As Britons cut down on credit, why Darling should borrow more

10th March 2008
By Ben Broadbent

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One of the most cited papers in economics demonstrates that, under certain conditions, tax cuts have no effect on demand. Higher borrowing has to be paid for eventually.

So, if they’re sufficiently forward-looking, and as long as they’re not ‘credit constrained’ (i.e. they’re already consuming as much as they want to), people will treat any increase in the government deficit simply as deferred taxation, and save the extra money.

Whatever the empirical significance of this result, there’s little doubt it has contributed to a generally accepted view that fiscal policy should not be used as an active stabilisation tool.

In the UK, this philosophy was evident in both the Conservative government’s Medium Term Financial Strategy during the 1980s and in the Fiscal Rules introduced by the current Labour government in 1997. Both enshrine the view that the job of stabilising the economy should lie primarily with monetary policy, and that fiscal policy should be directed towards longer-term objectives.

The notion that tax cuts or hikes are no more than a redistribution of resources, and therefore have no first-order impact on the economy, has also been cited by critics of the fiscal package proposed in the US. One leading commentator, for example, said that the proposed tax cuts will be ineffective because they simply ‘rob Peter to pay Paul’.

However, if there were ever a time for using fiscal policy actively to affect demand, a credit crunch is surely one such occasion. For one thing, monetary policy may be less effective. When banks are under pressure to improve their balance sheets and risk aversion is rising, the financial system may not be that willing, or that able, to pass on reductions in official interest rates.

Second, the very thing that would make the credit crunch significant — the dependence of private-sector spending on the availability of credit — also undermines the case that fiscal policy is ineffective; credit constrained people will spend to cover their present cash flow problems rather than save to cover anticipated future tax rises.

So fiscal policy is only powerless if the credit crunch is also irrelevant; and, symmetrically, the more serious the impact of tighter credit, the more effective fiscal policy will be in alleviating it.

Exactly how serious the credit crunch turns out to be is very difficult to judge. But whatever its exact scale, the qualitative impact of tighter credit is clear enough. Finance is becoming scarcer, and debt-dependent spending is likely to contract.

Another objection to fiscal policy as a stabilisation device is that it is much less flexible than monetary policy (interest rates can be changed every month, discretionary taxes or spending only once or twice a year). However, it so happens that we are now approaching one of those annual occasions (the 2008 Budget) when discretionary fiscal policy can easily be changed.

One the face of it, the government’s own rules require it to increase taxes significantly in the coming year. The pre-Budget report anticipated a reduction of half a per cent of GDP in the cyclically-adjusted deficit in 2008/09; the outlook for the economy, and for the tax base, has deteriorated markedly since then (notwithstanding the jump in tax receipts in January, which did no more than make up for disappointing receipts over the previous three months).

Based on independent economic forecasts, and assuming the same dating of the current cycle, the government just fails to meet its fiscal rules, even if we ignore the impact of Northern Rock on public debt.

However, it’s not clear that failure to meet its fiscal rules would matter much, at least from an economic perspective. The UK is a small, open economy and, relative to the global financial market, additional government borrowing of a few billion pounds will make no difference at all to long-term UK interest rates.

On the other hand, with private-sector interest rates still half a per cent higher than in mid-07, but yields on ten-year government debt one per cent lower — both, in part, a reflection of the ongoing credit crunch — it is considerably cheaper for the government to borrow than for its citizens, as illustrated by the second figure above. It would therefore be an odd time to get too doctrinaire about fiscal policy or, on the back of that, to increase taxes. The more pressing need is to support the economy.

The government will no doubt be criticised if, as we expect, it projects higher public deficits in this year’s Budget, further compromising the reputation of its fiscal rules. However, the whole point of these rules was to keep governments from the risk of having to tighten fiscal policy in the face of a slowing economy, and it would be perverse indeed if in meeting the letter of the rules the Budget were to go against its spirit.

Allowing the deficit to rise would, at this juncture, be the economically sensible thing to do.

Ben Broadbent is chief UK economist

at Goldman Sachs.

Filed Under: , Budget 2008
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