The Dangers of Spending Cuts: Some Advice from the IMF
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.