Monday, June 21, 2010

Deflationary Fiscal Policy

With the evangelical fervour of Franciscan friars, the Conservatives are preparing us for a metaphorical fiscal hairshirt - spending cuts and tax rises. Is it me or do they seem to be revelling in this period of inflicting 'austerity' and 'necessary pain' on the economy? There is a seductive ideology (see: economics of suffering) that if there is 'pain' there must be some gain. Conservative ideology loves to portray spending cuts as saving us from 'the road to ruin'.

Presumably, that is what the electorate were told in 1931, the establishment pushing through spending cuts, and tax rises as the world teterred on the brink of the Great Depression. Needless to say, the deflationary fiscal policy combined with tariff rises and lack of money supply growth pushed the global economy into the worst recession on record. And we didn't even learn from our mistakes, in 1936-37, deficit hawks pushed the economy back into a double dip recession as fears of growing deficits led to tax rises and spending cuts pushing an economy back into recession.

Deflationary fiscal policy involves higher taxes and lower spending. This will reduce the growth of aggregate demand and could lead to lower growth or even negative economic growth. The impact of deflationary fiscal policy on growth depends on:
  • The resilience of consumer spending in face of tax rises and wage freezes
  • Whether exports can take the slack of slowing domestic demand
  • Whether monetary policy can absorb some of the deflationary pressure on the economy.
Conservatives may point to individual countries which have reduced a budget deficit without too much pain. (e.g. Canada) However, these experiences of reducing deficit are usually accompanied by
  • falls in exchange rate and growth in exports to other countries
  • a significant loosening of monetary policy which enables demand to remain strong.
The problem is that at the moment, every major economy seems to be considering deficit reduction as primary macro objective. There is little prospect of exports compensating for fall in domestic demand. We can't have all major currencies depreciating - who is going to depreciate against whom?
Also, with interest rates at close to zero there is little prospect of interest rate cuts. We could pursue further quantitative easing, but, with inflation already above target, this would be complicated.

If UK domestic demand suffers, I can't see exports to Europe compensating. The ECB seem firmly entrenched in fiscal and monetary austerity - whatever the costs to growth or unemployment.

More on fiscal policy

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