Tuesday, November 25, 2008

Do Economic Stimulus Packages Work?

Yesterday, the Chancellor, Alistair Darling announced an economic stimulus package worth over £20billion. [Times link] It raises the prospect of national debt rising from £512bn to £1 tn in a couple of years. With the UK Economy already facing a recession and rising national debt, will the recovery package work?

The justification for the economic stimulus:

  • Borrowing is justified because it will stimulate spending and encourage economic growth. With falling house prices and low confidence, tax cuts are an essential way of encouraging people to spend and avoiding a sharp deflationary downturn.
  • The sooner the economy recovers the sooner tax revenues will start to rise and the government can stop paying unemployment benefits. If the government doesn't borrow now to kickstart the economy, the recession will be deeper and therefore borrowing will rise anyway.
  • The tax changes are progressive. Cuts in VAT tend to have a relatively bigger impact on low incomes because they have a higher propensity to spend. Tax increases are focused on those earning over £39,000 (higher rate of income tax will rise to 45%)
  • National Debt will rise. But, that is to be expected in a recession.
  • With interest rates low, the cost of servicing national debt will remain manageable. (national debt interest payments are currently £31bn or 2.5% of GDP)
  • The traditional concerns of higher national debt are often exaggerated. National debt rarely leads to higher interest rates and increased money supply. Stimulating the economy is more important than worrying about National Debt.
  • National Debt in the UK has been much higher than the current 43% of GDP. e.g. in 1970 it was 70% of GDP.
  • By planning tax rises, the government has made a commitment to bringing national debt under control when the economy recovers and can absorb tax rises. The fact the Pound rose yesterday, suggested the markets approved of the government's stimulus package.

Problems of the Economic Stimulus Package

  • Cutting VAT may not stimulate spending because consumers are looking to pay off debt and increase their savings.
  • Cutting VAT will encourage spending on electronic goods and other expensive imports. Imports don't help UK aggregate demand, but will worsen the current account deficit.
  • Administration costs of changing VAT prices of goods is quite high especially for small business.
  • The proposed tax rises are very modest in comparison to the rise in National debt. e.g. the increase in the higher rate of income tax from 40% to 45% may only raise about £1.5bn
  • Government borrowing of £80bn is failing to stimulate the economy this year, so why should borrowing of £118bn next year do the same. Japan increased national debt to 195% of GDP without boosting the economy.
  • If more banks need nationalising would the government be able to do it?
  • Because the government has pursued expansionary fiscal policy, the MPC may have less room to cut interest rates.
What Would I Have Done?

In a recession, I do believe in pursuing expansionary fiscal policy. Temporary tax cuts, will help mitigate the impact of falling spending and hopefully lead to a shorter recession. The rise in National debt is a concern, but, at the same time it is just about manageable. People often point to the experience of Japan as evidence expansionary fiscal policy fails. But, that was because Japan was suffering from deflation. The main benefit of this expansionary fiscal policy is ensuring deflation doesn't occur in the UK. If we avoid deflation, then I would expect the UK economy to recover at the end of 2009. Then will come the necessary tax rises. As an economist I don't mind the fact that taxes will rise during economic recovery.


Rob Slack said...

Whilst it is true lower income families spend larger fractions of income than those on higher incomes it is also true much of that spending is on Zero/low rated items, such as food, childrens' clothing and fuel. The VAT cut may be of little benefit to them.

Anonymous said...

this definition of 'kick starting the economy' is simply rubbish..

take an example of a living being..(national economy is a living thing in a way)if that being is ill and if that illness is a result of and cumulation of long period of wrong doing/ignorance, you can not simply administer some medication and expect the patient to get up and run.even if he does this will be for a limited period of time. we also call it boom and bust.therefore it is not the appropriate remedy to try to kick start the economy.the approach should have been much moor fundimental and spread over longer period of time.how do you do it? by nationalising some important aspects of economy, like utilities, some banks, and restrict imports ( you dont need apples coming from new zealand or garden rake from china).
is the capitalism gone bancrupt? well yes. lets remember the good old expression; the world has got everything the man needs but not for his greed.