by Michael Burke
‘Growth is the Fix for British Finances’ is the excellent title of a recent piece in the Financial Times from Martin Wolf.
In contrast to all of those who have argued that ‘overspending’ by Gordon Brown has created the large public sector deficit, the FT’s chief economics commentator sets the record straight. He points out, as SEB has done previously, that the decline in tax revenues is the cause of the crisis in government finances. In the 2010 Budget, spending is just 2.2 per cent higher than was projected 2 years ago, despite the recession, while tax revenues are 18.1 per cent lower. In addition, the 9.3 per cent fall in nominal GDP has increased all debt/GDP measures.
From this the policy prescription is equally clear, as Wolf argues, “the single most effective way to bring the public finances back under control is greater demand and higher GDP. This needs higher investment and net exports and more dynamic supply. Measures that seek to close the fiscal deficit, but destroy demand in doing so, will not help: fiscal austerity is just not enough.”
But the actual policy prescriptions advanced are wide of the mark. Wolf ends the piece with a renewed call for spending cuts and tax increases. He must know that these directly run counter to the stated goal of creating “higher demand and higher GDP”.
This is because his starting-point is the need for the government to pander to a reluctant private sector, to tempt it to increase its investment levels through taxpayer-funded tax cuts. But Britain, in common with all the OECD economies, is experiencing an investment strike. The slump in business investment is the main component and driving force behind the recession. Private investment continues to fall, even as other areas of activity rebound moderately.
This is because private investment is driven by profit. Unless national incomes can be driven up, or labour’s share of national income driven down, businesses will continue their investment strike. All proposals for cuts, including Martin Wolf’s, amount to an effort to secure the second option, at the expense of workers and the poor.
In addition, any policy based on encouraging businesses to invest is likely to be wholly ineffective. SEB recently highlighted IMF research on the various forms of fiscal stimulus . It is worth returning to, as it deals precisely with this question. Its finding is that corporate tax incentives are the least effective of all possible fiscal stimulus measures examined.
According the research, based on seven different macroeconomic models from leading central banks and agencies such as the IMF, OECD and EU, stimulus equivalent to 1 per cent of GDP comprised of corporate tax cuts yields an increase in GDP of just 0.5 per cent of GDP over 5 years. By contrast, government investment yields the highest return, up to 4.5 per cent of GDP over 5 years. In the words of the authors, “only target transfers [to the poor] come close.”
Their key conclusions are worth quoting more fully, “First, there is a robust finding across all models that fiscal policy can have sizeable output multipliers, particularly for spending and targeted transfers. Second, the effectiveness of fiscal policy will be largest in circumstances in which monetary policy supports fiscal policy by accommodating stimulative fiscal actions through holding interest rates constant for some period of time. Third, more persistent stimulus, if the additional stimulus is measured in years rather than decades, is even more effective if monetary policy remain accommodative.”
The authors’ sole caveat is that the fiscal stimulus should last years, not decades. But if fiscal stimulus has not worked even over that timescale, then a ‘somewhat more comprehensive socialisation of investment’ would be on the agenda.
The first task is to recognize the nature of the problem, as Martin Wolf has done. But, as the IMF research demonstrates, relying on the private sector to correct the crisis of its own making will not provide the fix Britain needs.
1. IMF, The Effects of Fiscal Stimulus in Structural Models, IMF WP/10/73
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