The potential positive and negative effects of fiscal stimulus in light of the UK’s fragile economic recovery.

The UK’s emergence from recession has been said to be a “fragile recovery”, bringing fiscal policy under great scrutiny as economists analyse how to strengthen and quicken the pace of our recovery.

During a recession, there is a direct effect of a decreased spending from consumers who have lost their jobs or have become more cautious because of job insecurity. The unintended consequence is that companies reduce production to adapt to the reduced demand, which, in turn, may lead to further job losses, thus creating a self-perpetuating recession. The attempt to break this cycle is the rationale for government intervention: the government can compensate for individuals not spending by increasing its own spending. This would help to sustain demand in production and help to secure or create jobs with subsequently increased consumer spending. Consequently, businesses will respond to this rise in demand by investing and further increasing output. If individuals spend a significant proportion of their income in the economy, the government will have higher tax revenues, which can be used to pay for the increase in government spending, and means they will have less debt to pay off in the future. This is popularly known as “growing our way out of a recession”.

The key to the government’s success will depend on the type of spending. Successful fiscal stimulus packages such as the American Recovery and Reinvestment Act have been based on a combination of tax cuts and investment in infrastructure. Tax cuts will be most effective if they are directed at poorer individuals who are most hit by recession, as they will be the most likely to spend their tax credits or unemployment benefits within the economy and thus help to stimulate growth. Investment in infrastructure is also effective because governments are able to take advantage of the reduced costs brought about by a recession. This means that they can make more investments for a given amount of spending and will not only stimulate the economy, but investments in science and technology will make the economy more productive in the long run.

However, the effect of an increase in government spending may be mitigated by the rise in the interest rate. The government will not raise taxes to fund its extra spending because this would decrease the individual’s disposable income and further discourage spending. Instead, it will borrow from the public by selling government bonds, i.e. a fixed term interest paying loan from individuals to the government. A rise in government borrowing will then cause a rise in the supply of bonds in the bond market. This causes an excess supply of bonds and thus the central bank will need to increase the interest rate to attract individuals to purchase these bonds. This rise in the interest rate not only increases the return on government bonds but also increases the cost of borrowing from credit cards, mortgages and overdrafts. In turn this discourages individuals from spending and as a result the rise in output from increased government spending will be completely offset by a reduction in investment and consumer spending. This is referred to as “crowding out”.

However empirical evidence shows that this effect does not render fiscal policy useless, for example, the recent American Recovery and Reinvestment Act in 2009, worth $800 billion, was found to have raised GDP growth by two to three percentage points between April and June 2009.

A stimulus package should be most effective the earlier in a recession it is implemented. Therefore any delays in the implementation of fiscal policies need to be minimised. However the process of planning and implementing a package is not trivial: the government must first assess the severity of the deviation in output through data collection and decide whether to take action. Then, any significant changes in fiscal policy must be planned in advance and require time for approval through political processes. Next, there is a delay in the effect of the implemented changes. Individuals will then have to plan their own consumer spending and investment decisions in response to the increase in government spending. This protracted process of course means that by the time fiscal policy begins to take effect the recession may have ended and the rise in government spending could have a destabilising effect on the economy.

Another problem associated with increasing government spending is having to pay off the debt when the recession has ended. This will occur through increased taxes or decreased spending with reduced provision of public services. This would lead to a fall in disposable income and job losses will be inevitable, which could in turn cause another recession. This is a danger the UK currently faces; we are undergoing a “fragile recovery” from the recent recession and if the government decreases spending too early, there is a likelihood that the UK may descend back into recession.

However, a stimulus package may not be sustainable for long periods of time because of the associated costs. A high level of government debt could lead to concerns about the ability to repay, which would discourage individuals from purchasing bonds in the future. This means that when the government tries to sell bonds in the future, the interest rate must be sufficiently high in order to attract individuals; a proportion of prospective investors may feel that the government may default on its debt and hence view the bonds as a risky investment. The net result being that the second set of bond sales will leave the government facing higher interest payments and further increases the debt. This is a problem that Greece is currently facing; after years of borrowing, debt levels in Greece have reached a very high level compared to GDP. This has caused a rise in the country’s interest rate and the costs of borrowing have mounted.

The country was in a position where additional borrowing was needed to service existing debts, leading to the current bail out by the IMF and Eurozone partners.

While the risk of increased costs of borrowing from money markets as a consequence of excess government spending is a general one, it must be noted that Greece arrived in this situation due to profligate spending, for example excessive rises in public sector wages, and not as a result of a stimulus package. It is unlikely that this would happen to relatively stable economies such as the UK. Therefore there is still a compelling argument to increase government spending during a recession, providing this is done in a controlled and targeted fashion.

Due to the weaknesses associated with using government spending to spur a recovery during a recession, some economists favour monetary policy, which involves using the interest rate to revive the economy. The Bank of England has cut interest rates to a historically low rate of 0.5% to stimulate investment and consumption. This has an immediate effect and does not leave the government with debt. In fact, since the early 1990s the UK has predominantly used the interest rate to stabilise the economy because it can be changed rapidly and the economy is usually responsive to changes in the interest rate. However interest rates cannot go below zero and during the previous recession the banks were not passing on low interest rates to consumers. They continued lending at higher rates, which meant individuals did not want to take out loans and output did not increase. Even if rates are being passed on, if individuals believe that the economy will remain in recession for the near future, they will be reluctant to spend.

In conclusion, there are strong arguments both for and against increasing government spending in a recession. The key to effectively dealing with a recession involves a combination of increasing government spending to raise employment, coupled with lowering the interest rate to prevent a fall in interest-sensitive spending. Spending must also be targeted and controlled to reduce the risk of unsustainable debt levels and to seize the opportunity of making productive investments that establish a path for long-run growth.