Unit 4 Macro: Fiscal Policy in the UK - A Question of Credibility

Credibility is a term widely used by politicians who like to claim that their policies and programmes have a stamp of approval and must be followed through to their logical conclusion.

For economists the keep word to link to credibility is commitment – i.e. the expectation that a given policy target or objective will be met in the years ahead

1. Inflation: The Bank of England’s inflation target of 2% had strong credibility in the first ten years after the Bank was made independent, but that credibility has been questioned in recent years with inflation persistently above target

2. Government borrowing and debt: The new Coalition government make repeated references to its policy of cutting the structural budget deficit and a need to commit to this to maintain their credibility especially in financial markets. Chancellor George Osborne has often linked this credibility to keeping the UK’s AAA credit rating for UK sovereign debt

Credibility is also be linked to the word trust – i.e. trust among the public that economic policies are being used to meet a broader range of economic and social objectives. This doesn’t just mean meeting specific inflation or borrowing targets but includes trust that policies will create jobs, prevent another recession, meet environmental aims, or to help maintain economic and social cohesion in vulnerable communities. The danger is that credibility simply becomes associated with the financial markets’ judgement on monetary and fiscal policies.

A tightening of fiscal policy and the start of higher policy interest rates (a tightening of monetary policy) might together tip the UK economy back into a recession. The argument here is that a rigid commitment to keeping inflation within target and cutting the deficit in line with the planned reductions could end up threatening other key objectives such as growth and jobs.

The Osborne View – Cut the deficit to maintain economic credibility and secure the recovery

Remember two key aims of the Coalition government in this area are:

1. To accelerate the reduction of the structural budget deficit over the course of a Parliament

2. The main burden of deficit reduction is from reduced spending rather than increased taxes

The case for cutting the budget deficit

1. Credit rating: High and rising debt threatens the UK’s financial stability and the AAA credit rating. Losing the rating would increase borrowing costs, choking off the recovery

2. Limit future tax rises: Higher public sector debt will eventually lead to a rise in the tax burden for businesses and consumers. The Institute of Fiscal Studies has estimated that that to reduce the UK budget deficit over the next five years will require every person in the UK to pay over £1250 of extra taxes each year.

3. Avoid crowding out: Putting points 1 and 2 together, if borrowing stays high, increased interest rates and taxes risk crowding-out spending and investment by the private sector

4. Fairness: It is inequitable to leave future generations with excessive levels of debt to repay, today’s tax payers need to make a bigger contribution to the cost of state spending. Higher public sector debt represents a transfer of income from those who pay taxes to people who hold government debt and causes a redistribution of income and wealth in the economy

5. Emphasis on monetary policy: If the government cuts spending and borrowing, this will give the Monetary Policy Committee more freedom to continue using low interest rates and other techniques such as quantitative easing (QE) to promote growth and recovery

Naturally there are plenty of opponents to the Osborne approach to fiscal deficit reduction. Many of approach the issue from a Keynesian perspective and they argue that there is a strong case for the government allowing higher levels of public sector borrowing especially when private sector confidence and demand is weak because of domestic and global uncertainty.

Arguments against fiscal austerity – the case for higher government borrowing

1. Stimulus: Government borrowing can benefit growth:
a. A budget deficit can have positive effects if it is used to finance capital spending that leads to an increase in the stock of national assets. For example, spending on transport infrastructure improves the supply-side capacity of the economy.
b. Increased investment in health and education boosts productivity and employment

2. Demand management: Keynesian economists support the use of changing the level of government borrowing as an instrument of managing aggregate demand.
a. An increase in borrowing is a vital stimulus to demand when other sectors of the economy are suffering from weak or falling spending. Fiscal policy can play an important counter-cyclical role “leaning against the wind” of the economic cycle
b. Deep cuts in government spending risks de-railing a fragile recovery
c. A second recession will actually make the fiscal deficit worse

3. Bond interest rates are low – there is a strong demand for UK bonds (gilts) and the UK government can currently borrow at low interest rates. It makes sense to take advantage of this now and boost government spending in key areas to kick-start a weak economy.

4. Multiplier effects: If the multiplier effect of higher spending or tax cuts is high, a fiscal stimulus might be self-financing because it will generate higher incomes, more jobs and extra tax revenues.

5. Targeted and temporary tax cuts: Instead of cutting government spending, Osborne should change course and allow tax cuts to boost demand. Shadow Chancellor Ed Balls has been calling for reductions in the rate of VAT from the current level of 20% and also reductions in employer national insurance contributions in a bid to expand employment particularly among the long-term unemployed.

Credibility and the interest rate (yield) on government bonds

The key aspect of the chart below is that the cost of servicing UK government debt as measured by bond yields has been falling. The ten year bond yield is often taken as the benchmark and this has dropped from over 5% in the summer of 2008 as the economy was falling into recession to just over 2% in November 2011. Is it the result of strong international demand for UK bonds (driving prices higher?) or a belief in the credibility of UK fiscal policy plans to cut the deficit? Or perhaps fears of renewed recession and a period of deflation?