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October 19, 2010 10:41 pm
The US and UK have similarities that go beyond speaking the same language: both had huge expansions in household credit; both had to rescue their financial sectors; both have watched their central banks push interest rates close to zero and adopt “quantitative easing”; and both have experienced massive post-crisis increases in fiscal deficits. Yet a big policy divergence is on the way. The coalition government of the UK will on Wednesday announce details of their cuts in government spending. Nothing comparable is expected in the US. In its latest forecasts, the International Monetary Fund has noted this divergence. But the bond markets seem quite insouciant, at least so far (see chart).
We can identify differences in the post-crisis experience of the two countries: the US had a smaller decline in gross domestic product (a peak to trough fall of 4 per cent, against 6.4 per cent for the UK) and a bigger increase in the rate of unemployment (a rise of 5 percentage points between 2007 and 2010, against 2.5 per cent for the UK). US core inflation has fallen further than that of the UK (to 0.8 per cent in the year to September, against 2.9 per cent), largely because of the impact of depreciation on the UK.
Yet the countries share the lengthy and depressing process of post-bubble deleveraging and retrenchment explained by Carmen Reinhart of the University of Maryland and Harvard’s Kenneth Rogoff in their masterpiece, This Time is Different. Both economies are running well below capacity.
Both must choose between the short-run risks of fiscal retrenchment for recovery and the longer-run risks of huge fiscal deficits for creditworthiness. Both rely on monetary policy. But the UK must rely on it far more, given its prospective fiscal tightening.
Why, then, has this divergence occurred? What impact might it have? How far will QE offset its impact? What, finally, might we learn about the respective roles of monetary and fiscal policy?
The answer to the first question is that the British policymaking elite was shocked into sobriety by the eurozone fiscal crisis. I have argued that the example of Greece, a country without a central bank and limited prospects for a return to growth, is very different from that of the UK. I have argued that the fiscal retrenchment planned in the UK – a cyclically-adjusted tightening of 8 per cent of GDP over five years – is excessive. Yet the failure of the US to develop any credible path for fiscal tightening in the longer term is also grossly irresponsible.
On the likely impact of fiscal tightening, the IMF’s latest World Economic Outlook provides a superb analysis. It demolishes the arguments for “expansionary contractions”. It shows that previous studies failed to identify episodes of deliberate fiscal tightening. They look, instead, at episodes of cyclically-adjusted deficit reduction, which are a very different thing.
The principal conclusions of this analysis are as follows.
First, a fiscal consolidation of 1 per cent of GDP tends to reduce real domestic demand by 1 per cent and GDP by 0.5 per cent over two years. If so, the UK consolidation would lower real demand, other things equal, by a total of 8 per cent and GDP by 4 per cent.
Second, lower interest rates usually cushion these effects. This cannot be the case today. That will make consolidation more expensive.
Third, a decline in the real exchange rate normally cushions the impact. This is relevant to the UK, which has enjoyed a roughly 18 per cent depreciation of the real exchange rate since the crisis began.
Fourth, fiscal contractions that rely on spending cuts are more expansionary than tax-driven adjustment. But this is partly because central banks seem to act more aggressively in response.
Finally, reduced debt is beneficial in the longer term, other things equal, because it lowers real interest rates. Whether this is relevant now, when real interest rates are so low (close to 1 per cent) is doubtful.
The conclusion is that the UK’s fiscal consolidation is likely to be contractionary at a rate of between 1 and 2 per cent of GDP, each year.
Would quantitative easing offset this? The plausible answer is: no.
The obvious impact of central bank purchases of securities is on long-term interest rates. But these are already low for creditworthy large borrowers (many of which are flush with funds, in any case). Meanwhile, banks remain unwilling to expand credit. The low interest-rate environment helps the process of deleveraging. But it is doubtful whether additional quantitative easing would add much to this. The same may be true in the US, even though last week’s important speech by Ben Bernanke, Fed chairman, strongly indicates that extra easing is in the offing. But the drag from fiscal policy is going to be far smaller in the US. So a second round of quantitative easing should be rather more successful, since its economy should need less assistance.
Now let us consider the final question: what are we learning about the relative role of monetary and fiscal policies? It is conventional wisdom among economists that monetary policy is precise, predictable and effective, while fiscal policy is the opposite. Yet, as Joseph Stiglitz argued in the FT this week, it is far from evident that this is true. The impact of quantitative easing is anything but predictable. More important, monetary policy has worked, in practice, via credit expansion. It is, as a result, at least partly responsible for the debt crisis of today. Who can now confidently state that reliance on a policy which worked by financing overpriced housing was better than using surplus savings for higher public investment? Similarly, who can confidently state that it must be better to rely on relaunching a private credit boom than on higher public investment? Monetary policy is not self-evidently the most reliable instrument for tackling the implosion of a prior private debt explosion.
The big argument in favour of the UK government’s austerity is that the alternative might, in the words, of George Osborne, chancellor of the exchequer, be “bankruptcy”. Why a country whose actual and prospective public debt will remain below the average of the past two centuries should be in such dire straits is very far from evident. What we do know is that the UK has launched a remarkable policy experiment. The contrast with the US should at least be instructive. We will never know whether disaster was indeed imminent. But the British are going to learn much – and so will the rest of the world.
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