In 2009-2010, the UK's budget deficit was about 11% of GDP (see here); there was no dispute among economists that a credible plan for fiscal consolidation was required. The discussion turned on the timing, given the fact that short-term interest rates are effectively at zero, output is substantially below capacity, and unemployment well above most estimates of the natural rate of unemployment.
- Many argued that consolidation should be delayed until recovery was clearly established.
- Others argued that early action was required to prevent large deficits leading to higher interest rates.
However, few on either side attempted to quantify the costs and benefits of delay. Our new research attempts to do just that (Bagaria et al. 2012).
In standard macroeconomic models of the sort used by most central banks and finance ministries, the effects of fiscal policy are often small and short-lived. This is for three reasons:
- With an inflation target, the central banks will largely offset the impact on demand of changes to fiscal policy;
- Fiscal multipliers don't vary much, if at all, across the cycle, so it doesn't really matter much when consolidation is undertaken
- The strong equilibrium-reverting properties of such models means that output tends to revert to trend in any event.
But these assumptions are all questionable (see, for example, DeLong and Summers 2012; and Auerbach and Gorodnichenko 2012).
- First, interest rates, both short and long term, are currently extraordinarily low, despite very high deficits.
The response of monetary policy to fiscal policy may be different if consolidation is undertaken at a time when interest rates are close to the zero lower bound.
- Second, in normal times, the ability to borrow enables households and firms to smooth consumption and investment over time, reducing the impact of fiscal policy.
But, given the impact of the financial crisis on the banking system, some households and firms may be unable to borrow under current conditions – they may be ‘credit constrained’ (Barrell et al. 2012).
- Third, protracted high levels of unemployment may have an impact on the supply side of the economy over the medium term.
The long-term unemployed are less likely to look for, or to get, jobs, and may suffer permanent damage to skills and motivation. This may reduce the efficiency of the labour market, damaging output and employment; the existence of these hysteresis effects in the UK labour market are well established, but rarely incorporated into macroeconomic forecasting (see, for example, Nickell 1987 and Manning 1993).
In Bagaria et al. (2012), we use NIESR's macroeconomic model, NiGEM, to model all three of these effects. We assume that monetary policy would not in practice have responded to changes in fiscal policy, with interest rates at the zero lower bound and demand depressed; we assume that a higher proportion than normal of consumers and firms are credit constrained; and we incorporate into our wage determination equation the impact of current elevated levels of long-term unemployment, using the transition probabilities estimated by Elsby and Smith (2010). We do not, however, incorporate the even longer-lasting hysteresis effects that would occur if long-term unemployment led to permanent withdrawal from the labour force; it is too early to tell if this is happening in the UK in this recession.
We contrast three scenarios:
- The consolidation plan implemented by the current British government;
- The same plan, but with implementation delayed for three years; and
- No consolidation at all.
As expected, the modelling does indeed show that doing nothing was not an option; our ‘no fiscal consolidation’ scenario leads to unsustainable debt ratios . So some pain is inevitable; under both our ‘immediate consolidation’ scenario, and the ‘delayed consolidation’, the necessary increases in taxes and reductions in spending reduce growth and increase unemployment.
But our estimates indicate that the impact would have been substantially less, and less long-lasting, if consolidation had been delayed until more normal times. The cumulative loss of output over the period 2011-2021 amounts to about £239 billion in 2010 prices, or about 16% of 2010 GDP. And unemployment is considerably higher for longer – still 1 percentage point higher even in 2019, because the impact of consolidation lasts for 2-4 years longer if tightening comes when the economy is depressed. So early tightening has real, and large, costs.
Table 1. GDP in £billion, 2010 prices under two scenarios
Source: NiGEM simulations
We assume that delaying fiscal tightening has no impact on long-term interest rates. This is consistent with recent experience, both in the UK and in other advanced countries with monetary independence (IMF 2012), who suggest that there is "little evidence" that slowing consolidation would trigger an adverse market reaction . As pointed out in Portes (2012) and IMF (2012), "long term interest rates in the UK and US have also correlated positively with equity price movements, indicating that bond yields have been driven more by growth expectations than fears of a sovereign crisis."
It is important to say that these are scenarios, not forecasts; our modelling could be overestimating or indeed underestimating the impact of delay. The choice of 2014 as a time when the economy would have returned to normal is arbitrary, and of course in reality wider global economic developments could well have changed that in any case. But they are a useful illustration of why, and how much, macroeconomic policy judgements matter.
The good news is that, in the long run, in our model at least, it does all wash out; whatever the path of consolidation, the economy eventually returns to long-run equilibrium. What this analysis shows is that the economic pain resulting from fiscal consolidation could not have been avoided, but could have been substantially reduced. The standard policy prescription – to delay deficit reduction until after recovery is clearly under way and the output shortfall significantly reduced – remains valid.
Auerbach, Alan and Yuriy Gorodnichenko, (2012), "Fiscal multipliers in recession and expansion”, American Economic Journal; Economic Policy, 4(2):1-27
Bagaria, Nitika, Dawn Holland and John Van Reenen (2012), "Fiscal Consolidation in a Depression", National Institute Economic Review 221.
Barrell, Ray, Dawn Holland and Ian Hurst, (2012), "Fiscal consolidation Part 2: fiscal multipliers and fiscal consolidations", OECD Economics Department Working Paper No. 933
Elsby, Michael and Jennifer Smith (2010), "The great recession in the UK labour market: a transatlantic perspective", National Institute Economic Review 214.
DeLong, Brad, and Lawrence Summers, "Fiscal policy in a depressed economy", presented at the Brookings Panel on Economic Activity, March 2012.
Machin, Steve and Alan Manning (1999), "The causes and consequences of long term unemployment in Europe", Handbook of Labour Economics, Vol. 3.
Manning, Alan (1993), "Wage bargaining and the Phillips curve: the identification and specification of aggregate wage equations", Economic Journal, 103(416):98-118.
Nickell, Steve (1987), "Why is wage inflation in Britain so high?", Oxford Bulletin of Economics and Statistics, 49(1):103-128.