of the global financial crisis was almost four years ago (provided the eurozone does not actually melt down) and that the UK economy has been stagnant for almost two years. How long then is a change in policy supposed to wait?
I find it hard to believe that the Fund staff disagree that action is needed right now. It is far more likely that they (and, not least, the IMF’s Managing Director, Christine Lagarde) felt unable to take on the government of what remains an important member country. That is also what the BBC’s Stephanie Flanders suggests in her excellent post, “IMF: ‘Great Policies: Shame about the Economy’." The economy – by which I mean spending by the private sector – is strong, not weak, as it is now. What, then, is the argument against using fiscal policy more aggressively, to support the economy now?….
Is it the case that greater flexibility on fiscal policy, to support demand, might destroy the UK government’s credibility, with disastrous results? Here is why I believe the answer to this view is: no.
First, it is quite easy to make a sharp fiscal loosening, through tax cuts and increased infrastructure spending, credibly temporary…. Second, the government has, rightly, targeted the structural, not actual, deficit…. [A] credibly temporary increase in the actual deficit does not increase the structural deficit, other than through additional interest costs, which are negligible at present. The fiscal costs of borrowing for a government able to borrow at a real interest rate of close to zero are, well, just about zero. Indeed, not to borrow when the real interest rate is zero is folly.
Third, a fiscal boost should, plausibly, lower, not raise, the prospective structural deficit. By increasing output both now and in future (by both accelerating deleveraging of the private balance sheet and stimulating private spending), the economy should be permanently bigger and so the structural deficit, for any given level of real spending, smaller. This is particularly plausible when real interest rates are this low and if, as is also very likely, strong hysteresis effects also exist. On the latter, see the influential recent paper by Brad de Long and Larry Summers.
Fourth, if the additional deficit is credibly temporary it should not undermine confidence in the UK’s public finances. Investors could more reasonably conclude that a persistently weak economy, particularly one that does permanent damage to the long-run capacity of the UK economy, is a greater danger to the political and economic sustainability of the government’s plans than a temporary relaxation of those plans, aimed at promoting recovery….
Fifth, the government has already changed its plans in a quite fundamental way, without any effect on “credibility”. Prospective deficits have substantially increased since it announced its initial plans. Indeed, its plans for future borrowing are now remarkably close to those of the Labour government…. This combination of overshooting with backsliding ought, on the government’s very own logic, to have undermined credibility and led to rising interest rates. Has it? No…. Sixth, it is indeed possible that fiscal stimulus would raise interest rates. But this would be because hopes for recovery had improved…. Finally, a willingness to make determined use of fiscal policy should also reduce the uncertainty of decision-makers about the likely direction of the economy. If businesses think the authorities are not determined to sustain demand, they are right to be more cautious. Ultimately, the government insures business against the macroeconomic risks of investment, via its determination to sustain demand in a slump. But the government has shown no such determination, with effects on the willingness of business to invest that we now see. Thus, the very determination to act might make a huge difference to the outcome for the economy.
In brief, the endlessly repeated “credibility” arguments against a change in fiscal policy are feeble. The UK has fiscal levers at its disposal and should use them.
What is true, however, is that a change would weaken the government’s credibility. But this is because the government made an unwise commitment….
There is, however, one interesting alternative to reconsidering fiscal policy. It would be to change the remit for the Bank of England, to focus on nominal GDP, instead of inflation. I intend to examine the advantages and disadvantages of that possibility in a future post.