Why Did Europe Expect Fiscal Consolidation to Work?

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Readers Question. Can you explain why the Government and Economic Commentators  are talking about a multiplier (in relation to budget cuts) of between 0.5 and 1, whereas I always thought that the GDP multiplier was bigger than this.

Just to summarise a multiplier of 0.5 would mean fiscal consolidation (spending cuts) of £1bn, would lead to a drop in GDP of only £0.5bn. In other words, they hoped fiscal consolidation would be successful and only have a limited impact on reducing economic growth rates.

However, evidence from the IMF and other studies have shown the fiscal multiplier has proved much higher. In fact a multiplier of up to 2. (for every spending cut of £1bn, we have seen GDP fall £2bn. See: Fiscal multiplier and European austerity).

Essentially, this shows the limitations of using economic models which are applied during very different economic circumstances. If you look at previous attempts at fiscal consolidation undertaken during strong economic growth (e.g. Canada in 1990s), a multiplier of 0.5 would be quite reasonable.

However, there was an unwillingness to admit that the economic situation in the aftermath of a financial crisis and liquidity trap was very different.

 

Why might the Government and European Commentators expect  a multiplier of 0.5?

To some extent, I answered this yesterday on the post – why austerity will increase the budget deficit. But, just to recap, the may have hoped for a multiplier of 0.5 because:

1. Expansionary monetary policy. With spending cuts, usually a Central Bank can cut interest rates and loosen monetary policy so that there is a boost to demand to offset the impact of tax increases and spending cuts.

  • But, the EU and UK government should have realised that interest rates were already at record lows in 2010. Quantitative easing has done little to boost spending in the UK. In Europe, the ECB has never showed any real sign of loosening monetary policy in response to fiscal consolidation. In fact in 2011, the ECB increased interest rates over misplaced fears on inflation.

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Employment Rates – Population ratio

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A look at some varying employment rates across OECD countries.

employment-rates-working-population

Source: OECD short term Labour Market stats

Employment rates are determined by the number of people of working age, who have a job.

The employment rate excludes:

  • People who are unemployed. – actively seeking work and willing to take work
  • People who are students
  • People who take early retirement.
  • People on disability or sickness benefits.
  • Parents staying at home to look after their kids.

Implications of Employment Rates

  • A fall in the employment rate to less than 70% is an indicator that the economy is working well below full capacity.
  • The government will be losing out on employment tax revenue
  • The government will be paying more on welfare benefits to support those out of employment.

 

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Austerity will Increase UK’s debt burden

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According to the National Institute for Economic and Social Research (Niesr), fiscal consolidation in the UK is likely to increase the UK’s debt burden. Or to put it in layman’s terms there will be ‘pain, but no gain’ They model the impact of fiscal consolidation in both ‘normal’ times (scenario 1)  and in the current …

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Independent Currency and Economic Performance

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Why have countries in the Eurozone faced greater difficulties in promoting economic recovery?

How does a country with its own currency find greater flexibility in overcoming a recession?

1. Impact of Currency and Bond Yields

eu-bond-yields-7-countries

A striking feature of recent years is that countries in the Eurozone have been significantly more susceptible to rising bond yields. By comparison, the UK and US who have their own currency, have seen falling bond yields, despite high budget deficits.

Firstly, if you have your own currency, your Central Bank has the ability to print money and buy government bonds if necessary. Therefore bond markets know that a country like the UK is unlikely to have a liquidity crisis. I.e. if not enough people buy bonds on one occasion, the Central Bank can step in and buy the necessary bonds. This creates certainty and removes fears over a temporary liquidity crisis. (it doesn’t solve a solvency issue but, apart from Greece, most Eurozone economies are not insolvent)

However, countries in the Eurozone don’t have this luxury. There is no Central Bank willing to step in and buy bonds (at least not without very protected wrangles and uncertainty)

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The impact of changing the inflation target

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Readers Question: The task of MPC is to stabilise inflation at 2%. Current inflation is around 5% and the Bank of England has to tighten the Monetary policy to control the inflation. If the Government revises the inflation target and set it to 5%, then what would be the effect on the economy and what …

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Data on extent of austerity in UK

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Following on from previous posts – How much has government spending been cut – | How was budget deficit cut by 25%?.

It will be useful to republish some data from Mainly Macro – on a post UK austerity and some facts

UK Cyclically adjusted primary deficit

2010
2011
2012
2013
IMF 2
-6.1
-3.9
-2.8
-1.5
OECD [3]
-5.8
-4.1
-3.0
-1.9

The cyclically adjusted deficit strips away the part of the deficit related to the economic cycle. The actual budget deficit is much higher – because in a recession, borrowing increases as tax revenues fall and welfare payments increase.

A primary deficit takes away interest payments.

The cyclically adjusted primary deficit could also be viewed as the ‘underlying structural deficit’

The sharp fall in the cyclically adjusted primary deficit from 6% of GDP to 1.5% GDP in 2013, shows a contractionary fiscal policy – the combination of spending cuts / freezes and tax increases.

Econ Growth and Unemployment Stats – Countries with Own Currency

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Readers Question I was wondering if you have any graphs plotting UK GDP and Unemployment against other economies which have monetary independence and their own currency. I often see graphs comparing the US with the UK. Are there any which include Sweden, Norway, Switzerland and other countries?

econ-growth-table-aus-nor-swe-swit-uk-us

click to enlarge

Economic growth rates for selected countries.

  • Australia has weathered the global recession well. Helped by strength of its commodity export market.
  • Sweden experienced one of the deepest recession (-5.0% in 2009), but also one of the quickest recoveries with very strong growth since 2010.
  • The Eurozone went back into recession in 2012, and the growth forecasts for 2013 may prove over-optimistic.

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The Economics of Doping in Cycling

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Apart from economics my big interest is in cycling. This weekend, I’m  doing the UK national hill climb championships, a short race up a steep hill in Ramsbottom (the Rake). First prize is a nice cloth cotton cap and a pat on the back. It is unlikely there will be any dope tests (though there are sometimes dope tests at national championships) because they are really expensive and the race is so low key, there isn’t the sponsorship money to pay for them.

doping

However, across the pond, professional races, such as the Tour de France, are a little more well known than amateur UK races I compete in.

I’ve been following the Tour, ever since I’ve been interested in cycling in the early 1990s. I’m sure there was a time when I looked upon cycling with rosy spectacles and admired only the heroic efforts of riders battling through the mountains with nothing more than bread and water. But, alas the doping culture of professional cycling was so deeply embedded that revelations about EPO and other wonder products slowly seeped through – no matter how much you didn’t want to hear it.

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