Guido says the economy can grow even if government spending is cut. There is quite a bit of historical (pdf) evidence (pdf) for this, and not just for the UK.
The question, though, is: what’s the mechanism whereby lower public spending can raise GDP growth? Two obvious possibilities are blocked off.
First, tighter fiscal policy in the past has been accompanied by lower short-term interest rates. But this can’t happen now. Yes, the Bank of England could step up its QE policy, but the efficacy of this is uncertain.
Secondly, past fiscal tightenings came when the personal sector’s debt-income ratio was low, and when banks freely lent to households, so personal borrowing increased to offset lower government borrowing. A repeat of this is unlikely.
So, what mechanisms are left?
1. Lower gilt yields could crowd in corporate spending. But real yields are already under 1%, so they can’t fall far. And aggregate corporate investment isn’t very sensitive to moves in the risk-free rate; if they were, it wouldn’t have collapsed in the last two years.
2. Ricardian equivalence; households respond to the prospect of lower government debt by borrowing in anticipation of lower future taxes. This, however, only predicts that a tighter fiscal policy will not affect the economy, not that it’ll expand it. And even this requires that households be able to borrow freely, which is unlikely in an era when banks will have to increase their capital ratios.
3. Sterling could fall, as the FX market anticipates lower interest rates than would otherwise be the case, and this boosts exports. But as we’ve learned this year, the response of trade volumes to exchange rate falls is, at best, slow and at worst small.
There is, however, a fourth possibility. Silvia Ardagna has shown (pdf) that fiscal tightenings can sometimes raise GDP - though not always - if they involve cutting the public sector wage bill. The mechanism here, I suspect, is not just the mechanical effect of lower wages tending to raise private sector employment. It could also be the case that capitalists’ confidence - profit expectations - improves if they see a government attacking workers.
In this sense, a fiscal contraction might boost growth, if it is part of a class war.
But how likely is a repeat of this? Yes, for many countries in the 1970s and 80s, capitalists’ investment intentions were depressed by a fear of worker militancy, which receded as governments successfully attacked public sector workers. But is this really the case now?
The question, though, is: what’s the mechanism whereby lower public spending can raise GDP growth? Two obvious possibilities are blocked off.
First, tighter fiscal policy in the past has been accompanied by lower short-term interest rates. But this can’t happen now. Yes, the Bank of England could step up its QE policy, but the efficacy of this is uncertain.
Secondly, past fiscal tightenings came when the personal sector’s debt-income ratio was low, and when banks freely lent to households, so personal borrowing increased to offset lower government borrowing. A repeat of this is unlikely.
So, what mechanisms are left?
1. Lower gilt yields could crowd in corporate spending. But real yields are already under 1%, so they can’t fall far. And aggregate corporate investment isn’t very sensitive to moves in the risk-free rate; if they were, it wouldn’t have collapsed in the last two years.
2. Ricardian equivalence; households respond to the prospect of lower government debt by borrowing in anticipation of lower future taxes. This, however, only predicts that a tighter fiscal policy will not affect the economy, not that it’ll expand it. And even this requires that households be able to borrow freely, which is unlikely in an era when banks will have to increase their capital ratios.
3. Sterling could fall, as the FX market anticipates lower interest rates than would otherwise be the case, and this boosts exports. But as we’ve learned this year, the response of trade volumes to exchange rate falls is, at best, slow and at worst small.
There is, however, a fourth possibility. Silvia Ardagna has shown (pdf) that fiscal tightenings can sometimes raise GDP - though not always - if they involve cutting the public sector wage bill. The mechanism here, I suspect, is not just the mechanical effect of lower wages tending to raise private sector employment. It could also be the case that capitalists’ confidence - profit expectations - improves if they see a government attacking workers.
In this sense, a fiscal contraction might boost growth, if it is part of a class war.
But how likely is a repeat of this? Yes, for many countries in the 1970s and 80s, capitalists’ investment intentions were depressed by a fear of worker militancy, which receded as governments successfully attacked public sector workers. But is this really the case now?
" It could also be the case that capitalists’ confidence - profit expectations - improves if they see a government attacking workers."
How would you test that hypothesis?
Posted by: Innocent Abroad | December 19, 2009 at 03:52 PM
Good question. My point is a variation of the animal spirits hypothesis, which is also awkward to test. One problem is that business investment is horribly noisy, which makes testing any hypothesis tricky.
I guess one thing to look for would be if business confidence - which can be measured by things like the CBI survey in the UK - improves more than normal in times when the government wage bill falls.
Posted by: chris | December 19, 2009 at 06:24 PM
We're in a liquidity trap, so Guido is insane.
Posted by: Alex | December 19, 2009 at 11:21 PM
Alternatively it could be because if you shrink the number of people in government it will do less. Bureaucracy is bad within an organisation (you've posted loads of papers showing this), so externally imposed bureaucracy should also be bad and therefore getting rid of it should be good.
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Posted by: Law Dissertation | December 26, 2009 at 02:21 PM
>>The question, though, is: what’s the mechanism whereby lower public spending can raise GDP growth?<<
The other question, which you neglect, is what happens to interest rates if public spending is not brought under control ?
The UK government will not be able to carry on borrowing on present terms for very much longer.
We are in a position where there are no good choices. The best we can expect is less bad ones.
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What British prime minister declared the “Class war” over in 1959?
What British prime minister declared the “Class war” over in 1959, then appointed a duke, a marquess and three earls to his cabinet?
Posted by: viagra online | February 11, 2010 at 03:48 PM
I don't believe Guido as I cannot personally imagine how economy can grow without the government spending on the things that lets the economy grow.
Posted by: Evans | February 17, 2010 at 02:21 AM
These businesses are mean, take a look at point 3.
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