The Economics of Stimulus

The Economics of Stimulus
Fiscal mismanagement during the boom years constrains the UK's ability now to spend its way out of recession. Fixing the banking sector must be the priority

With the financial crisis intensifying last autumn, Gordon Brown wrote to EU leaders to urge a “new global financial architecture”. As the host of the G20 summit of advanced and emerging economies next month, Mr Brown has apparently tempered his ambitions for reform of the international order. European leaders - notably Angela Merkel, the German Chancellor, and President Sarkozy of France - have shown a marked lack of enthusasiam to be lectured to.

There is indeed much in Mr Brown's schemes that merits scepticism. But reforms to a dysfunctional international financial system are a direct route to remedying the crisis. The recession was born in the banking sector, through imprudemt lending and a credit bubble. The most immediate way of supporting economic activity is to fix the weaknesses in the financial system by recapitalising the banks and ensuring they have sufficient reserves to resume lending.

On an international scale, it will be important to reconsider the role of the International Monetary Fund, which traditionally acts to provide financial assistance to countries that face a liquidity crisis. The IMF cannot strictly act as a lender of last resort, because unlike a central bank, it cannot create money. The G20 should consider how best the IMF can help countries facing a capital crisis, and also consider the vexed question of reforming the voting weights to reflect the shift of power to the emerging economies.

The case for co-ordinated fiscal stimulus, as advanced by President Obama's Administration and by Mr Brown, has a respectable theoretical pedigree. The aim is for governments to fill the gap left by the collapse of private spending. But there are severe practical difficulties. To be effective, stimulus needs to be co-ordinated. The realities of national politics in the G20 economies make that unlikely. The sheer scale of the Obama fiscal package in the US is an open invitation for sectional interests to appropriate public funds for purposes that may have no lasting economic benefit. The wastefulness of huge public works projects in the 1990s during Japan's long recession is not a model to be copied.

The problem is acute in the UK, because public finances are in a mess. Fiscal management was too loose during the boom years. The use of fiscal policy to boost demand is popularly thought of as a Keynesian approach. But Keynes stressed the use of monetary and fiscal policy to stabilise the economy rather than to stimulate it. That means that budget surpluses should be built up during an expansion, so that there is scope to stimulate the economy during a downturn. Since 2002, Mr Brown as Chancellor and now Prime Minister has abandoned that fiscal discipline.

The result is that public borrowing is now expanding alarmingly. The UK budget deficit for February amounted to £9 billion - eight times the level of a year earlier. This brought public-sector net borrowing to a record £75 billion for the first eleven months of the fiscal year. As the recession continues, tax receipts will fall and public borrowing will expand further. It is crucial to the UK that other countries do follow expansionary policies. There will be pressure on the exchange rate if international investors worry about the sustainability of the public finances.

The CBI believes that scope for fiscal easing is limited. The chief executive of the Audit Commission has publicly worried about an Armageddon scenario in which there will be insufficient lenders to match the scale of public borrowing. Even if the economy recovers in 2010, the scale of the UK's public debt will then require a sharp fiscal contraction. It will have to be paid for in large tax increases and cuts in public spending. It is, to adapt an unfortunate phrase of Mr Brown's, beyond any conventional notion of boom and bust.


http://www.timesonline.co.uk/tol/comment/leading_article/article5956066.ece