Duncan’s Economic Blog

Fiscal Counterfactuals

Posted in Uncategorized by duncanseconomicblog on June 23, 2009

I wonder…

 If Cameron had been PM and Osborne Chancellor last year, would this article have appeared in the Times rather than the Irish Times?

 Sometimes a government may decide to “let the deficit ride” and borrow money to bridge the gap. Our Government has decided not to do this, but to reduce the deficit as much as it can – by about €5 billion in 2009 and by about the same in each of the next two years. The target is to get the deficit below 3 per cent of GDP by 2013, in line with EU guidelines.

This means raising taxes and cutting expenditure over a long period, and runs the risk of deepening the recession. Higher taxes will hurt consumption, investment and work effort. Lower spending will mean less demand and perhaps less essential infrastructure.

The fact that the “stabilisation” will continue for three or more years means people may hoard. Household incomes – already reduced – will be budgeted carefully, not just to pay this year’s higher taxes and levies but also in anticipation of new carbon, property, and other taxes in the pipeline. People also have to allow for the fact that they may not have a job next year.

It is hard to overestimate the fear factor. It seems unlikely that non-essential consumer spending will pick up soon. It doesn’t matter much if our consumption of imported goods falls, but falling demand for domestically produced goods will mean more job losses and bankruptcies.

Instead of a stimulus package – which other countries have introduced – we have gone in the other direction. It could prove to be the worst own goal in our history. If the Government’s top priority of “stabilising the public finances” does extinguish the last spark in the economy, all bets are off. It might not even succeed in reducing the deficit. If economic activity falls further, so will revenue, and the Government will find itself chasing a target from which it is constantly moving away.

Sticking with alternative policies, Germany is on the verge of passing what I would describe as the most economically illiterate law ever conceived: a balanced budget amendment. As Wolfgang Munchau puts it

From 2016, it will be illegal for the federal government to run a deficit of more than 0.35 per cent of gross domestic product. From 2020, the federal states will not be allowed to run any deficit at all. Unlike Europe’s stability and growth pact, which was first circumvented, later softened and then ignored, this unilateral constitutional law will stick. I would expect that for the next 20 or 30 years, deficit reduction will be the first, second and third priority of German economic policy.


 To meet the interim deficit reduction goals, the new government will have to start cutting the structural deficits by 2011 at the latest. There is clear danger that the budget consolidation timetable might conflict with the need for further economic stimulus, should the economic crisis take another turn for the worse.


What is the rationale for such a decision? It cannot be economic, for there is no rule in economics to suggest that zero is the correct level of debt, which is what a balanced budget would effectively imply in the very long run.


4 Responses

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  1. Paul said, on June 23, 2009 at 9:50 pm

    Those pesky Germans up to their free-riding actvities again, hoping the rest of the EU will provide a stimulus whenever necessary, and thus ensure they don’t have to? all very strange.

    • duncanseconomicblog said, on June 24, 2009 at 7:56 am

      Indeed – but the best thing is… They then complain about the very same policies on which they free ride!

  2. ben said, on June 24, 2009 at 6:34 pm

    free loading off the back of everyone elses public debt is one thing, but when your as important as Germany to EU economic strength and international clout, slashing budgets and smashing investment is hidiously irresponsible….tut tut ange

  3. […] UK net borrowing is still a lot lower than in the USA, Japan, France and Germany. Duncan’s not worried, and nor is Chris Dillow. An aggressive pursuit of government budget balance during the recession, as in Ireland, would be disastrous. […]

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