Saturday, February 11, 2012

How fiscal policy does and doesn't work

It's remarkable that the politicians of Europe and America are making things much worse for themselves and their people because they've unlearnt the economic lessons of the past 70 years.

Economists spent many years studying what policymakers did wrong in the Great Depression of the 1930s, making it much worse than it needed to be. One well-understood lesson was not to try to get the government budget back into balance too quickly.

This is counter-intuitive to many people. The government's tax revenues have collapsed, its spending has increased, it has a yawning budget deficit and government debt is piling up. Surely it's obviously right to get spending and your income back into line as quickly as you can.

Not if you're a national government. Why not? Because governments are so big that what they do affects the rest of the economy. Remember, governments can borrow more for longer than the richest individual or corporation, since they represent the whole community and have the power to pay their bills by levying taxes.

Economic downturns, recessions or depressions almost always manifest themselves in consumers and businesses cutting their spending. The more they cut, the more people lose their jobs and their businesses and the greater the decline in spending.

In such circumstances, it's not possible for the private sector to lift itself up by its bootstraps. Clearly, the government needs to do something that helps the private sector get back on its feet.

One thing the central bank can do is cut interest rates to encourage borrowing and spending. In normal times this is usually effective, but in really bad times a lot of people are too uncertain about the future to want to borrow and expand, no matter how low rates are. And if interest rates are already very low - as they are in the advanced economies at present - you can't cut them below zero.

The next tool available to help the private sector is "fiscal policy" - the budget. The first way to help is do nothing: when fewer people paying tax and more people on the dole cause the budget deficit to blow out, don't do anything to counter it.

This process happens automatically when the private sector turns down, and the fact that some people are paying out less money to the government while others are getting more money from it means the government is helping to cushion the private sector's fall, stopping it from falling further. Thus economists say budgets contain "automatic stabilisers".

If you try to counter the effect of these stabilisers by cutting spending or increasing taxes, you'll push the private sector down further and, because of that, probably won't succeed in getting the budget closer to balance in any case.

The second way to help is more active: stimulate the private sector by cutting taxes or increasing spending. If you were to do this when the economy was strong, you'd just worsen inflation. But if you do it when the economy is flat on its back, it will probably be effective, particularly if you increase spending rather than cutting taxes (which would allow some people to save their tax cuts).

Once you get the economy growing again, tax collections will improve and people will go off the dole, thus causing the deficit to reduce. This is the automatic stabilisers working the other way. Keep it up and the budget balance will turn to surplus, which you can then use to repay government debt.

See the point? Exercise enough discipline and patience and eventually the budget problem will fix itself.

All this had been well understood by economists and politicians for many years. It was how governments responded to the global financial crisis in 2008. But governments in Britain and the euro zone, and the US Congress, are now doing pretty much the opposite.

Their economies are still quite weak but they want to increase taxes or - more commonly - slash government spending to get their big budget deficits down in a hurry. In consequence of this policy of "austerity", the European economies are heading back into recession and their deficits getting worse.

Why are they doing something so counter-productive? Because their stock of government debt is so unsustainably high. Whereas sensible policy involves running surpluses and reducing debt during the good years, they kept running deficits and piling it up in the noughties.

When the global financial crisis struck in 2008, many had to borrow heavily to rescue their banks and then borrow even more to kick-start their economies. Their debt is now so high the financial markets have started wondering whether they'll be able to repay it.

But the flighty financial markets are an unreliable guide to good policy: though they seemed to approve when governments announced their austerity programs, they started disapproving when they saw those programs were causing economies to weaken.

Of course, when a country's sovereign debt gets so high that markets will soon refuse to lend more to it at any price, it has no choice but austerity. You can renege on your debts, but you can't run a deficit if no one will finance it.

Even if some international institution bails you out, it will punish you for your profligacy by insisting on austerity. Will this make things worse long before it makes them better? Inevitably.

That's the case of Greece. But most of the European countries aren't in those dire straits, so why are they slashing spending?

What they should be doing is promising and laying plans to reduce their spending down the track, as their economies recover and can take it in their stride.

Why don't they? Because, after decades of fiscal indiscipline, they don't have much credibility when making promises to be good tomorrow.

But that doesn't change economic reality: cut when the economy's weak and you make it weaker. The answer is to find ways of making their promises more credible.

As for the Americans, they too have years of fiscal indiscipline and a way-too-high level of debt. But though it suits President Obama's critics to claim the US has a "debt crisis", it doesn't. The world is still so anxious to lend to the US government that the yield (effective interest rate) on its long-term debt is down to 2 per cent.

It has plenty of time to get its budgetary house in order but, at present, a hostile Congress has the budget set up to crunch the US economy next year. These guys have learnt nothing.