Do we need a fiscal stimulus?

Firstly, it could be argued that it is unnecessary as the economy already has had a significant stimulus from the reduction in interest rates and the depreciation of the pound as Anatole Kaletsky argued in The Times last Monday.

Sterling is now about the same value as it was as we came out of recession in the 1990s, a level which encouraged exports and did not lead to inflation because demand was subdued. I appreciate that the boost to exports may not be that great at the moment because of the recession elsewhere.

As far as interest rates go, there is still room for base rates to fall and even more room for a decline in the London Interbank Offer Rate.

Secondly, have we not learnt from years of using fiscal policy to manage the economy in the 1950s, 60s and 70s that it does not work very well? (I do not remember all of these decades! I started my study of Economics in 1970 but I have studied the earlier decades.)

If taxes are reduced, people may save the extra money or use it to repay debt. If they spend it, they might spend it on imports which does not help demand in the British economy. Admittedly, if tax reductions are targeted on the low paid, the chances are greater that they will spend it and spend it on British produced goods and services. But how soon will they get any benefit from reductions which they notice?
If the government choose to increase their spending, it may not happen that soon. New capital expenditure is difficult to start; roads have to be planned, hospitals and schools designed.

Any fiscal boost has to be financed by extra borrowing. It is likely that this extra borrowing will “crowd out” private expenditure which will reduce the impact of the extra public expenditure of any expenditure arising from tax reductions. In addition, as taxpayers will realise that the money will have to be repaid so that taxes will rise in the future, they may decide not to spend money now. Think about Friedman’s permanent income hypothesis.
Finally, there will be time lags both before the fiscal stimulus results in extra spending and before the extra spending has any effect on the economy. By the time it does have any effect we may be recovering from recession; the Bank of England’s projection for GDP growth certainly suggested a V-shaped recession with recovery in 2010. We could be back to a “stop-go” era.

Of course, I may be wrong. We may not be going to recover from this recession as quickly as the Bank of England project. The fact that we are entering this recession with lower inflation than in the recessions of the 70s, 80s and 90s means that deflation is a greater risk and we should try to avoid deflation. We will only know in two years time!