Duncan’s Economic Blog

The Dangers of Spending Cuts: Some Advice from the IMF

Posted in Uncategorized by duncanseconomicblog on February 15, 2011

Recently I’ve been telling a lot of people that if they want a clear and balanced overview of how the government’s coming spending cuts might hurt the economy they should look no further than the October edition of the IMF’s World Economic Outlook. In particular they should read chapter 3.

I realise that many people don’t have a strong desire to read through 32 pages of economic analysis, so I thought I’d summarise the key points below.

Whilst looking at this – try to remember two things:

First, the scale of Osborne’s planned fiscal consolidation (this graph from a June edition of the Economist will help).

 

And second, that according to the OBR that the trend growth rate for the UK economy over the next few years is some where between 2% and 2.5% per year.

So we have trend growth of somewhere between 2% and 2.5% per annum and a fiscal tightening of about 6.2% of GDP over the next 4 years.

The IMF estimates that spending cuts of 1% of GDP subtract 0.5% from growth.

However they also believe that the effects of spending cuts are typically cushioned by the central bank cutting rate sand the value of a country’s currency falling.

The Bank of England has no room to cut rates to support growth (they are already at 0.5% and are more likely to rise rather than fall in the coming year). Sterling is unlikely to fall much further, it already depreciated heavily in 2008-09 and in an era of more managed exchange rates (‘currency years’) it’s hard to see a much greater fall.

If interest rates don’t fall and the currency doesn’t lose value then the IMF estimate that spending cuts of 1% of GDP subtract 1% from growth.

In previous periods of large fiscal austerity (Canada & Sweden, for example, in the early 1990s), countries were able to grow by exporting their way to growth. Although spending cuts suppressed domestic demand, these countries could still rely on external demand.

What is very unusual about the current situation is that we have austerity policies across the developed world. Europe already and the US starting in 2012.

The IMF estimate that if other countries are cutting at the same time, if interest rates cannot fall and if the currency does not depreciate, then spending cuts of 1% of GDP subtract 2% from growth.

As they say:

Overall, these results illustrate that changes in both the interest rate and the exchange rate are important to the adjustment process. When countries cannot rely on the exchange rate channel to stimulate net exports, as in the case of the global consolidation, and cannot ease monetary policy to stimulate domestic demand, due to the zero interest rate floor, the output costs of fiscal consolidation are much larger. Thus, in the presence of the zero interest rate floor, there could be large output costs associated with front-loaded fiscal retrenchment implemented across all the large economies at the same time.

We are about to find out how large the costs of ‘front-loaded fiscal retrenchment’ actually are.

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15 Responses

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  1. michael burke said, on February 15, 2011 at 2:00 pm

    Very useful pointer to some equally valuable IMF research.

    It’s possible that a renewed dive in Sterling could offset some of that 2:1 impact on growth (as the economy contracts by twice the amount of the cuts), but in the recent period the trend has been in the opposite direction and Sterling’s appreciation would be more likely to increase the ratio.

    The effect on the deficit too is disastrous. The Treasury’s assumption is that a £1 decline in output leads to a £0.75 deterioration in government finances. So, a £1 cut could lead to a £2 decline in output, which produces a £1.40 decline in government finances, a net deterioration in public finances of £0.40.

    This is what has happened in Greece, Ireland and Portugal.

  2. Dave Holden said, on February 15, 2011 at 2:29 pm

    The point of course is not that things are going to get very tough under Osbourne it’s that things are going to get very tough no matter who’s policies get implemented – it’s just a question of when and how tough.

    See for instance this frightening analysis

    http://www.ritholtz.com/blog/2011/02/the-future-of-public-debt-3/

  3. Neil Wilson said, on February 15, 2011 at 2:29 pm

    Of course what the graph really shows is that Labour and the Tories both operate pretty much the same economic policy.

    Which is removing money from the economy needlessly and hoping the Deus ex Machina of ‘investment’ will magically appear to save the day.

    It won’t.

  4. gastro george said, on February 15, 2011 at 2:42 pm

    And then when you add in a probable rise in interest rates … demand goes further south – in the metaphorical not geographical sense.

  5. Cian said, on February 15, 2011 at 4:56 pm

    Trouble is that you’re arguing against what is essentially a religious belief by this point. All government spending bad, all private spending bad. And so we march to hell.

  6. gastro george said, on February 15, 2011 at 5:26 pm

    Has there been any discussion anywhere about the tendency for the (neo-liberal) economy to become more interested in extracting money by bringing future income streams forward.

    You can argue that private debt is one way of bringing forward future purchases. The property bubble and equity extraction thereof is another way of extracting cash today from tomorrow’s values (spending our children’s money).

    Similarly (to my untrained mind) the securitisation of future income streams is another way of realising tomorrow’s profits today.

    Is this a pattern we see here?

  7. Luis Enrique said, on February 15, 2011 at 5:46 pm

    “We are about to find out how large the costs of ‘front-loaded fiscal retrenchment’ actually are.”

    so we’ve got spending cuts of what, 1 or 2 per cent each year? (the 6.25 per cent is cumulative, right?) so if IMF is right, that would take 2 to 4 per cent off GDP?

    If we take OBR as baseline, do you think we’re going to see zero output growth next year?

    For future reference what could happen next year to cause you to say “the costs of ‘front-loaded fiscal retrenchment’ …. were zero” – if we grow at 2.5% next year, will that mean you were wrong about the impact of cuts? (This is a bet I am not going to be offering – this forecasting business is too difficult for me, and the arguments that cuts will really hurt look compelling – I just think it’s useful to know what determines whether an assertion/forecast is true or false, ex-post)

    • duncanseconomicblog said, on February 16, 2011 at 5:32 pm

      Very fair questions.

      I think the OBR has underestimated the impact of spending cuts, of course with a rate rise likely we’ll never be able to tell precisely what caused 2011′s slowdown.

      I shall ponder the last question you raise and get back to you!

  8. Newmania said, on February 16, 2011 at 10:29 pm

    Its so confusing .I pop in rarely and each time I do the IMF is either an absurd joke whose opinions are random or an omniscient deity who knows the price of eggs after the next ice age .Its an omniscient day today is it ?
    Not sure I understand that graph either I thought the Party previously known as ‘New’ were going for a nice sharp 80% taxes , 20% cuts deal. Is that what I am looking at ?You see I `d have thought that taxing everyone to the point of curling up in a ball and crying might be slightly worse than slashing some golden pensions from baby boomer teachers who have netted oodles out of the same property bubble they blame everyone else for .
    Duncan, 2011`s slow down was caused by the fact Brown turned on the taps to try and buy the election and someone had to turn them off before we drowned. Simples mate.

    Forward together in idle squander brother Duncan we shall prevail.

  9. crossland said, on February 17, 2011 at 10:27 am

    I’m just wondering,
    One of the Coalitions main arguments was that it had to make level of cuts it did to reassure the markets and keep bond rates down etc.
    They even appeared a lot on the telly to tell us how the Bond rates showed that the markets were reassured by their ‘tough plans’.
    However,
    We’ve had a series of U-turns on the forest sell off,housing benefit etc all of which point to the government not being able to follow through on its plans.

    If the coalition case re what markets want has merit,shouldnt there be a reaction in the bond markets ?

  10. Britain: Targeting Stagflation said, on February 22, 2011 at 9:01 am

    [...] 4 See Duncan Weldon ‘The danger of spending cuts: some advice from the IMF’; http://duncanseconomicblog.wordpress.com/2011/02/15/the-dangers-of-spending-cuts-some-advice-from-th… [...]

  11. [...] is unlikely to be correct, the evidence (see this post for example on recent IMF work) suggests that austerity policies lead to weaker growth – [...]

  12. [...] has chosen to stay in the real world and argue that although government deficits must be cut, the impact of the cuts will hurt the economy, much of the right has adopted the Mirror World Logic that cuts will actually help the economy to [...]

  13. [...] 1 – The impact of spending cuts on growth has to be a lot lower than the IMF estimate them to be. [...]

  14. [...] – The impact of spending cuts on growth has to be a lot lower than the IMF estimate them to be. 2 – We have to experience very fast export growth (despite our major trading partner, the EU, [...]


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