The Financial crisis is contributing to a deteriorating economic situation in both US and UK. The UK, German and Spanish economies are all forecast to have negative growth in the next quarter. To deal with this slowdown in the economy, governments could use expansionary fiscal policy (a Keynesian approach).
Expansionary fiscal policy involve cutting taxes and or increasing government spending. In theory, this injection of money into the economy increases aggregate demand and helps to increase economic growth and prevent a recession.
The US has already tried an economic stimulus package (mainly tax cuts) earlier in the year, with limited affects.
Cutting taxes may not prevent recession because:
1. People may save tax cuts. The savings ratios is very low (close to 0%). Therefore, with low confidence, people may not spend a tax cut, but use it to pay off debts or increase their savings. Therefore, consumer spending may not increase.
2. Other Factors May Outweigh tax cuts. A cut in income tax may increase spending. However, this positive effect may be outweighed by the decline in house prices and the consequent negative wealth effect. Alternatively, the difficulties of borrowing in the credit crunch may keep investment low. To overcome the economic slowdown may require a very large fiscal stimulus.
3. Crowding Out. Expansionary fiscal policy leads to higher government borrowing. To finance the growing national debt, bond interest rates may be forced upwards. This can put upward pressure on interest rates and therefore reduce consumer spending. (This is known as financial crowding out)
4. Also government borrowing may cause resource crowding out. If the government borrows, it borrows from the private sector. Therefore, although the government spend more, the private sector have less to spend and invest.
5. Government borrowing is already understrain with high levels of National debt. Therefore, governments are limited in their ability to pursue expansionary fiscal policy. In the UK, the government have just broken their own rules on national debt. Expansionary fiscal policy would increase public debt even more.
Tax Cut vs Government Spending
Higher government spending on public works is likely to be more effective than tax cuts. This is because public spending directly affects output and jobs, whearas tax cuts may just be saved and not spent. Unfortunately, in the US the Bush administration seem to feel fiscal policy only involves tax cuts (often targetted at high earners, who are the most likely not to spend it)
Despite the limitations of fiscal policy. I still believe that in a recession increased government spending can help to kickstart the economy. I do not believe the philosophy of Monetarists that expansionary fiscal policy always has no real affect in the long run.
However, fiscal policy does not address the causes of the credit crisis; it attempts to deal with its consequences. In this particular crisis, with high debt levels and financial uncertainty, fiscal policy may be even less effective than usual.